Introduction

In the world of financial derivatives, volatility and variance swaps have gained prominence as essential tools for managing and trading volatility risk. These swaps offer investors unique ways to speculate on or hedge against changes in market volatility. In this chapter, we will delve into the concepts of volatility and variance swaps, explaining their mechanics, applications, and key differences.

Volatility Swaps

Volatility swaps provide a way for traders and investors to take a position on future implied volatility levels without directly trading options or futures contracts. A volatility swap involves two parties: the volatility buyer and the volatility seller. The buyer agrees to pay the seller a predetermined fixed volatility rate, while the seller agrees to pay the actual realized volatility at the expiration of the contract.

The mechanics of a volatility swap can be illustrated through an example: Suppose Trader A believes that the market’s implied volatility is overstated and will decrease over the next three months. Trader A enters into a volatility swap agreement with Trader B. If the implied volatility decreases more than anticipated, Trader A will profit as they locked in a fixed rate that is higher than the realized volatility.

Variance Swaps

Variance swaps are closely related to volatility swaps, but instead of focusing on implied and realized volatilities, they center around the squared returns of an underlying asset. Variance swaps allow traders to bet on the magnitude of price movements rather than the direction.

The formula to calculate the payoff of a variance swap is the difference between the realized variance and a predetermined strike variance. If the realized variance is greater than the strike, the buyer of the variance swap receives a positive payoff, and if it’s lower, the buyer pays the difference.

Comparing Volatility and Variance Swaps

While both volatility and variance swaps provide exposure to market volatility, they differ in their underlying mechanics and applications. Volatility swaps focus on the actual volatility level, which can be directly tied to options’ implied volatilities. On the other hand, variance swaps concentrate on the squared returns, offering a way to hedge portfolio risk more directly.

Another key distinction lies in the volatility term structure. Volatility swaps are typically sensitive to the term structure, whereas variance swaps are more dependent on the overall level of volatility rather than its term structure.