Variance Swap

Definition

A Variance Swap is a financial derivative that allows investors to speculate on the magnitude of price movements of an underlying asset without needing to predict the direction of these movements. Essentially, it’s like putting your money where your volatility is! In more formal terms, a variance swap is a contract where two parties agree to exchange payments based on the variance (the square of volatility) of the price changes of an underlying asset — be it exchange rates, interest rates, or indices.

Variance Swap vs. Volatility Swap Comparison

How a Variance Swap Works

A variance swap acts like a wager on the market’s tantrums. If investors believe the price of an underlying asset (like stocks or currencies) will swing wildly off-course, they might bet on that volatility.

1. Contract Initiation: Two parties agree on a formal contract that specifies terms, including strike variance and notional amounts.
2. Settling Time: At expiration, the variance swap will settle based on the difference between the realized variance of the underlying asset’s returns and the agreed-upon strike variance.
3. Payoff: If the realized variance is above the strike variance, the buyer profits; if it’s below, the seller of the variance swap takes the payout.

Example

Imagine you’ve bet with your buddy over a fun game of “How many wild swings my stock can take this week?” If the realized variance climbs above your pre-decided level, you cash in and claim your winnings!

Related Terms

• Volatility: The extent of price fluctuations, typically expressed as a percentage. A rollercoaster for your assets!
• Implied Volatility: The market’s forecast of a likely movement in asset price, often reflecting trader sentiment and expected future volatility.

    graph LR
	A[Variance Swap] --> B[Contract Initiation]
	B --> C[Settling Time]
	C --> D[Payoff]
	D --> E{Realized Variance}
	E -->|High| F[Profit]
	E -->|Low| G[Loss]

Fun Facts

• The concept of variance swaps originated from the options trading desk but left its high heels to dance in the world of structured products. It’s not just high fashion but high finance!
• Variance trading became popular among hedge funds in the 2000s as markets became increasingly “volatile” (a.k.a. crazy roller coaster rides).
• A famous trader once quipped, “I would rather bet on volatility than lose sleep over trying to predict the market’s mood swings!” On second thought, he was probably just losing that bet too.

Frequently Asked Questions

1. What is the main advantage of variance swaps?

   • They allow traders to express views on expected volatility without trading the underlying asset itself, thereby reducing directional risk.

2. Are variance swaps for everyone?

   • Not quite! They can be complex and risky, best suited for professional traders and institutions who have experience in derivatives.

3. How can I profit from variance swaps?

   • You profit when the realized variance exceeds the strike variance at expiration. Watch for rollercoaster rides in the market!

4. What markets can variance swaps be based on?

   • Any market! They can be based on equities, commodities, fixed income, and currencies — it’s a volatility buffet!

5. Can variance swaps hedge other positions?

   • Absolutely! They are often employed to hedge against unwanted exposure to volatility.

Suggested Resources

• Books:

  • “Options as a Strategic Investment” by Lawrence G. McMillan - A fantastic resource for understanding derivative strategies.
  • “Volatility Trading” by Euan Sinclair - Focuses on the intricacies of volatility trading.

• Online Resources:

  • Investopedia on Variance Swaps
  • CME Group’s Guide to Variance Swaps

Test Your Knowledge: Variance Swap Quiz

Thank you for exploring variance swaps with us! Remember, in the volatile world of finance, it’s better to be rollercoaster-ready than to be stuck on a merry-go-round.