What are Variance Swaps? Financial Derivatives - Trading Volatility

In todays video we learn about variance swaps

These classes are all based on the book Trading and Pricing Financial Derivatives, available on Amazon at this link. https://amzn.to/2WIoAL0
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What is a Variance Swap?

A variance swap is a financial derivative used to hedge or speculate on the magnitude of a price movement of an underlying asset.

A variance swap is a forward contract with a payoff based on the realized variance of the underlying asset. Variance swaps settle in cash based on the difference between the realized variance and the variance strike

Similar to a regular swap, one of the two parties involved in the transaction will pay an amount based upon the actual variance of price changes of the underlying asset. The other party will pay a fixed amount, called the strike, specified at the start of the contract. The strike is typically set at the start to make the net present value of the payoff zero.

At the end of the contract, the net payoff to the counterparties will be the notional amount multiplied by the difference between the variance and the strike variance, settled in cash. Due to any margin requirements specified in the contract, some payments may occur during the life of the contract should the contract's value move beyond the agreed limits.

The variance swap, in mathematical terms, is the arithmetic average of the squared differences from the mean value. The square root of the variance is the standard deviation.

A variance swap is a pure-play on an underlying asset's volatility. Options also give an investor the possibility to speculate on an asset's volatility. But, options carry directional risk, and their prices depend on many factors.

There are two main classes of users for variance swaps.

Speculators use these swaps to speculate on the future level of volatility for an asset.

Hedgers use variance swaps to cover short volatility positions.

They are similar to volatility swaps, watch my video on those here.    • What are Volatility Swaps? Financial Deriv...