Variance Swap

From binaryoption
Jump to navigation Jump to search
Баннер1
  1. Variance Swap

A variance swap is a financial derivative contract that allows investors to trade the *implied volatility* of an underlying asset, typically a stock index, without directly trading the asset itself. It's a powerful tool for expressing a view on future volatility, and unlike options, it provides exposure to realized variance (the square of realized volatility) rather than price direction. This article will delve into the mechanics of variance swaps, their pricing, uses, advantages, disadvantages, and how they compare to other volatility products. It's geared towards beginners, assuming limited prior knowledge of derivatives.

Understanding Volatility: The Foundation

Before we dive into variance swaps, it's crucial to understand the concept of volatility. In finance, volatility refers to the degree of variation of a trading price series over time. High volatility means the price can change dramatically over a short period, while low volatility indicates more stable prices.

There are two main types of volatility:

  • Historical Volatility (Realized Volatility): This measures the actual price fluctuations that *have already occurred* over a specific period. It's calculated using past price data. Methods for calculating historical volatility include standard deviation of returns.
  • Implied Volatility (IV): This is derived from the market prices of options contracts. It represents the market’s expectation of future volatility. It's the volatility input that, when used in an option pricing model (like Black-Scholes model), yields the current market price of the option. Higher option prices generally suggest higher implied volatility, and vice versa. Greeks are particularly important for understanding implied volatility changes.

Variance swaps trade on *realized variance* – the square of realized volatility. This is a key distinction. Volatility is measured in percentage terms, while variance is measured in percentage squared. Squaring the volatility magnifies the effect of large price swings.

How Variance Swaps Work

A variance swap is an over-the-counter (OTC) derivative, meaning it’s traded directly between two parties and not on an exchange (though some exchange-traded variance swaps are emerging). It's essentially an agreement to exchange a fixed payment (the variance premium) for a variable payment based on the difference between realized variance and a strike variance.

Here’s a breakdown of the key components:

  • Notional Amount: This is a predetermined amount of money used to scale the payments. It doesn’t change hands; it’s simply used to calculate the payoff.
  • Strike Variance (K): This is the agreed-upon level of variance. It represents the market’s expectation of the average variance over the life of the swap. Determining the strike variance is a crucial aspect of pricing, often based on implied volatility.
  • Realized Variance (σ²): This is the actual average of the squared returns of the underlying asset over the life of the swap. It's calculated using the daily returns of the asset. Time series analysis is often used to calculate realized variance.
  • Variance Premium: This is the fixed payment made by the buyer of the variance swap to the seller. It’s determined at the outset of the contract.
  • Payoff: The payoff at the end of the swap is calculated as:
   `Payoff = Notional Amount * (Realized Variance – Strike Variance)`
   *   If Realized Variance > Strike Variance: The buyer of the variance swap receives a payment from the seller. The buyer profited because actual volatility was higher than expected.
   *   If Realized Variance < Strike Variance: The buyer of the variance swap makes a payment to the seller. The buyer lost money because actual volatility was lower than expected.

A Simple Example

Let’s say an investor believes the S&P 500 index will experience higher-than-expected volatility over the next three months. They enter into a variance swap with the following terms:

  • Notional Amount: $1,000,000
  • Strike Variance: 0.01 (equivalent to an implied volatility of roughly 10% annually)
  • Term: 3 months

At the end of the three months, the realized variance of the S&P 500 is calculated to be 0.015.

Payoff = $1,000,000 * (0.015 – 0.01) = $5,000

The buyer of the variance swap receives $5,000 from the seller. They were correct in their assessment that volatility would rise.

If, instead, the realized variance was 0.008, the payoff would be:

Payoff = $1,000,000 * (0.008 – 0.01) = -$2,000

The buyer would pay $2,000 to the seller.

Pricing Variance Swaps

Pricing variance swaps is more complex than pricing simple options. It involves several factors, including:

  • Strike Variance Selection: The strike variance is usually determined based on the current implied volatility of options on the underlying asset. A common approach is to use the average implied volatility of options with different strike prices and maturities. Volatility Smile and Volatility Skew are important concepts here.
  • Discounting: Future cash flows (the payoff) need to be discounted back to their present value using an appropriate discount rate.
  • Volatility Risk Premium: This represents the difference between the implied variance (derived from option prices) and the expected realized variance. It reflects the market’s willingness to pay a premium for protection against volatility increases. The Variance Risk Premium is a critical component.
  • Jump Diffusion Models: More sophisticated pricing models, like those incorporating jump diffusion, consider the possibility of sudden, large price movements. Stochastic calculus is used in developing these models.
  • Volatility Surface Construction: Creating an accurate volatility surface is vital for determining the appropriate strike variance.

The basic pricing formula can be expressed as:

`Variance Swap Price = Notional Amount * (K - Expected Realized Variance)`

Where 'K' is the Strike Variance.

Uses of Variance Swaps

Variance swaps serve several purposes for different types of investors:

  • Hedging Volatility Risk: Portfolio managers can use variance swaps to hedge against unexpected increases in market volatility. For example, a fund manager holding a large equity portfolio might buy a variance swap to protect against a market crash. Portfolio diversification alone may not be enough.
  • Speculating on Volatility: Traders can use variance swaps to profit from their views on future volatility. If they believe volatility will increase, they can buy a variance swap. If they believe volatility will decrease, they can sell a variance swap.
  • Arbitrage: Opportunities may arise when there are discrepancies between the price of variance swaps and the prices of options. Arbitrageurs can exploit these differences to earn a risk-free profit.
  • Volatility Trading Strategies: Variance swaps are a core component of many sophisticated volatility trading strategies, such as straddles, strangles, and condors.
  • Asset Allocation: Understanding the volatility landscape, as revealed by variance swaps, can inform asset allocation decisions.

Advantages of Variance Swaps

  • Pure Volatility Exposure: Variance swaps provide a pure play on volatility, without being affected by the direction of the underlying asset.
  • Leverage: The notional amount allows investors to gain leveraged exposure to volatility.
  • Flexibility: Variance swaps can be customized to match specific volatility views and risk profiles.
  • Lower Transaction Costs (Potentially): Compared to replicating the same exposure using options, variance swaps can sometimes have lower transaction costs, especially for large positions.
  • No Gamma Risk: Unlike options, variance swaps do not suffer from gamma risk (the rate of change of delta). This simplifies risk management.

Disadvantages of Variance Swaps

  • Complexity: Variance swaps are complex instruments that require a good understanding of volatility and derivatives.
  • Illiquidity: Being OTC instruments, variance swaps can be less liquid than exchange-traded options. Finding a counterparty can be challenging.
  • Counterparty Risk: Since they are OTC contracts, variance swaps are subject to counterparty credit risk – the risk that the other party will default on their obligations.
  • Model Risk: Pricing variance swaps relies on complex models, which are subject to model risk – the risk that the model is inaccurate.
  • Realized Variance Calculation: Accurately calculating realized variance can be challenging, especially during periods of market stress. The choice of calculation methodology can impact the payoff.
  • Volatility Surface Risk: Changes in the shape of the volatility surface can affect the value of a variance swap.

Variance Swaps vs. Other Volatility Products

  • Variance Swaps vs. Options: Options provide exposure to both volatility and price direction. Variance swaps provide pure volatility exposure. Options are path-dependent (their payoff depends on the path of the underlying asset), while variance swaps are path-independent (their payoff depends only on the realized variance).
  • Variance Swaps vs. Volatility ETFs (e.g., VXX): Volatility ETFs track the VIX index (a measure of implied volatility). Variance swaps offer a more direct and customizable way to trade volatility. VIX ETFs are often negatively correlated with the stock market, while variance swaps can be used to hedge specific volatility exposures.
  • Variance Swaps vs. Volatility-Indexed Bonds: These bonds offer some exposure to volatility, but it's typically limited and embedded within the bond structure. Variance swaps provide more targeted and leveraged volatility exposure.
  • Variance Swaps vs. Forward Variance Contracts: Forward variance contracts are similar to variance swaps but typically have shorter maturities. Variance swaps are generally used for longer-term volatility trading.

Risk Management Considerations

  • Delta Hedging (Not Applicable): Unlike options, variance swaps do not have a delta, so delta hedging is not relevant.
  • Vega Risk: Variance swaps are highly sensitive to changes in implied volatility (vega risk).
  • Theta Risk: Variance swaps are subject to time decay (theta risk), as the time to expiration decreases.
  • Stress Testing: It’s essential to stress test variance swap positions under various market scenarios to assess potential losses.
  • Counterparty Credit Risk Management: Thoroughly assess the creditworthiness of the counterparty.
  • Monitoring Realized Variance: Continuously monitor realized variance to track the performance of the swap. Risk management tools are valuable here.

Real-World Applications and Examples

  • A hedge fund using variance swaps to express a bearish view on the stock market without taking a direct short position.
  • An insurance company using variance swaps to hedge the volatility risk associated with its variable annuity products.
  • A pension fund using variance swaps to protect its portfolio against unexpected market downturns.
  • A proprietary trading firm using variance swaps to arbitrage discrepancies between implied and realized volatility.
  • A corporate treasurer using variance swaps to hedge the volatility risk associated with future earnings.

Further Learning Resources

Start Trading Now

Sign up at IQ Option (Minimum deposit $10) Open an account at Pocket Option (Minimum deposit $5)

Join Our Community

Subscribe to our Telegram channel @strategybin to receive: ✓ Daily trading signals ✓ Exclusive strategy analysis ✓ Market trend alerts ✓ Educational materials for beginners

Баннер