Specific Hedging Purposes

Variance swaps can be useful for hedging purposes since volatility is directional at least over short time horizons.

--> VS will likely profit if martkets sell-off significantly and especially if it happens suddenly.

Problems with attempting to hedge an underlying using variance swaps:

- Not clear how much variance should be used to hedge a fixed quantity of the underlying.

- If the underlying slowly drifts down without large moves --> long VS may fail to provide protection.

Forward variance swaps:

- are not directly exposed to RV --> do not suffer carry in benign market environment

- suffer slide as the position ages (assuming upward sloping term structure)

Variance swaps can also be useful for hedging out specific volatility exposures.

Example 1:

Life assurance companies offer many products which offer some form of guaranteed benefits.

These companies have essentially sold equity put options to their policy holders --> they have taken short vol exposure.

They may delta-hedge but this will not hedge mark-to-market volatility risk.

Increasingly, insurers are looking to use VS to hedge their volatility exposure.

Example 2:

Structured products desks offer equity-based investmenets which incorporate volatility and correlation exposures.

The aggregate risks of their positions needs to be hedged and VS provide a useful way to do it.

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