DEFINITION of 'Volatility Swap'

Volatility swaps are forward contracts with a payoff based on the realized volatility of the underlying asset. They settle in cash based on the difference between the realized volatility and the volatility strike.

They are not swaps in the traditional sense, with an exchange of cash flows between counterparties.

They are also similar to variance swaps, where the payoff is based on realized variance.

BREAKING DOWN 'Volatility Swap'

Volatility swaps are pure volatility instruments allowing investors to speculate solely upon the movement of an underlying asset's volatility without the influence of its price. Thus, just like investors trying to speculate on the prices of assets, by using this instrument investors are able to speculate on how volatile the asset will be.

The name swap is a misnomer because swaps are structured contracts consisting of cash flow exchanges, typically matching a fixed rate with a variable rate.  Volatility swaps, and the similar variance swaps, are actually forward contracts with payoffs based on the observed or realized variance of the underlying asset.

At settlement, the payoff is:

Payoff = Notional Amount * (Volatility – Volatility Strike)

The volatility strike is a fixed number that reflects the current price and the market’s expectation of volatility at the time that the swap begins. In a sense, the volatility strike represents implied volatility, although it is not the same as traditional implied volatility in options. The strike itself is typically set at the beginning of the swap to make the net present value (NPV) of the payoff zero.

Using Volatility Swaps

A volatility swap is a pure-play on an underlying asset's volatility. Options also give an investor the possibility to speculate on an asset's volatility. However, options carry directional risk, and their prices depend on many factors, including time, expiration, and implied volatility. Therefore, the equivalent options strategy requires additional risk hedging to complete.

There are three main classes of users for volatility swaps.

  1. Directional traders use these swaps to speculate on the future level of volatility for an asset.
  2. Spread traders merely bet on the difference between realized volatility and implied volatility.
  3. Hedger traders use swaps to cover short volatility positions.

Theoretically, variance swaps are simpler than volatility swaps because it is possible to hedge with static positions in European call and put options, together with a position in the underlying asset. Hedging volatility swaps requires a dynamic portfolio of European options. This makes variance swaps a more popular choice than volatility swaps.

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