## Definition

A variance swap is a financial derivative contract that allows investors to speculate on or hedge risks associated with the magnitude of movement, known as volatility, of some underlying asset, like an exchange rate, stock price, or interest rate. Essentially, it is an over-the-counter financial instrument that allows one to trade future realized price volatility. In a variance swap, the payout is determined by the difference between the realized variance (volatility squared) and a predetermined variance strike price.

### Phonetic

**The phonetics of the keyword “Variance Swap” is: Variance: /ˈveɪrɪəns/Swap: /ˈswɒp/**

## Key Takeaways

- Variance Swap allows exposure to an underlying asset’s volatility: A variance swap is a type of derivative financial contract that enables investors or traders to gain exposure to the volatility of an underlying asset, such as a stock, index, or exchange-traded fund, without having to own the asset. The parties in a variance swap bet on whether the future volatility will be higher or lower compared to a variance strike level at the start of the contract.
- Determined by Variance, not Direction: Unlike vanilla options, the payout in a variance swap is determined by the variance of the asset’s price, not the direction in which the price moves. This makes variance swaps a pure play on an asset’s volatility and is not susceptible to the effects of market direction or drift.
- Often used for Hedging and Speculation: Traders often use variance swaps to hedge against volatility or to speculate on future price fluctuations. For instance, a trader might enter into a variance swap if they anticipate a rise in volatility and want to profit from it. Alternatively, an investor might hedge their long-term positions in volatile securities by entering into a variance swap to mitigate the risk associated with potential upswings in volatility.=

## Importance

A Variance Swap is a significant financial instrument primarily used in hedging or speculating on volatility within financial markets. It permits investors to trade future realized (or historical) volatility against current implied volatility. This is essential as it allows investors to gain direct exposure to an asset’s volatility and isolate pure volatility risk. Variance Swaps are particularly useful as they’re immune to the effects of sudden changes in price, known as ‘jumps’ , making them more accurate in reflecting the true volatility. Understanding how Variance Swaps work can provide key insights into market expectations for future price fluctuations, assisting investors in making more informed decisions. Thus, the tool plays a crucial role in efficient risk management, speculative strategies, and the overall functioning of financial markets.

## Explanation

A variance swap is a complex financial derivative that allows investors to speculate or hedge against future volatility changes. It is used for taking a view on future volatility, i.e., to trade potential swing in asset prices. This kind of contract allows one party to gain exposure to an underlying asset’s volatility, without having to buy or sell the said asset physically. It eliminates the need to continuously manage a volatility portfolio, hence reducing transaction costs.

Furthermore, since a variance swap is not instrument-specific, it provides pure exposure to an asset’s volatility. This versatility allows for a wide range of applications. For instance, hedge fund managers often use variance swaps to hedge portfolio risk against significant market fluctuations. Strategic investors leverage these derivatives to profit from predictions about future volatility trends. So they can be used to generate profits or to protect existing investments from adverse market situations.

## Examples

Variance Swaps are used commonly in the financial world to hedge risks or speculate on future volatility. Here are three real-world examples:

1. Equity Markets: Suppose a fund manager overseeing a particular portfolio believes that the volatility of an equity index, for instance, the S&P 500, will increase over a specific period, they may decide to enter into a variance swap. The fund manager will profit if the realized volatility of the equity index is more than the strike price agreed upon in the variance swap contract. However, the fund manager will lose if it’s less.

2. Investments in Emerging Markets: Consider an investor invested in emerging markets where there’s high unpredictability due to political instability or changes in economic fundamentals. To hedge their risk towards potential adverse market swings, they might enter a variance swap where they would receive a payout if the realized volatility is higher than the agreed-upon value or ‘strike’ volatility.

3. Energy Markets: A natural gas trader, given the historically high volatility of natural gas prices, may enter into a variance swap as a hedge against increased price volatility. If the future realized volatility of natural gas prices turns out to be higher than the agreed ‘strike’ volatility, the trader would receive a payout, helping offset potentially lower gains or even losses in his underlying natural gas trading business.

## Frequently Asked Questions(FAQ)

## What is a Variance Swap?

A Variance Swap is a type of financial derivative contract where counterparties agree to trade future payments based on the variance (volatility) of an underlying asset, usually an equity index, a single stock, or an exchange rate.

## How does a Variance Swap work?

In a Variance Swap, one party agrees to pay the other party the realized variance (difference from the expected price) of the underlying asset over a specific period of time. In return, they receive a fixed amount which is agreed upon at the contract’s start. The swap is cash-settled in most cases.

## What is the underlying asset in a Variance Swap?

The underlying asset in a Variance Swap can be any asset, though the most common ones are equity indices, single stocks, and exchange rates.

## Who uses Variance Swaps?

Variance Swaps are used by hedge funds, investment banks, and other financial institutions to mitigate or speculate on the risk associated with the volatility of an underlying asset.

## What is the difference between a Variance Swap and a Volatility Swap?

The fundamental difference lies in their payoff structures. Variance swaps offer payoffs based on volatility squared, while Volatility Swaps offer payoffs that are directly proportional to volatility. This makes Variance swaps more sensitive to changes in volatility.

## How is the payout of a Variance Swap calculated?

The payout for the swap is calculated as the difference between the realized variance and the variance strike agreed upon in the contract, times the notional amount of the contract. If the realized variance is higher than the strike, the fixed rate payer will receive a payout, and conversely, if the realized variance is lower, they will make a payment.

## Are Variance Swaps instruments of high risk?

Due to their nature, Variance Swaps can be high-risk instruments. The payout is dependent on the square of the difference between the realized and strike variance, which can lead to significant gains or losses.

## Why would an investor choose a Variance Swap over other financial derivatives?

Variance Swaps offer a pure exposure to an underlying asset’s volatility, independent of its price direction. Therefore, they can be utilized for effective hedging and speculation strategies, protecting against drastic price changes, or profiting from anticipated high volatility.

## Related Finance Terms

**Volatility Index:**This is a measurement of market risk and is often used in the pricing of variance swaps.**Strike Price:**The fixed amount at which a variance swap can be bought or sold when it is first issued.**Hedge:**In a financial context, this refers to an investment made to reduce the risk of adverse price movements in an asset. Variance swaps can be used as part of hedging strategies.**Spot Price:**This is the current price in the market at which a particular asset, such as a variance swap, can be bought or sold for immediate delivery.**Quadratic Variation:**It’s a mathematical concept applied to the calculation of realized variance in a variance swap contract.