Introduction

Variance swaps are instruments which offer investors straightforward and direct exposure to the volatility of an underlying asset without the path-dependency issues associated with delta-hedged options. They are swap contracts where the parties agree to exchange a pre-agreed variance level for the actual amount of variance realised over a period.

Buying a variance swap is like being long volatility at the strike level; if the market delivers more than implied by the strike of the option, you are in profit, and if the market delivers less, you are in loss. However variance swaps are convex in volatility: a long position profits more from an increase in volatility than it loses from a corresponding decrease. For this reason variance swaps normally trade above ATM volatility.

The directness of the exposure to volatility and the relative ease of replication through a static portfolio of options make variance swaps attractive instruments for investors and market-makers alike.

Bid/offer spreads have come in significantly over recent years and in Europe they are now typically in the region of 0.5 vegas for indices and 1–2 vegas for single-stocks – although the latter vary according to liquidity factors. Spreads are naturally higher in emerging markets although these too are becoming more liquid.

The most liquid variance swap maturities are generally from 3 months to around 2 years. The most liquid maturities generally coincide with the quarterly options expiry dates, meaning that they can be efficiently hedged with exchange-traded options of the same maturity. Good liquidity is also seen in the front 3 months for short-dated index variance. The VIX, VSTOXX and VDAX indices represent the theoretical prices of 1-month variance swaps on the S&P500, Euro Stoxx and DAX indices respectively, and are calculated by the exchanges from listed option prices, interpolating to get 1-month maturity. These volatility indices are widely used as benchmark measures of equity market risk, even though they are only short-dated measures and are not directly tradable.

Increasingly, investors have come to view volatility itself as an asset class, one that can diversify investment returns or hedge unwelcome investment scenarios.

Below we list some common uses of variance swaps :

Exploiting a volatility view: Variance swaps are ideal for taking a direct view on the volatility of an underlying without the path-dependency issues of a delta-hedged option.
Specific hedging purposes: Variance swaps can be used for macro-hedging and also for hedging specific volatility exposures, such as that resulting from structured products or life assurance policies.
Rolling short variance: Short variance swaps can be used to capture the observed equity index volatility risk premium. Rolling short index variance is an attractive systematic volatility strategy from a risk-return perspective.
Diversification: Volatility can be thought of as an asset class in its own right, and as such can act to diversify returns within a portfolio.
Index variance spreads: Variance swaps can be used to trade the spread of volatilities between two indices. Such trades can be thought of as either relative value volatility trades or as ‘volatility-beta’ trades aiming to profit from a spread of volatilities widening as volatility increases.
Relative value single-stock volatility: Use volatility pairs, or cross-sectional regression volatility models to find rich/cheap single-stock volatilities
Variance dispersion and correlation trading: Trading variance swaps on an index against variance swaps on its constituents provides exposure to equity correlation.
Forward variance and volatility spikes: Long forward volatility can avoid potentially negative carry at the cost of slide down the term structure, and can be a useful way of positioning for volatility spikes.
Trading the variance term structure: Variance swaps can be used to trade the shape of the variance term structure.
Skew and convexity trades: Variance swaps are long skew and convexity. Trading variance against (delta- hedged) vanilla options provides interesting exposures to skew and/or convexity.
Cross asset class trades: Equity Volatility and credit spreads are correlated, both being measures of corporate risk. Variance swaps are useful instruments in debt/equity trades, either at the index or single name level.