#2 Variance Swaps Demystified!

Digging deep into trading volatility squared!

In these volatile times, we have been hearing a lot about the importance of asset allocation. Equity markets usually have a negative correlation with volatility and that is why hedging becomes important. In today’s article, we talk about ‘Variance’ as an emerging asset class, and due to which investing in volatility is becoming increasingly easier.

So, how do you take exposure on volatility? As soon as we hear about volatility, the instrument which comes to our minds is good old option contracts. Now, we have heard about options but they are not pure volatility play. Why, you ask? Before we get into that, let’s first understand what a variance swap is. For that, let us first discuss a plain vanilla swap contract, which involves exchange of cashflows. The cashflows are determined based on the difference between two financial underlyings. while in the case of a variance swap, cashflow are determined based on the difference between realised and implied variance. If you think that volatility is going to shoot up in coming times, you can consider entering into a variance swap where you will pay current implied variance (think volatility) and receive the realised variance at the time of settlement.

Before the existence of variance swaps, traders used to take exposure on volatility through option contracts. Options are not a perfect instrument to take exposure on volatility due to the massive impact of delta on the valuation of options along with other factors. So, if you buy options, you are not only long on volatility but you are also taking exposure to other option greeks. There is a good chance that you are not perfectly hedged and you may even incur the loss due to movements in the underlying securities. One of the ways to eliminate the exposure on the other greeks is to create a portfolio of options on different strike prices.

You might wonder why variance swap and not volatility swap? One of the reasons is Convexity i.e., the gains on the contract will be greater and the losses will be smaller than what would have been under volatility swap. Take a look at the graph of convexity of payoff as shown below:

However, the main reason is ‘replication of portfolio returns’. The replication of payoff of a variance swap is more reliable than that of a volatility swap because the volatility swap is nothing but the squared root of a variance swap. Therefore, it is theoretically more significant to value a variance swap by using a portfolio of options than to value a volatility swap, and how do we go about the same?

What we need to do here is to nullify the impact of all the factors except volatility in our portfolio of option contracts. For this, we need to buy and sell options simultaneously on the same underlying in such a way that it will eliminate the impact of any small change in the underlying (delta), as well as theta and vega. This process is called ‘delta-hedging’ where we are left with exposure to gamma and volatility.  

The next step is to get rid of the gamma risk to face only volatility exposure. This is where it gets tricky. We need to further add options in our portfolio in such a way that we are able to minimise the impact of gamma. To do this, in our portfolio, we need to add options in higher weights to lower strike OTM put options and in lower weights of higher strike OTM call options. This will reduce the exposure to the gamma to a great extent, but won’t make it entirely neutral. To make this entirely neutral, we need to add very large number of options where the weights are inversely proportional to the squared strike prices. After this tedious and complex exercise of having nullified all the other factors, what we are left with is exposure to pure volatility. This entire process of using the options to take the exposure to pure volatility is not perfect, but is a good substitute in a market where variance swaps are inaccessible. This comes especially handy during these volatile times.

The market for variance swaps is increasing drastically with an estimate of outstanding notional value of approx. $2 billion with daily volume of more than $5 million. With the growing prominence of volatility indices such as S&P VIX, India VIX, etc., and with the volume of variance swaps roughly doubling every year since past few years, variance is becoming an asset class in itself. 

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References

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