Variance Swap
A variance swap is a financial derivative that allows two parties to exchange the difference between the realized volatility of an asset and its anticipated volatility over a specified period. The settlement of a variance swap is based on the difference between the actual variance (or volatility) of the underlying asset over the swap period and the variance level agreed upon at the inception of the swap. Variance swaps are commonly used for hedging or speculating on volatility risk.
Definition: A variance swap is a financial derivative that allows two parties to exchange the difference between the future realized volatility of an asset and its expected volatility. The settlement of a variance swap is based on the difference between the realized variance (or volatility) of the underlying asset over a period and the predetermined variance level. Variance swaps are commonly used for hedging or speculating on volatility risk.
Origin: The concept of variance swaps originated in the 1990s, as the demand for volatility management in financial markets increased. The earliest variance swap transactions appeared in the late 1990s, primarily used by hedge funds and institutional investors to manage and hedge volatility risk.
Categories and Characteristics: Variance swaps are mainly divided into two categories: 1. Standard Variance Swaps: Settled based on the difference between the realized volatility and the expected volatility of the underlying asset. 2. Volatility Swaps: Similar to variance swaps but settled based on volatility rather than variance. The main characteristics of variance swaps include:
- Hedging Volatility Risk: Investors can hedge the volatility risk of the underlying asset through variance swaps.
- Speculative Opportunities: Traders can use variance swaps to speculate on changes in expected volatility.
- No Directional Risk: The payoff of a variance swap is independent of the direction of the underlying asset's price, only related to volatility.
Specific Cases: Case 1: Suppose Investor A expects the volatility of a certain stock to increase, while Investor B expects the volatility to decrease. A and B enter into a variance swap agreement with a predetermined variance level of 20%. If the actual volatility is 25%, A will receive compensation from B because the actual volatility is higher than expected. Case 2: A hedge fund uses variance swaps to hedge the volatility risk in its investment portfolio. The fund manager expects market volatility to rise, so they lock in the current low volatility level through a variance swap to avoid losses from future volatility increases.
Common Questions: 1. What is the difference between a variance swap and a volatility swap? Variance swaps are settled based on variance, while volatility swaps are settled based on volatility. 2. What are the main risks of variance swaps? The main risks include model risk, market risk, and liquidity risk. 3. How is the settlement amount of a variance swap calculated? The settlement amount is typically based on the difference between the realized variance and the agreed variance, multiplied by the notional amount.
