Conditional variance swap
Encyclopedia
A conditional variance swap
is a type of swap
Derivative (finance)
product that allows investors to take exposure to volatility
in the price of an underlying security only while the underlying security is within a pre-specified price range. This ability could be useful for hedging complex volatility exposures, making a bet on the volatility levels contained in the skew
of the underlying security's price, or buying/selling variance at more attractive levels given a view on the underlying security.
were introduced first, and became a popular instrument for hedging against the effect of volatility on option prices. Thus, the market for these securities became increasingly liquid, and pricing for these swaps became more efficient. However, investors noticed that to a certain extent the price levels for these variance swaps still deviated from the theoretical price that would have resulted from replicating the portfolio of options underlying the swaps using options pricing formulas such as the Black-Scholes model. This was partly because the construction of the replicating portfolio
includes a relatively large contribution from out-of-the-money options, which can often be illiquid and result in a pricing discrepancy in the overall swap. Conditional swaps mitigate this problem by limiting the hedge to strikes within an upper and lower level of the underlying security. Thus, the volatility exposure is limited to when the underlying security lies within this corridor.. Another problem in replicating variance swaps is that dealers rarely use a large collection of options over a large range to hedge a variance swap due to transaction costs and the cost of managing a large number of options. A conditional variance swap is attractive as it is easier to hedge and better fits the payoff profile of hedges used in practice.
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 a type of swap
Swap
- Finance :* Swap , a derivative in which two parties agree to exchange one stream of cash flows against another* Barter- Technology :* Swap space, related to a computer's virtual memory subsystem...
Derivative (finance)
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
product that allows investors to take exposure to 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...
in the price of an underlying security only while the underlying security is within a pre-specified price range. This ability could be useful for hedging complex volatility exposures, making a bet on the volatility levels contained in the skew
Skewness
In probability theory and statistics, skewness is a measure of the asymmetry of the probability distribution of a real-valued random variable. The skewness value can be positive or negative, or even undefined...
of the underlying security's price, or buying/selling variance at more attractive levels given a view on the underlying security.
History
Regular variance swapVariance 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....
were introduced first, and became a popular instrument for hedging against the effect of volatility on option prices. Thus, the market for these securities became increasingly liquid, and pricing for these swaps became more efficient. However, investors noticed that to a certain extent the price levels for these variance swaps still deviated from the theoretical price that would have resulted from replicating the portfolio of options underlying the swaps using options pricing formulas such as the Black-Scholes model. This was partly because the construction of the replicating portfolio
Replicating portfolio
In the valuation of a life insurance company, the actuary considers a series of future uncertain cashflows and attempts to put a value on these cashflows...
includes a relatively large contribution from out-of-the-money options, which can often be illiquid and result in a pricing discrepancy in the overall swap. Conditional swaps mitigate this problem by limiting the hedge to strikes within an upper and lower level of the underlying security. Thus, the volatility exposure is limited to when the underlying security lies within this corridor.. Another problem in replicating variance swaps is that dealers rarely use a large collection of options over a large range to hedge a variance swap due to transaction costs and the cost of managing a large number of options. A conditional variance swap is attractive as it is easier to hedge and better fits the payoff profile of hedges used in practice.