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Variance Term Structure

The shape and potential movement of the implied variance curve is important in determining the most promising parts of the curve to buy or sell variance, including positioning for volatility exposure through forward variance.

 

Variance Swap term structures: 

- are usually upwards sloping 

- have tendency to flatten following increases in volatility 

- generally steeper than ATM vol curves --> increasing effect of skew at longer maturities. 

- can be thought of representing the mean-reverting nature of volatility. 

  • short end is most sensitive to prevailing levels of realised volatility.
  • long end is more anchored to some LT estimate of average volatility.
  • long end is also driven by structured product flows and tends to be more susceptible to supply/demand dynamics. 

 

Other important point is the effect of the mark-to-market P&L. 

- Short-date VS is principally exposed to realised variance --> gamma

- Long-dated VS take on significant exposure to changes in implied variance before expiry --> vega

 

An investor has just bought a 5y variance swap --> principal exposure = 5y implied variance. 

--> Driven by factors not necessarily correlated with current realised variance --> P&L can be unpredictable. 

 

Typical movements of term structures can be explained in part by the "root-time" rule. 

For "normal" move in vol --> change in implied variance at a given point on the curve will be proportional toVs root time

- flattens normal upward-sloping term structure as volatility increases

- steepens normal upward-sloping term structure as volatility decreases 

- changes will be most visible at shorter end of the curve

 

Example: If 1y variance increases by 1% --> 3m variance increases by 2% and 4y variances increases by 0.5%. 

 

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