Definition for : Variance Swap
A Variance Swap is a contract between two parties, A and B, in which they reach agreement on a reference level for the Variance of a given asset, let's say 12% and a Notional amount, let's say $100,000.When the contract reaches its term, the real Variance of the asset in question is looked at. If it's more than 12%, let's say 15%, the 3% on the Notional amount of the Swap is paid by A to B, ie, $30,000. If the Variance is lower, say 8%, the 4% difference is paid by B to A.In this operation, if B owns the asset question, B will get the Future Variance on the asset (12% in this case) since B will receive monetary compensation if it is higher and will pay monetary compensation if it is lower. A, on the other hand, is taking a Risk on a fluctuation of the Variance and only wins if it falls. Variance Swaps make it possible to take advantage of the Future Volatility of an asset, whether this Future Volatility results in a fall or a rise in the Value of the asset.It is possible to benefit from this Volatility by buying put or call options on the asset, but in this case, a bet should also be made on the price rising or falling, and consequently, put or call options should be bought and two Risks taken: a Risk that the price will rise or fall and a Volatility Risk. In a Variance Swap this Hedging is unnecessary. We're not betting on the Share price rising or falling, but on the level of the Share price's Volatility.
(See Chapter 49 Managing cash flows of the Vernimmen)
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