Definition
A Variance Swap is a financial derivative contract that allows one to hedge against or speculate on the variability of an underlying asset’s price. The contract enables the investor to trade future realized (or historical) volatility against current implied volatility. In other words, the investor is betting on the future volatility of an asset being higher or lower than the market’s current expectations.
Key Takeaways
- Variance Swap is a type of derivative product used by investors to speculate or hedge against future volatility levels in the market. It allows investors to trade the difference between the actual and forecasted variance of an asset’s price.
- Unlike standard options and futures contracts, variance swaps are not influenced by the direction of the asset’s price movement, therefore it gives a pure exposure to the volatility without any directional risk.
- Variance Swaps are often used by hedge funds and large financial institutions. They are inherently risky products and typically recommended for advanced, sophisticated investors. Hence, understanding the mathematical calculations and risk implications is crucial before entering into such deals.
Importance
A Variance Swap is a financial instrument that allows investors to speculate on or hedge risks associated with the magnitude of movement, i.e., volatility, of some underlying product, such as an exchange rate, interest rate, or stock index.
It is important because it offers direct exposure to the volatility of the underlying asset, removing the skew risk in volatility trading.
Moreover, variance swaps are more straightforward to price and understand than volatility swaps, making them a preferred choice for many traders and investors.
By allowing them to speculate on future levels of volatility, these tools provide a vital means to mitigate risk, making them an essential component in comprehensive financial strategies.
Explanation
A variance swap is a specialized financial instrument that allows investors to speculate or hedge against future volatility. The purpose of this derivative is to isolate and trade the variance or volatility of an underlying asset, such as a stock, interest rate, or exchange rate, without direct exposure to the asset itself.
The value of a variance swap relies upon the difference between realized and implied variances, with the buyer betting that the actual variance will surpass the one initially forecasted/expected at the start of the contract. Thus, it serves as a risk management tool for investors to forecast and speculate on the magnitude of changes in markets.
Variance swaps come handy when an investor wishes to gain exposure to the volatility of an underlying asset, without having a directional bias. For instance, a fund might use a variance swap to hedge against potential equity market volatility.
Meanwhile, market makers might use it to manage their inventory of options, as the instrument helps them estimate how much an option’s value changes with fluctuations in volatility. Therefore, the application of variance swaps helps market agents and participants mitigate certain risks and potentially profit from the uncertainties of market fluctuations.
Examples of Variance Swap
Risk Management: Financial institutions use variance swaps to manage their risk exposure. For example, if a bank has a significant amount of variance risk in its portfolio due to diverse investments, it might enter into a variance swap agreement to mitigate this risk. Under the agreement, the bank would make a payment based on the realized volatility of the underlying asset, and in return, it would receive a payment based on a pre-determined fixed level of variance. This helps limit the institution’s variance risk, as any loss connected to additional variance of its investments beyond the predetermined level would be neutralized by the variance swap payment.
Stock Market Investment: An investor thinks that the market is underestimating the future volatility of a particular stock. To profit from this prediction, the investor can enter into a variance swap where he pays a fixed rate and would receive a payment if the stock’s volatility is higher than expected. If the stock’s volatility indeed turns out to be higher, the investor would make a profit from the swap.
Pension Funds: Pension funds often require predictable returns to meet their obligations to beneficiaries. They may use variance swaps to hedge against the volatility of their portfolio’s returns. By entering into a variance swap, the pension fund can receive a payment if the volatility of its portfolio’s returns exceeds a predefined level, effectively insuring against an unexpected increase in portfolio volatility.
Frequently Asked Questions: Variance Swap
What is a Variance Swap?
A Variance Swap is a type of volatility derivative contract that allows investors to gain exposure to the volatility of an underlying instrument, such as a stock index, without having to directly trade options or other volatility instruments. It’s an over-the-counter financial derivative that takes advantage of the difference between the realized variance of a financial asset and a set level of variance agreed upon in the contract.
How does a Variance Swap work?
In a Variance Swap, two parties agree to exchange payments based on the difference between the realized variance and the strike variance agreed upon in the swap contract. If the realized variance is greater than the strike variance, the seller pays the difference to the buyer. If the realized variance is less than the strike variance, the buyer pays the difference to the seller.
What are the risks involved in a Variance Swap?
The primary risk in a Variance Swap is price risk, as the payments depend on the volatility of the underlying asset. If the volatility is less than the strike variance, the buyer must pay the difference, which could be significant if the asset’s price moves considerably. Counterparty risk is also a factor, as the swap is an OTC contract and depends on the other party fulfilling their obligations.
What are the benefits of a Variance Swap?
A Variance Swap allows investors to hedge against or speculate on the volatility of an underlying asset without having to trade the asset directly. It also provides pure exposure to volatility, since it is not affected by the price movements of the underlying asset. It can be a useful tool for portfolio diversification and risk management.
Related Entrepreneurship Terms
- Volatility: This refers to the degree of variation of a financial instrument’s price over time. In variance swaps, volatility plays a significant role as it refers to the underlying asset’s unpredictability.
- Derivative: A variance swap is a type of derivative, which is a financial contract whose value depends on, or derived from, an underlying asset.
- Swap Contract: These are derivative contracts through which two parties exchange financial instruments. Variance swaps are a type of swap contract.
- Standard Deviation: It measures the amount of variability or dispersion for a subject set of data from the mean, using in calculating variance in a variance swap.
- Underlying Asset: This refers to the financial instrument (for example, stocks, bonds, commodities, currencies, interest rates, market indices) upon which a derivative’s price is based. In a variance swap, the returns of the underlying asset are crucial.
Sources for More Information
Sure, here are some helpful sources to learn more about Variance Swap:
- Investopedia: A reliable source of information on a broad range of financial topics, including Variance Swaps.
- Risk.net: A comprehensive resource for professionals working in the areas of risk management, derivatives and regulation.
- CME Group: This is an online platform that provides a trading marketplace. They showcase definitions and detailed explanations about various financial terms, including Variance Swap.
- QuantStart: A good source for understanding the quantitative finance concept such as Variance Swap.
