Volatility swap refers to a financial derivative, the payoff of which is based upon the volatility of the underlying asset of that security, which is a forward contract.

Volatility swaps enable investors to trade the volatility of an asset without explicitly trading the underlying asset. The payoff, which is the difference between the realized or actual volatility and the volatility strike, is settled in cash.

Summary

Volatility swap refers to a financial derivative, the payoff of which is based upon the volatility of the underlying asset of that security.

A swap is a derivative instrument that represents a two-party contract wherein they agree to the exchange of cash flows over a given period.

The payoff is calculated by multiplying the notional value of the contract by the difference between the actual and the predetermined volatility.

What is a Swap?

A swap is a derivative instrument that represents a two-party contract wherein they agree to the exchange of cash flows over a given period. Since the contracts are based on a mutual agreement, investors can exercise flexibility with the design, structure, and specific terms of the contracts. Thus, there exist multiple variations of swaps, and each of them is customized to fulfill the needs of the parties.

Swaps also offer the added financial benefit of an alternative cash inflow to investors. They help diversify their income stream. They also enable parties to mitigate or hedge the risk associated with debt obligations that carry a floating rate.

Volatility swaps are different from traditional swaps because they are a payoff-based instrument. Traditional swaps include an exchange of cash flows, which may be based on fixed or varying rates. Volatility swaps, on the other hand, are based on volatility.

In structure, volatility swaps resemble variance swaps, but variance swaps are more commonly traded in equity markets. Since volatility swaps are over the counter (OTC) derivatives, there are multiple ways of constructing them. Common examples include calculating the difference in volatility on a daily basis rather than at the end of the contract, as well as calculating the differences in volatility on an annual basis.

Payoff for a Volatility Swap

Using volatility swaps enables investors to speculate upon the direction and degree of movement of the volatility of an underlying asset. The movement must be independent of any price movements or changes in the value of the underlying asset.

At the time of settlement of the contract, the payoff must be calculated. This is done by multiplying the notional value of the contract by the difference between the actual and the predetermined volatility. This predetermined level of volatility is a fixed number that is a reflection of the market’s expectation at the time of inception of the forward contract. This is known as the volatility strike.

This is different from implied volatility that is used in options. At the inception of the contract, the volatility strike is set such that the Net Present Value of the payoff becomes equal to zero. Moreover, no notional amount is exchanged at the inception of the contract.

When the realized volatility is different from the volatility strike, there is a payoff.

Example of Volatility Swap

Consider a situation where an institutional trader wants a volatility swap on an index such as the S&P 500. The contract has a notional value of $10,000 and a maturity of 12 months. The implied volatility, according to prevailing investor sentiment is, 15%. Thus, the volatility strike for the contract is 15%.

After 12 months, the actual volatility turns out to be 20%. It becomes the realized volatility. Given that there is a 5% (20% –15%) difference between the realized volatility and the strike, there will be a payoff, which is $500 ($10,000 * 5%).

The settlement will be: The seller of the volatility swap must pay a sum of $500 to the buyer.

Similarly, if the volatility subsequently dropped to 10% upon the completion of 12 months, the buyer would be required to pay the seller a sum of $500.

Additional Resources

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