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A variance swap is a financial derivative product designed to allow professional investors to manage portfolio risk. It can be used to remove risk, or hedge, or to take on additional risk, to speculate. In variance swap transactions, one party is typically a hedger and the other a speculator, although this depends on the opening risk position of each party. When the deal for the swap is made, one party agrees to buy the volatility from the other at a fixed price, the swap strike. The difference in volatility, or variance, between the square of the strike level and the square of the actual realized volatility is multiplied by the notional amount of the swap to determine the payoff for the investor.
Virtually all financial securities suffer a decrease in their theoretical valuation if the volatility of their market price increases. This decrease in theoretical valuation provides a basis for the traded price of that security to trend down and eventually suffer a real, not merely theoretical, loss in valuation. Increased volatility can therefore lead to a sustained lowering in the price of a financial security.
The impact of increased price volatility on a large portfolio, valued at hundreds of millions of dollars, can be severe. Variance swaps are a sophisticated product aimed at large-scale portfolio managers rather than small individual investors. They provide a cost effective way of protecting large portfolios from value erosion due to increased volatility. Variance swaps are a wholesale, not retail, product.
Variance swaps are a relatively new product. Over that short period, the number and value of variance swap transactions has grown rapidly. More and more professional portfolio managers are now familiar with and appreciate the flexibility these products offer in managing risk. They represent an improvement on an earlier product known as a volatility swap.
Variance swaps trade in the over-the-counter market rather than on an official exchange. This is largely because they are not standard contracts. Each contract specifies a unique set of conditions tailored to the requirements of the original contracting parties. It is difficult for either of those parties to find other parties to whom the contract conditions are attractive. As a result, there is limited secondary market trading of variance swaps.
The most common counterparties in a variance swap are, on the one hand, portfolio managers within large asset management institutions and, on the other hand, the derivatives teams within major investment banks and hedge funds. Typically, portfolio managers seek to hedge risk, while investment banks and hedge funds are willing assume that risk. Portfolio managers view the variance swap as a justified cost of doing business while investment banks and hedge funds see it as an opportunity to secure a speculative profit.
In essence, variance swaps are analogous to insurance policies. The portfolio manager makes a decision as to whether or not there is a need to purchase insurance cover for the portfolio. The investment banks and hedge funds offer that cover.