What is Swap?
A Swap is an exchange of any financial instrument between two parties. It is a derivative contract. Swaps are traded only in the OTC markets and not on exchange and so are customizable. The most common swaps are interest rate swaps and currency swaps. The exchange takes place only at a predetermined time or as mentioned in the contract.
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What is Volatility Swap?
A volatility swap is a forward contract on the future realized 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. A volatility swap refers to a financial derivative and the payoff of it is based on the volatility of the underlying asset of that security which is a forward contract.
How the volatility swap is used?
They provide exposure on volatility only and not on other options or swap unlike vanilla options and the volatility depends on the price of the underlying asset. While trading the spread between realized and implied volatility these swaps can be used to speculate on future volatility. These are majorly used for hedge funds and some pension funds trading.
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Example and payoff of a volatility swap
To speculate the direction and the degree of movement of the volatility of any underlying asset is enabled by a volatility swap. The movement here should be independent of any price movements in the value of the underlying asset.
The payoff is calculated at the time of settlement. The process of calculation of payoff is done by multiplying the notional value by the difference between the actual and the predetermined volatility. The predetermined value is a fixed number. At the time of inception of the forward contract, it’s a reflection of the market’s expectation. This is known as a volatility strike. At the time of inception, the volatility strike is set such that the NPV of the payoff equals zero. No notional amount is exchanged at the inception of the contract. When realized volatility is different from the volatility strike, there is a payoff.
Payoff = Notional Amount *(volatility – volatility strike)
An example of a volatility swap would be if there is a situation where a trader wants a volatility swap on an index such as S&P 500 and the contract notional value is $20,000 and a maturity of 12 months. The implied volatility and the volatility strike both are 15% each. But after 12 months that is the maturity, the volatility turns to be 20%, and hence the realized volatility will also be 20%. Now the difference is 5% (20%- 15%) and hence the payoff will be $1000 ($20,000 * 5%).
Now the seller will pay $1000 to the buyer and if the volatility would have not dropped then the buyer would have paid the seller.
In a volatility swap, there is no directional underlying risk and all the hedging is performed by the provider which saves time and money both. Trading volatility directly can help investors to diversify risks and move towards an uncorrelated portfolio. They provide pure exposure to the variability of the underlying price rather than regular call and put options.
Author – Saachi Lodha
About the Author – A passionate professional with knowledge of Accounting and Finance and currently exploring Financial Risk Management (FRM) to gain knowledge and exposure. As a part of the FRM course also writing blogs to explore the field more and deep dive into the content.