Variance Swap
A variance swap is a type of financial derivative that allows investors to bet on the volatility of an underlying asset. In essence, it is a contract that enables the buyer to receive a fixed amount of cash if the realized variance of the underlying asset over a specific period of time is greater than or less than a pre-determined level.
The underlying asset for a variance swap can be almost anything that has measurable variance, including stocks, indices, commodities, or currencies. For instance, an investor may choose to buy a variance swap on the S&P 500 index, betting that the realized variance of the index over a certain period of time will be higher or lower than a predetermined level.
A variance swap is a financial contract that allows investors to bet on the volatility of an underlying asset, such as a stock or index. The payout for a variance swap is based on the difference between the actual variance of the underlying asset over a specified period of time and a pre-determined level of variance.
Let’s say you’re an investor and you want to buy a variance swap on a stock called ABC. The pre-determined level of variance is set at 10%. If the actual variance of ABC’s stock over the specified period is 15%, you would receive a payout of 5% (15% – 10%). Conversely, if the actual variance is only 8%, you would pay the seller the difference of 2% (10% – 8%).
During the lifespan of a variance swap, several events can occur, such as changes in the market volatility, expiration of the contract, or early termination due to default or credit events. There are two types of variance swaps: long variance swaps and short variance swaps. A long variance swap is bought by an investor who believes that the actual variance of the underlying asset will be higher than the pre-determined level, while a short variance swap is sold by an investor who believes that the actual variance will be lower.
The life cycle events on a variance swap include trade execution, confirmation, collateral posting, daily marking-to-market, and settlement. Payments during the life cycle include the initial payment (or premium) paid by the buyer to the seller, as well as any additional payments due to changes in the market volatility over the life of the contract.
For confirmation and settlement, standard SWIFT messages such as MT300, MT303, and MT304 are used, depending on the nature of the transaction and the parties involved.
The valuation of a variance swap is typically done using a mathematical model, such as the Black-Scholes model. The model takes into account several variables, such as the current price of the underlying asset, the strike price, the time to expiration, and the expected volatility. The actual variance of the underlying asset is then compared to the pre-determined level to determine the payout.
The payout for a variance swap is determined by the difference between the actual variance of the underlying asset over the contract period and the pre-determined level of variance. If the realized variance is higher than the pre-determined level, the seller of the swap pays the buyer the difference in cash. Conversely, if the realized variance is lower than the pre-determined level, the buyer pays the seller the difference.
The pricing of a variance swap is based on the market’s expectation of the future volatility of the underlying asset. The buyer of a variance swap is essentially making a bet on whether the realized volatility will be higher or lower than what the market expects. If the market expects the volatility to be higher than the pre-determined level, the price of the variance swap will be higher. Conversely, if the market expects the volatility to be lower, the price of the variance swap will be lower.
One of the key benefits of a variance swap is that it allows investors to hedge against volatility risk. For example, a trader who expects a spike in volatility may buy a variance swap to protect against potential losses. Similarly, a portfolio manager who wants to generate additional returns from a portfolio may sell a variance swap to earn additional income from the implied volatility.
However, variance swaps are not without their drawbacks. One of the main challenges is the difficulty in accurately estimating the future volatility of an underlying asset. This can result in pricing errors, which can lead to significant losses for traders who misjudge the market. Moreover, because the payout for a variance swap is based on the difference between the actual variance and the pre-determined level, there is no guarantee that the payout will be positive, even if the realized variance is higher than expected.
In conclusion, variance swaps are a popular financial derivative that allows investors to bet on the volatility of an underlying asset. They offer traders a way to hedge against volatility risk and generate additional income from portfolio holdings. However, the pricing of a variance swap can be difficult to estimate, and there is no guarantee of a positive payout. As with any financial instrument, investors should carefully consider the risks and benefits before investing in a variance swap.
There are two main types of variance swaps: long variance swaps and short variance swaps.
- Long Variance Swap: A long variance swap is a contract where the buyer pays a premium to the seller in exchange for a payout that is based on the actual variance of the underlying asset being higher than the pre-determined level of variance. This means that the buyer is betting on an increase in market volatility. An example of a long variance swap is an investor who believes that the stock market is going to experience a significant increase in volatility in the coming months. They can purchase a long variance swap to profit from this expected increase in volatility.
- Short Variance Swap: A short variance swap is a contract where the seller receives a premium from the buyer in exchange for a payout that is based on the actual variance of the underlying asset being lower than the pre-determined level of variance. This means that the seller is betting on a decrease in market volatility. An example of a short variance swap is an options trader who expects that the stock market will remain relatively stable over the next few months. They can sell a short variance swap to generate income from the expected low volatility.
Overall, both long and short variance swaps are financial contracts that allow investors to bet on the future volatility of an underlying asset. Investors can choose the type of variance swap that aligns with their market expectations and investment strategies.