Variance Swap - Risk Management Tool For Big Investors

A variance swap is a derivative financial product designed to be a risk management tool for large professional investors. It allows them to manage portfolio risk by either hedging (removing risk) or, where appropriate, by speculating (increasing risk). Variance swaps trade mainly in the over-the-counter (OTC) market.

The basic features of a variance swap may be explained by examining the payoff earned by each party to the transaction. In simplified terms, a party's pay-off from a variance swap is given by the following formula:

($Notional amount) * (A2 - B2) x 100

where

A = forward realized volatility (expressed as a decimal)

B = swap strike level (expressed as a decimal)

In plain terms, the above formula indicates that payoff is determined by taking the notional amount and multiplying it by the difference between the forward volatility squared minus the strike level squared. This product is then multiplied by one hundred merely as an adjustment to correct for the fact that A and B are expressed in the formula as decimals rather than percentages.

The above formula is a basic representation of a variance swap payoff. Actual variance swap contracts are likely to have more complicated expressions, but the essence is captured in the above expression.

On the day the swap is traded, the two parties agree a strike price as well as the notional value for the contract. The strike price is the base or reference level against which future realized volatility will be compared. The notional value can be any amount agreed by the parties.

Assume two parties agree to enter into a three month variance swap on the Standard & Poor's 500 stock index with a strike price of 20 percent and a notional amount of $100,000. The buyer of the swap pays the seller $100,000 and will receive the volatility realized during the contract period. At the swap expiration date, the realized variance is measured to have been 10 percent. The payoff to the swap buyer is $100,000 x (0.202 - 0.102) x 100, or $300,000. The swap seller pays the buyer $300,000. The buyer made a net gain and the seller a net loss, of $200,000.

Most financial securities decrease in value if their price volatility increases. The larger the portfolio the larger the value loss caused by price volatility. Variance swap contracts are a complex product designed for professional portfolio managers not small investors. They allow flexible terms and come at relatively low cost.

Variance swaps are a recent financial innovation introduced during the 1990s. The first known variance swap traded in 1993 with the FTSE Index as the underlying asset. Significant volumes have traded in the OTC market since about 1997. A three-month variance futures contract has traded on the Chicago Board Options Exchange since 2004.

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