What are Variance Swaps? Financial Derivatives - Trading Volatility

In todays video we learn about variance swaps

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.

A variance swap is a forward contract with a payoff based on the realized variance of the underlying asset. Variance swaps settle in cash based on the difference between the realized variance and the variance strike

Similar to a regular swap, one of the two parties involved in the 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 start to make the net present value of the payoff zero.

At the end of the contract, the net payoff to the counterparties will be the notional amount multiplied by the difference between the variance and the strike variance, 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 the 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.

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.

There are two main classes of users for variance swaps.

Speculators use these swaps to speculate on the future level of volatility for an asset.

Hedgers use variance swaps to cover short volatility positions.

[vgrooveman]

Very awesome. Best channel period. Examples of how this information is used by all types of traders in the market would been golden.

[MoayyadYaghi]

Aside from your bow tie 😁. This vid is perfect and direct to the point.

[SusieAspen]

Only you can make that bow-tie look very stylish.

[anny]

Absolutely great video, thank you! Just ordered the book, I hope is as good as the videos

[jondoe]

Could a market maker use a variance swap portfolio to generate additional income if they are capable of fixing the underlying to a desired strike price? For example, manipulate a stock to $100/share and build a variance swap portfolio built upon the stock being there?

[claytonestey]

Hi Patrick. I wanted to clarify a concept with you about the static replication of VIX squared for buy/hold long vol hedging strategy because I'm getting an unintuitive answer elsewhere In portfoliovisualizer I found a preliminary Sharpe portfolio with VTSMX=85% and ^VIX=15% from 1992-Present month-to-month with Mean=13.7% SD=9.9% compared to just VTSMX=100% at Mean=11.3% SD=15%.

If back in 1992 I recreated VIX squared using its definition as you described it (weighted calls/puts), and continuously bought into it is that the same thing as someone buying into square of ^VIX? If not, what are the differences that would limit such a strategy in real life? You touched on underlying price moving beyond available strikes. Are there other things like time decay, etc.?

I was told that merely recreating VIX squared like above is not the same as replicating the month-to-month returns of squared VIX index. I thought it replicated the payout. How is that not the same?

[joejoeh]

Hey Patrick, I got your book and I’m really interested in volatility strategies. Can you msg me to chat?