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

What Is a Variance Swap?

A variance swap is a financial derivative used to hedge or speculate on the magnitude of a price movement of an underlying asset. These assets include exchange rates, interest rates, or the price of an index. In plain language, the variance is the difference between an expected result and the actual result.

A variance swap is quite similar to a volatility swap, which utilizes realized volatility instead of variance.

How a Variance Swap Works

Similar to a plain vanilla swap, one of the two parties involved in a var swap transaction will pay an amount based upon the actual variance of price changes of the underlying asset. The other party will pay a fixed amount, called the strike, specified at the start of the contract. The strike is typically set at the onset to make the net present value (NPV) of the payoff zero.

At the end of the contract, the net payoff to the counterparties will be a theoretical amount multiplied by the difference between the variance and a fixed amount of volatility, settled in cash. Due to any margin requirements specified in the contract, some payments may occur during the life of the contract should the contract's value move beyond agreed limits.

The variance swap, in mathematical terms, is the arithmetic average of the squared differences from the mean value. The square root of the variance is the standard deviation. Because of this, a variance swap's payout will be larger than that of a volatility swap, as the basis of these products is at variance rather than the standard deviation.

A variance swap is a pure-play on an underlying asset's volatility. Options also give an investor the possibility to speculate on an asset's volatility. But options carry directional risk and their prices depend on many factors, including time, expiration, and implied volatility. Therefore, the equivalent options strategy requires additional risk hedging to complete. Variance swaps are also cheaper to put on since the equivalent of an option involves a strip of options.

There are three main classes of users for variance swaps.

1. Directional traders use these swaps to speculate on the future level of volatility for an asset.
2. Spread traders merely bet on the difference between realized volatility and implied volatility.
3. Hedger traders use swaps to cover short volatility positions.

Additional Variance Swap Characteristics

Variance swaps are well suited for speculation or hedging on volatility. Unlike options, variance swaps do not require additional hedging. Options may require delta-hedging. Also, the payoff at maturity to the long holder of the variance swap is always positive when realized volatility is more significant than the strike.

Buyers and sellers of volatility swaps should know that any significant jumps in the price of the underlying asset can skew the variance and produce unexpected results.