What Is a Variance Swap?
Let me explain what a variance swap is: it's a financial derivative you can use to hedge or speculate on how much the price of an underlying asset moves. These assets might be exchange rates, interest rates, or the price of an index. Simply put, variance measures the difference between what you expected and what actually happened.
You'll notice a variance swap is a lot like a volatility swap, but it deals with realized volatility in terms of variance instead.
Key Takeaways
- A variance swap is a derivative contract where two parties exchange payments based on the underlying asset's price changes, or volatility.
- Directional traders use variance trades to speculate on future levels of volatility for an asset, spread traders use them to bet on the difference between realized volatility and implied volatility, and hedge traders use swaps to cover short volatility positions.
- If realized volatility is more significant than the strike, then payoffs at maturity are positive.
How a Variance Swap Works
Just like a plain vanilla swap, in a variance swap, one party pays based on the actual variance of the underlying asset's price changes. The other pays a fixed amount, the strike, which we set at the beginning. We typically set that strike so the net present value of the payoff starts at zero.
At the contract's end, the net payoff is a theoretical amount times the difference between the variance and a fixed volatility level, all settled in cash. If there are margin requirements, you might see some payments during the contract if the value goes beyond limits.
Mathematically, variance is the arithmetic average of squared differences from the mean. The square root gives you standard deviation. That's why a variance swap pays out more than a volatility swap—it's based on variance, not deviation.
A variance swap gives you a pure play on the asset's volatility. Options let you speculate on volatility too, but they come with directional risk and depend on time, expiration, and implied volatility. You'd need extra hedging for an equivalent options strategy. Plus, variance swaps are cheaper since an options equivalent requires a strip of options.
There are three main types of users for these swaps. Directional traders speculate on future volatility levels. Spread traders bet on the gap between realized and implied volatility. Hedgers cover their short volatility positions.
Additional Variance Swap Characteristics
Variance swaps work well for speculating or hedging on volatility. Unlike options, they don't need extra hedging—no delta-hedging required. If you're long on the swap and realized volatility beats the strike, your payoff at maturity is always positive.
As a buyer or seller, you should know that big jumps in the underlying asset's price can skew the variance and lead to unexpected results.
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