Volatility swap
Encyclopedia
In finance
, a volatility swap is a forward contract
on the future realised volatility
of a given underlying asset. Volatility swaps allow investors to trade the volatility of an asset directly, much as they would trade a price index.
The underlying is usually a foreign exchange (FX) rate (very liquid market) but could be as well a single name equity or index. However, the variance swap
is preferred in the equity market due to the fact it can be replicated with a linear combination of options and a dynamic position in futures.
Unlike a stock option, whose volatility exposure is contaminated by its stock price dependence, these swaps provide pure exposure to volatility alone. This is truly the case only for forward starting volatility swaps. However, once the swap has its asset fixings its mark-to-market value also depends on the current asset price. You can use these instruments to speculate on future volatility levels, to trade the spread between realized and implied volatility, or to hedge the volatility exposure of other positions or businesses.
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
, a volatility swap is a forward contract
Forward contract
In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a...
on the future realised volatility
Volatility (finance)
In finance, volatility is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices...
of a given underlying asset. Volatility swaps allow investors to trade the volatility of an asset directly, much as they would trade a price index.
The underlying is usually a foreign exchange (FX) rate (very liquid market) but could be as well a single name equity or index. However, the variance swap
Variance swap
A variance swap is an over-the-counter financial derivative that allows one to speculate on or hedge risks associated with the magnitude of movement, i.e. volatility, of some underlying product, like an exchange rate, interest rate, or stock index....
is preferred in the equity market due to the fact it can be replicated with a linear combination of options and a dynamic position in futures.
Unlike a stock option, whose volatility exposure is contaminated by its stock price dependence, these swaps provide pure exposure to volatility alone. This is truly the case only for forward starting volatility swaps. However, once the swap has its asset fixings its mark-to-market value also depends on the current asset price. You can use these instruments to speculate on future volatility levels, to trade the spread between realized and implied volatility, or to hedge the volatility exposure of other positions or businesses.