Saturday, November 13, 2010

Variance Swap vs. Volatility Swap

- Theoretical exact hedging recipe: Var swap can be hedged using a log contract, which itself can be replicated with a continuum of OTM calls and puts, this result is model independent; Vol swap hedging is model dependent.

- Risk: From a sellers' perspective, Var swap has higher risk because convexity means the payoff can be very huge in extreme volatility spike events; Vol swap is relatively "safer".

- Hedging in practice: Vol swap is easier to hedge in practice than Var swap. First, the payoff of Vol swap is monotonic in S (<=> less convexity); Second, under high volatility scenario, hedging a Var swap requires many options to be hedged, but usually under these circumstances the option market is not liquid enough.

2 comments:

  1. Hi,
    Do you know any rule of thumb that relates the price of a variance swap with a volatility swap?
    I am trying to get an approximation for the volatility swap price from variance swap prices but don't want to fit an stochastic volatility or jump difussion model. Maybe you know a way to calculate the convexity adjustment easily?
    Thanks

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    Replies
    1. I recall reading a paper few years back:

      http://math.cims.nyu.edu/financial_mathematics/content/02_financial/2008-3.pdf

      I don't remember if there is any 'rule of thumb' though. Perhaps it's a good excuse to revise volatility derivatives ;) Come back to this blog in a few weeks.

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