Variance Swap: Definition Vs. Volatility Swap and How It Works

Summary:

Variance swaps are specialised financial instruments that let investors hedge against or speculate on an underlying asset’s variance. Even though they are like volatility swaps, there are inherent differences. This blog will outline what variance swaps are and how they differ from volatility swaps.

A variance swap is a financial derivative instrument that lets investors hedge against or speculate on an underlying asset's variance. The underlying asset, in this case, can be a commodity, currency exchange rate, or stock index. In financial markets, variance swaps are commonly used to gain exposure to volatility without having to engage in asset trading directly.

A volatility swap, on the other hand, enables investors to hedge against or speculate on the future volatility of an underlying asset. Unlike other financial derivatives that hinge on the price of the underlying asset, volatility swaps are based on expected or implied volatility.

Even though they are similar in several aspects, there are key differences in terms of underlying components and payoffs. But let us first explore the components and key characteristics of variance swaps to understand the differences better.

Understanding variance swaps

Primarily, investors who are looking to manage volatility exposure in their portfolios are the ones using variance swaps. While traders who anticipate reduced volatility may take short positions in their variance swaps, traders anticipating increased levels of market volatility tend to take longer positions. To understand how variance swap works, you need to understand its inherent components, including:

• Underlying Asset: The value of a variance swap hinges on the underlying asset’s realised variance over a specific period. Any asset with measurable price fluctuations such as a currency pair or a stock index can be used as the underlying asset.
• Realised Variance: Variance represents the square of the daily returns of an asset. Over a specific timeframe, it measures the amount of deviation an asset’s price experiences from its average return. The realised variance is thus calculated by averaging the squared daily returns.
• Strike Variance: The strike variance is also called the reference variance of the variance swap. It’s a predetermined and agreed-upon level of variance when the swap is entered. When you are comparing the expected or strike variance to the realised variance, the strike variance is used as a benchmark.
• Payoff: You can arrive at the payoff of a variance swap by subtracting the realised variance from the strike variance and multiplying it with a pre-specified contract multiplier. As an investor, you can expect a positive payoff if the strike variance is lower than the realised variance. If, however, the strike variance is higher, you must pay the counterparty.
• Contract Size: A contract might specify that the investor has a chance to receive or pay a fixed amount for every point of variance above the strike variance. This is because variance swaps are typically traded in standardised contract sizes.
• Settlement: Variance swaps do not need the underlying asset to be physically delivered and can be settled by cash. This means that based on the difference between the realised and strike variances, the investor and the counterparty can exchange the payments.
• Maturity: The realised variance for variance swaps is calculated and the final payment is made on a predetermined maturity date. The maturity can be one month, three months, one year, or other time frames.

Differences between variance and volatility swaps

Conclusion

As sophisticated financial instruments, variance swaps are traded where customised contracts are negotiated between counterparties, typically in over the counter (OTC) markets. Investors and traders must have a good understanding of options pricing and financial derivatives before engaging in variance swap transactions due to their inherent complexity. Before trading, consulting a financial advisor to further your understanding is highly recommended.