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Volatility Swap

Volatility Swap
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What Is a Volatility Swap?

A volatility swap is a forward contract with a payoff in light of the realized volatility of the underlying asset. They settle in cash in view of the difference between the realized volatility and the volatility strike or pre-decided fixed volatility level. Volatility swaps permit participants to trade an asset's volatility without straightforwardly trading the underlying asset.

Volatility swaps are not swaps in the traditional sense, with an exchange of cash flows between counterparties.

They are additionally like variance swaps, where the payoff depends on realized variance.

Understanding Volatility Swaps

Volatility swaps are pure volatility instruments permitting investors to conjecture exclusively upon the movement of an underlying asset's volatility without the influence of its price. Subsequently, just like investors speculate on the prices of assets, by utilizing this instrument, investors are able to guess on how unpredictable the asset will be.

The name swap, in this case, is a misnomer since swaps are structured contracts comprising of cash flow exchanges, ordinarily matching a fixed rate with a variable rate. Volatility swaps, and variance swaps, are really forward contracts with payoffs in light of the noticed or realized variance of the underlying asset.

At settlement, the payoff is:

Payoff = Notional Amount * (Volatility - Volatility Strike)

At beginning, the notional amount isn't exchanged.

The volatility strike is a fixed number that mirrors the market's expectation of volatility at the time the swap starts. It might be said, the volatility strike addresses implied volatility, despite the fact that it isn't equivalent to traditional implied volatility in options. The strike itself is commonly set toward the beginning of the swap to make the net present value (NPV) of the payoff zero. What volatility really turns out to be toward the finish of the contract decides the payoff, expecting it is not the same as the implied volatility/volatility strike.

Utilizing Volatility Swaps

A volatility swap is a pure-play on an underlying asset's volatility. Options likewise give an investor the possibility to estimate on an asset's volatility. Nonetheless, options carry directional risk, and their prices rely upon many factors, including time, expiration, and implied volatility. Therefore, the equivalent options strategy requires extra risk hedging to complete. Volatility swaps don't need this, they are essentially founded on volatility.

There are three fundamental classes of users for volatility swaps.

  1. Directional traders utilize these swaps to estimate on the future level of volatility for an asset.
  2. Spread traders simply bet on the difference between realized volatility and implied volatility.
  3. Fence traders use swaps to cover short volatility positions.

Variance swaps are definitely more normal in equity markets than volatility swaps.

Illustration of How to Use a Volatility Swap

Expect that an institutional trader needs a volatility swap on the S&P 500 index. The contract will terminate in twelve months and has a notional value of $1 million. As of now, the implied volatility is 12%. This is set as the strike for the contract.

In year's time, volatility is 16%. This is the realized volatility. There is a 4% difference, or $40,000 ($1 million x 4%). The seller of the volatility swap pays the swap buyer $40,000, expecting the seller is holding the fixed leg and the buyer the floating leg.

Assuming that volatility dropped to 10%, the buyer would pay the seller $20,000 ($1 million x 2%).

This is a simplified model. Since volatility swaps are over-the-counter instruments (OTC) they can be built in various ways. A few alternatives might be to annualize the rates or work out the difference in volatility in terms of daily changes.

Features

  • The payoff for a volatility swap is the notional value of the contract increased by the difference between realized volatility and the volatility strike.
  • Volatility swaps are not swaps in the common sense, as for the most part swaps include an exchange of cash flows in light of fixed and additionally fluctuating rates. Volatility swaps aren't an exchange of cash flows, but instead a payoff-put together instrument based with respect to volatility.
  • A volatility swap is a forward contract with a payoff in view of the difference between realized volatility and a volatility strike.