A Quick Overview of Variance Swaps
A variance swap is a 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.
One leg of the swap will pay an amount based upon the
realised variance of the price changes of the underlying
product. Conventionally, these price changes will be daily log
returns, based upon the most commonly used closing price. The
other leg of the swap will pay a fixed amount, which is the
strike, quoted at the deal's inception. Thus the net payoff to
the counterparties will be the difference between these two
and will be settled in cash at the expiration of the deal,
though some cash payments will likely be made along the way by
one or the other counterparty to maintain agreed upon
margin.
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