Variance swap
Posté le 22-Apr-2011 par Raisepartner

A variance swap is an derivative used to trade future realized (or historical) volatility against current implied volatility. One counterparty pays a forward (fixed) variance in exchange for a future, realized variance. This counterparty is "long volatility" and will benefit if the realized variance is greater than expected.
The return of a variance swap depends directly on the difference between realized and implied volatility.

Variance swaps offer a simple way to make a pure bet on volatility. Indeed, speculating on the volatility alone with call and put options would require constant delta-hedging to get rid of the directional risk of the underlying asset.

The variance swap is preferred to the volatility swap in the equity market because it can be replicated with a linear combination of options and a dynamic position in futures.

Another nice property of the variance swap is the convexity (in volatility) of its payoff function:



This means that an investor who is long a variance swap benefits from asymetric returns (larger gains and smaller losses). A consequence of this asymetry is the slightly higher strike than the ‘fair’ volatility. This phenomenon amplifies when the volatility skew gets steeper.