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JUST WHAT YOU NE ED TO KNOW ABOUT VARIANCE SWAPS

Sebastien Bossu

Eva Strasser Regis Guichard

DERIVATIVES

Equity Derivatives Investor Marketing JPMorgan London

Quantitative Research & Development

EQUITY

IN THE UNITED S TATES THIS REPORT IS AVAIL ABLE ONLY TO PERSONS WH O HAVE RECEIVED THE PROPER OPTION RIS K DISC LOSURE DOCUMENTS

1

Initial publication February 2005

Overview

In this note we introduce the properties of variance swaps, and give details on the hedging and valuation of these instruments. Section 1 gives quick facts about variance swaps and their applications.

Section 2 is written for traders and market professionals who have some degree of familiarity with the theory of vanilla option pricing and hedging, and explains in intuitive mathematical terms how variance swaps are hedged and priced.

Section 3 is written for quantitative traders, researchers and financial engineers, and gives theoretical insights into hedging strategies, impact of dividends and jumps.

Appendix A is a review of the concepts of historical and implied volatility.

**Appendices B and C cover technical results used in the note.
**

SWAPS

We thank Cyril Levy-Marchal, Jeremy Weiller, Manos Venardos, Peter Allen, Simone Russo for their help or comments in the preparation of this note.

These analyses are provided for information purposes only and are intended solely for your use. The analyses have been derived from published models, reasonable mathematical approximations, and reasonable estimates about hypothetical market conditions. Analyses based on other models or different assumptions may yield different results. JPMorgan expressly disclaims any responsibility for (i) the accuracy of the models, approximations or estimates used in deriving the analyses, (ii) any errors or omissions in computing or disseminating the analyses and (iii) any uses to which the analyses are put. This commentary is written by the specific trading area referenced above and is not the product of JPMorgan's research departments. Research reports and notes produced by the Firm's Research Departments are available from your salesperson or at the Firm's website, http://www.morganmarkets.com. Opinions expressed herein may differ from the opinions expressed by other areas of JPMorgan, including research. This commentary is provided for information only and is not intended as a recommendation or an offer or solicitation for the purchase or sale of any security or financial instrument. JPMorgan and its affiliates may have positions (long or short), effect transactions or make markets in securities or financial instruments mentioned herein (or options with respect thereto), or provide advice or loans to, or participate in the underwriting or restructuring of the obligations of, issuers mentioned herein. The information contained herein is as of the date and time referenced above and JPMorgan does not undertake any obligation to update such information. All market prices, data and other information are not warranted as to completeness or accuracy and are subject to change without notice. Transactions involving securities and financial instruments mentioned herein (including futures and options) may not be suitable for all investors. Clients should contact their salespersons at, and execute transactions through, a JPMorgan entity qualified in their home jurisdiction unless governing law permits otherwise. Entering into options transactions entails certain risks with which you should be familiar. In connection with the information provided below, you acknowledge that you have received the Options Clearing Corporation's Characteristics and Risks of Standardized Option. If you have not received the OCC documents and prior to reviewing the information provided below, contact your JPMorgan representative or refer to the OCC website at http://www.optionsclearing.com/publications/riskstoc.pdf Copyright 2005 J.P. Morgan Chase & Co. All rights reserved. JPMorgan is the marketing name for J.P. Morgan Chase & Co. and its subsidiaries and affiliates worldwide. J.P. Morgan Securities Inc. is a member of NYSE and SIPC. JPMorgan Chase Bank is a member of FDIC. J.P. Morgan Futures Inc. is a member of the NFA. J.P. Morgan Securities Ltd. and J.P. Morgan plc are authorised by the FSA and members of the LSE. J.P. Morgan Europe Limited is authorised by the FSA. J.P. Morgan Equities Limited is a member of the Johannesburg Securities Exchange and is regulated by the FSB. J.P. Morgan Securities (Asia Pacific) Limited and Jardine Fleming Securities Limited are registered as investment advisers with the Securities & Futures Commission in Hong Kong and their CE numbers are AAJ321 and AAB026 respectively. Jardine Fleming Singapore Securities Pte Ltd is a member of Singapore Exchange Securities Trading Limited and is regulated by the Monetary Authority of Singapore ("MAS"). J.P. Morgan Securities Asia Private Limited is regulated by the MAS and the Financial Supervisory Agency in Japan. J.P.Morgan Australia Limited (ABN 52 002 888 011) is a licensed securities dealer. In the UK and other EEA countries, this commentary is not available for distribution to persons regarded as private customers (or equivalent) in their home jurisdiction.

JUST

WHAT

YOU

NEED

TO

KNOW

ABOUT

VARIANCE

1

Table of Contents

Overview............................................................................................ 1 Table of Contents ................................................................................. 2 1. Variance Swaps .............................................................................. 3

1.1. Payoff Convexity Rules of thumb Applications Volatility Trading Forward volatility trading Spreads on indices Correlation trading: Dispersion trades Mark-to-market and Sensitivities Mark-to-market Vega sensitivity Skew sensitivity Dividend sensitivity 3 4 5 5 5 5 6 7 8 8 9 9 9

1.2.

1.3.

SWAPS

2.

**Valuation and Hedging in Practice ......................................................11
**

2.1. Vanilla Options: Delta-Hedging and P&L Path-Dependency Delta-Hedging P&L path-dependency Static Replication of Variance Swaps Interpretation Valuation 11 11 12 14 16 16

VARIANCE

2.2. 2.3.

3.

Theoretical Insights ........................................................................18

3.1. 3.2. Idealized Definition of Variance Hedging Strategies & Pricing Self-financing strategy Pricing Representation as a sum of puts and calls Impact of Dividends Continuous Monitoring Discrete Monitoring Impact of Jumps 18 18 19 19 20 20 21 21 23

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ABOUT

3.3.

TO

3.4.

NEED

Appendix A Appendix B Appendix C

A Review of Historical and Implied Volatility ..........................24 Relationship between Theta and Gamma...............................27 Peak Dollar Gamma..........................................................28

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References & Bibliography .....................................................................29

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2

As explained later in this document. Variance Swaps 1.g. as of the Trade Date.1.1 Variance Swap on S&P 500 : sample terms and conditions VARIANCE SWAP ON S&P500 SPX INDICATIVE TERMS AND CONDITIONS Instrument: Trade Date: Observation Start Date: Observation End Date: Variance Buyer: Variance Seller: Denominated Currency: Vega Amount: Variance Amount: Underlying: Strike Price: Currency: Equity Amount: Swap TBD TBD TBD TBD (e. at Observation End Date. the Official Settlement Price of the Exchange-Traded Contract WHAT YOU Calculation Agent: Documentation: JP Morgan Securities Ltd.] Sample terms are given in Exhibit 1. being the number of days which. where 2 KNOW ABOUT VARIANCE SWAPS TO 252 Final Realised Volatility = t N t 1 NEED Expected _ N P ln t Pt 1 100 Expected_N = [number of days]. Exhibit 1. are expected to be Scheduled Trading Days in the Observation Period P0 = The Official Closing of the underlying at the Observation Start Date Pt = Either the Official Closing of the underlying in any observation date t or. ISDA JUST 3 .1. Payoff A variance swap is an instrument which allows investors to trade future realized (or historical) volatility against current implied volatility. JPMorganChase) TBD (e. Investor) USD (USD) 100.000 3.1 below. [See Sections 2. the Equity Amount will be calculated and paid in accordance with the following formula: Final Equity payment = Variance Amount * (Final Realized Volatility2 Strike Price2) If the Equity Amount is positive the Variance Seller will pay the Variance Buyer the Equity Amount.125 ( determined as Vega Amount/(Strike*2) ) S&P500 (Bloomberg Ticker: SPX Index) 16 USD T+3 after the Observation End Date.1.2 for more details.g.2 and 3.1. If the Equity Amount is negative the Variance Buyer will pay the Variance Seller an amount equal to the absolute value of the Equity Amount. only variance the squared volatility can be replicated with a static hedge.

This means that an investor who is long a variance swap (i.2 Variance swaps are convex in volatility $5.000. if the realized volatility is 1 vega (volatility point) above the strike at maturity.000 $4.) It is a market practice to define the variance notional in volatility terms: Variance Notional Vega Notional 2 Strike With this adjustment.e. a phenomenon which is amplified when volatility skew is steep.Note: Returns are computed on a logarithmic basis: ln Pt . the fair strike of a variance swap is often in line with the implied volatility of the 90% put.1.000 -$3.000. 4 .1. the payoff is approximately equal to the Vega Notional. This bias has a cost reflected in a slightly higher strike than the fair volatility2. as illustrated in Exhibit 1. This is because its impact on the price is negligible (the expected average daily return is 1/252 nd of the money-market rate).000.000 0 Payoff Variance ABOUT Strike =24 KNOW 10 20 30 40 50 Realized Volatility NEED TO Volatility WHAT YOU 2 JUST Readers with a mathematical background will recall Jensens inequality: E ( Variance ) E (Variance) . while its omission has the benefit of making the payoff perfectly additive (3-month variance + 9-month variance in 3 months = 1-year variance.000. Convexity The payoff of a variance swap is convex in volatility. which normally appears in statistics textbooks.2. Thus.000 $2.000.000 $1. receiving realized variance and paying strike at maturity) will benefit from boosted gains and discounted losses.000 $3.000.000 -$2. SWAPS VARIANCE Exhibit 1.000 $0 -$1.000. is dropped. Pt 1 The mean return.000.

which is in line with the 90% put implied volatility normally observed in practice. with vegas.8%. and a 90-100 skew of 2 is the at-the-money-forward volatility.000 on the EuroStoxx 50 starting in 1 year can be hedged as follows [levels as of 21 April. Convexity causes the strike to be around the 90% put implied volatility. 2005]: WHAT JUST 3 The skew curve is thus assumed to be of the form: (K) ATMF ln( K / F ) where F is the forward price. one can obtain a perfect exposure to forward implied volatility with a calendar spread. NEED TO YOU Forward volatility trading Because variance is additive. T = 2 years. and 3 the log skew curve .9) ATMF = 20%. and conversely for a short position [see Section 2.] Implied volatility: similar to options. variance swaps are fully sensitive at inception to changes in implied volatility KNOW ABOUT VARIANCE Variance swaps are especially attractive to volatility sellers for the following two reasons: Implied volatility tends to be higher than final realized volatility: the derivative house has the statistical edge. Note that these two rules of thumb produce good results only for non-steep skew. which is slightly higher than fair volatility. and skew is the slope ATMF of the skew curve. T is the maturity. For example. T = 2 years. we have Kvar 22. 5 . For log-linear skew. For example. Applications Volatility Trading Variance swaps are natural instruments for investors taking directional bets on volatility: Realized volatility: unlike the trading P&L of a delta-hedged option position. a long variance position will always benefit when realized volatility is higher than implied at inception. similar techniques give the rule of thumb: K var where ATMF 2 ATMF 3 ATMF T 2 4 12 2 ATMF T 5 4 ATMF T2 is the slope of is the at-the-money-forward volatility. and a 90-100 skew of 2 0.2.3%. SWAPS 1.1 on P&L path-dependency. For example.19 and Kvar 22. with vegas. T is the maturity. we have 2% ln(0. a short 2-year vega exposure of 100.Rules of thumb DemeterfiDermanKamalZou (1999) derived a rule of thumb for the fair strike of a variance swap when the skew is linear in strike: K var where ATMF ATMF 1 3T skew 2 = 20%.

e. with appropriate notionals: Buy 12x12 = Sell 12x1 = Buy spread = Buy 24m and Sell 12m Sell 13m and Buy 12m Buy 24m and Sell 13m SWAPS Exhibit 1. ABOUT Spot 3m fwd 6m fwd 12m fwd 2m 3m 4m 5m 6m 7m 8m 9m 10m 11m 12m NEED TO Spreads on indices Variance swaps can also be used to capture the volatility spread between two correlated indices. Exhibit 1.1 Spot and forward volatility curves derived from fair variance swap strikes VARIANCE KNOW 24 23 22 21 20 19 18 17 16 15 14 13 1m Source: JPMorgan. or equivalently sell 13m and buy 24m. a Variance Notional of 5.868) Implied forward volatility on this trade is approximately4: 19. where PV(t) is the present value of 1 paid at time PV ( 2 y ) WHAT YOU 4 An accurate calculation would be: 2 y vol 2 2 1 y vol 2 1 JUST 6 .128 / 2 = 2. the hedge will be approximately up ½ a vega.5 in one years time.50 2 year vol 2 .e. However. Therefore.1 below. a Vega Notional of 94.000 (i. Forward volatility trades are interesting because the forward volatility term structure tends to flatten for longer forward-start dates.50 on a Vega Notional of 200.50 tenor 1 year vol 1 tenor 20. an investor who believes that the term structure will revert to an upward sloping shape might want to sell the 12x1 and buy the 12x12 implied volatilities.2.5 .2 below shows that in the period 2000-2004 the historical spread was PV (1 y ) .564 (i. say at 21. Thus. we can see that the 1-year forward volatilities exhibit a downard sloping term structure.Long 2-year variance struck at 19.2. In this example.2.128) Short 1-year variance struck at 18. while the exposure will be down by the same amount.50 on a Variance Notional of 5. keep in mind that the fair value of a variance swap is also sensitive to skew.000. for instance by being long 3-month DAX variance and short 3-month EuroStoxx 50 variance. or 50. as illustrated in Exhibit 1.18. if the 1-year implied volatility is above 20.

Actual numbers may differ depending on skew.2. 5 WHAT JUST Measured as the difference between the 90% strike implied volatilities. transaction costs and other market conditions.2. YOU Correlation trading: Dispersion trades A popular trade in the variance swap universe is to sell correlation by taking a short position on index variance and a long position on the variance of the components. 7 . Exhibit 1. Exhibit 1.2 Volatility spread between DAX and EuroStoxx 50: historical (a) and implied (b) a) SWAPS b) TO KNOW ABOUT VARIANCE NEED Source: JPMorganDataQuery.3 below shows the evolution of one-year implied and realized correlation. while the implied spread5 ranged between -4 and +4 vegas.almost always in favor of the DAX and sometimes as high as 12 vegas.

Implied Vol(t. T ) Strike 2 YOU WHAT where Notional is in variance terms. realized volatility over the past 3 months JUST 8 .3 Implied and realized correlation of EuroStoxx 50 Source: JPMorganDataQuery. SWAPS More formally the payoff of a variance dispersion trade is: n i 1 VARIANCE wi Notional i 2 i Notional Index 2 Index Residual Strike where ws are the weights of the index components.3. t) is the realized volatility between inception and time t. T) is the fair strike of a variance swap of maturity T issued at time t. Typically. Mark-to-market and Sensitivities Mark-to-market Because variance is additive in time dimension the mark-to-market of a variance swap can be decomposed at any point in time between realized and implied variance: TO KNOW NEED VarSwap t Notional PVt (T ) T T t t T Realized Vol(0. struck at 20. and each variance notional is adjusted to match the same vega notional as the index in order to make the trade vega-neutral at inception. For example. PVt(T) is the present value at time t of $1 received at maturity T. and notionals are expressed in variance terms. t ) 2 2 Implied Vol(t . The 9-month zero-rate is 2%. consider a one-year variance swap issued 3 months ago on a vega notional of $200.2. Realized Vol(0.Exhibit 1. ABOUT 1. only the most liquid stocks are selected among the index components.000. s are realized volatilities.

1: 2 K var 2 ATMF VARIANCE 1 3T skew 2 6 Notional 2 ATMF ABOUT Skew Sensitivity T T t skew KNOW For example. Unfortunately there is no straightforward formula to measure skew sensitivity but we can have a rough idea using the rule of thumb for linear skew in Section 1. consider a one-year variance swap on a vega notional of $200.62. it can be shown that ex-dividend annualized variance should be JUST WHAT YOU 9 .000 14 2 2 15 Sensitivity 2.5 10 Skew $100. The mark-to-market of the one-year variance swap would be: VarSwap t 200.5 vegas. minus 20 strike.was 15. resulting in a higher variance. and the 90-100 skew is 2. According to the rule of thumb.619 1 15 2 4 3 19 2 4 20 2 Note that this is not too far from the 2 vega loss which one obtains by computing the weighted average of realized and implied volatility: 0.000 1 2 20 (1 2%) 0. the fair strike is approximately 14 x (1 + 3 x (2.000 NEED Dividend sensitivity Dividend payments affect the price of a stock.5/10)2) = 16. and a 9-month variance swap would strike today at 19.5 10 3 2. Vega sensitivity The sensitivity of a variance swap to implied volatility decreases linearly with time as a direct consequence of mark-to-market additivity: Vega VarSwap t implied Notional ( 2 implied ) T T t Note that Vega is equal to 1 at inception if the strike is fair and the notional is vega-adjusted: Notional SWAPS Vega Notional 2 Strike Skew sensitivity As mentioned earlier the fair value of a variance swap is sensitive to skew: the steeper the skew the higher the fair value.25 x 15 + 0.75 x 19 = 18. If the 90-100 skew steepens to 3 vegas the change in mark-to-market would be: TO MTM 6 200. When dividends are paid at regular intervals.000. At-the-money-forward volatility is 14. struck at 15.75 $359.

000 struck at 20. This phenomenon will normally augment the overall dividend sensitivity of a variance swap.31. SWAPS WHAT YOU NEED TO KNOW ABOUT VARIANCE 6 More specifically the adjustment is 1 T M j 1 2 dj M D 2 T where d1. in the presence of skew.31 5. The adjusted strike is thus (202 + 52 / 2)0. The fair strike is thus: K var ex ( K var div ) 2 ( Div Yield ) 2 Nb Divs Per Year Div Yield Nb Divs Per Year T t T K var From this adjustment we can derive a rule of thumb for dividend sensitivity: VarSwap t Div Yield Notional For example. See Section 3.5 5 Div Yield $12.000 5/ 2 20. dM are gross dividend yields and D is M JUST the annualized average dividend yield. 10 .310 skew sensitivity However.5 = 20.3 for more details. d2. changes in dividend expectations will also impact the forward price of the underlying which in turns affects the fair value of varianc. .5% the change in mark-to-market would be: MTM 200.adjusted by approximately adding the square of the annualized dividend yield divided by the number of dividend payments per year6. consider a one-year variance swap on a vega notional of $200. The fair strike ex-dividend is 20 and the annual dividend yield is 5%. Were the dividend yield to increase to 5. paid semi-annually.

and is the change in implied volatility.000 units of the S&P 500 (in practice 20 futures contracts: 6. implied volatility. and high-order sensitivities (e.1. Valuation and Hedging in Practice 2.2. and other P&L factors are negligible.200)) Were the delta to increase to $5. can be entirely offset by continuously holding a reverse position in the underlying in quantity equal to the delta. WHAT YOU 7 JUST Note that in Black-Scholes volatility is assumed to remain constant through time. as described in 1973 by BlackScholes and Merton. sensitivity of Vega to changes in stock price. 2) We proceed to interpret Equation 2 in terms of volatility. The concept of Vega is thus inconsistent with the theory. dividend expectations. In this world resembling Black-Scholes. or delta. t is the fraction of time elapsed (typically 1/365). SWAPS Vega: sensitivity of the option price to changes in the markets expectation of future volatility (i.000 for an index level of 1. an option trader is mostly left with three sensitivities: Gamma: sensitivity of the option delta to changes in the underlying stock price . The iteration of this strategy until maturity is known as delta-hedging. Once the delta is hedged. we have the reduced P&L equation: Daily P&L = TO 1 2 NEED ( S )2 ( t) (Eq.000/(250 x 1. and we will see that in this world the daily P&L of a delta-hedged option position is essentially driven by realized and implied volatility.e. Vanilla Options: Delta-Hedging and P&L Path-Dependency Delta-Hedging Option markets are essentially driven by expectations of future volatility. the hedge should be adjusted by selling an additional 250 units (1 contract). and so forth. yet critical in practice. KNOW where S is the change in the underlying stock price. For example. the sensitivity of an option price to changes in the stock price.)7 The daily P&L on a delta-neutral option position can be decomposed along these three factors: Daily P&L = Gamma P&L + Theta P&L + Vega P&L + Other (Eq. We now consider a world where implied volatility is constant. More specifically. as well as the P&L due to changes in interest rates. a long call position on the S&P 500 index with an initial delta of $5.000 per index point (worth $6. 11 . 1) Here Other includes the P&L from financing the reverse delta position on the underlying.000..) Equation 1 can be rewritten: Daily P&L = ABOUT VARIANCE 1 2 ( S )2 ( t) V ( ) . etc. Theta or time decay: sensitivity of the option price to the passage of time .. This results from the way an option payoff can be dynamically replicated by only trading the underlying stock and cash. the riskless interest rate is zero.g.000.200) is delta-neutralized by selling 5.250 per index point.

whereas here the weights depend on the option gamma through time. a phenomenon which is known to option traders as the path-dependency of an options trading P&L. This is because each squared return remains distributed around 2 YOU NEED TO t rather than equal to 2 t . which one could name the daily implied variance. illustrated in Exhibit 2. VARIANCE P&L path-dependency One can already see the connection between Equation 4 and variance swaps: if we sum all daily P&Ls until the options maturity. In our world with zero interest rate.We start with the well-known relationship between theta and gamma: 1 2 S 2 2 (Eq. Squared. and t the options gamma multiplied by the square of the stock price at time t. we obtain a characterization of the daily P&L in terms of squared return and squared implied volatility: Daily P&L = 1 2 S 2 S S S S 2 2 t (Eq. Equation 5 does not become nil. 3) the current implied volatility of where S is the current spot price of the underlying stock and the option. is the squared daily implied volatility. 5) KNOW where the subscript t denotes time dependence.1. one based on intuition and one which is more rigorous. it can be interpreted as the realized one-day variance. . rt the stock daily return at time t.1. The second term in the bracket. t . SWAPS Thus. is the percent change in the stock price in other words. 4) The first term in the bracket. However this particular JUST WHAT 12 . Plugging Equation 3 into Equation 2 and factoring S2. 2 the one-day stock return. The main difference is that in a variance swap weights are constant. not approximate. It is interesting to note that even when the stock returns are assumed to follow a random walk with a volatility equal to . we obtain an expression for the final P&L: Final P&L = ABOUT 1 2 n t 0 t rt 2 2 t (Eq. Equation 3 is the core of Black-Scholes: it dictates how option prices diffuse in time in relation to convexity. and breaks even when the stock price movement exactly matches the markets expectation of volatility. Appendix B presents two derivations of Equation 3. Equation 4 tells us that the daily P&L of a delta-hedged option position is driven by the spread between realized and implied variance. In the following paragraph we extend this analysis to the entire lifetime of the option. Equation 5 is very close to the payoff of a variance swap: it is a weighted sum of squared realized returns minus a constant that has the role of the strike. this relationship is actually exact. also known as dollar gamma.

) Because the daily P&L of an option position is weighted by the gamma and the volatility spread between implied and realized was negative. triggering the dollar gamma to soar (Figure b.50%. Exhibit 2.000 SWAPS Trading P&L -250.000 250.000 for an implied volatility of 30%. Wilmott notes that the daily Gamma P&L has a chi-square distribution.path-dependency effect is mostly due to discrete hedging rather than a discrepancy between implied and realized volatility and will vanish in the case of continuous hedging8. even though the realized volatility over the year was below 30%! a) Stock Price (Initial = 100) 140% 120% 100% 80% 60% 40% Stock Price Trading P&L ($) 'Hammered at the strike' ! 750. yet his final trading P&L is down $150k.000 trading days 20% 0% VARIANCE b) Stock Price (Initial = 100) 140% 120% 100% 80% 60% 40% 20% 0% 21% Stock Price Strike = 110 Volatility 70% 60% 50% 43% 40% 30% 20% 10% Dollar Gamma 0% tradin g days ABOUT KNOW 50-day Realized Volatility 31% WHAT YOU NEED TO 8 JUST See Wilmott (1998) for a theoretical approach of discrete hedging and AllenHarris (2001) for a statistical analysis of this phenomenon. the central-limit theorem indeed shows that the sum of n independent chisquare variables converges to a normal distribution.1 Path-dependency of an options trading P&L In this example an option trader sold a 1-year call struck at 110% of the initial price on a notional of $10. the final P&L drowned. and delta-heged his position daily. while AllenHarris include a bell-shaped chart of the distribution of 1000 final P&Ls of a discretely delta-hedged option position.000. Furthermore.000 Strike = 110 500. we can see (Figure a) that the P&L was up $250k until a month before expiry: how did the profits change into losses? One indication is that the stock price oscillated around the strike in the final months (Figure a). Neglecting the gamma dependence.) This would be good news if the volatility of the underlying remained below 30% but unfortunately this period coincided with a change in the volatility regime from 20% to 40% (Figure b.1. 13 . The realized volatility was 27.

We can see that the aggregate gamma is still non-constant (whence the adjective naïve to describe this approach). naïve approach to this weighting problem is to determine individual weights w(K) such that each option of strike K has a peak dollar gamma of. however we also notice the existence of a linear region when the underlying level is in the range 75135.2. Exhibit 2. We can see that the contribution of low-strike options to the aggregate gamma is small compared to high-strike options. The core idea here is to combine several options together in order to obtain a constant aggregate gamma.] Exhibit 2. 14 . Using the BlackScholes closed-form formula for gamma. In this paragraph. Therefore. 100.2.2 shows the dollar gamma resulting from this weighting scheme. Static Replication of Variance Swaps In the previous paragraph we saw that a vanilla option trader following a delta-hedging strategy is essentially replicating the payoff of a weighted variance swap where the daily squared returns are weighted by the options dollar gamma9. say. a natural idea is to increase the weights of low-strike options and decrease the weights of high-strike options.1 Dollar gamma of options with strikes 25 to 200 spaced 25 apart Dollar Gamma Aggregate SWAPS K = 200 K = 175 K = 150 K = 125 K = 100 K = 75 K = 50 K = 25 VARIANCE 0 25 50 75 100 125 150 175 200 225 250 275 300 Underlying Level (ATM = 100) ABOUT An initial. where c is a constant.1 shows the dollar gamma of options with various strikes in function of the underlying level.2.2. Exhibit 2. we use the terms gamma and dollar gamma interchangeably.e. one would find that the weights should be inversely proportional to the strike (i.) [See Appendix C for details.2. We now proceed to derive a static hedge for standard (non-gamma-weighted) variance swaps. WHAT YOU NEED TO KNOW 9 JUST Recall that dollar gamma is defined as the second-order sensitivity of an option price to a percent change in the underlying. w(K) = c / K.

JUST WHAT YOU NEED TO KNOW 15 .2 Dollar gamma of options weighted inversely proportional to the strike Dollar Gamma Aggregate Linear Region K = 100 0 25 50 75 100 125 150 175 200 225 250 275 300 Underlying Level (ATM = 100) This observation is crucial: if we can regionally obtain a linear aggregate gamma with a certain weighting scheme w(K). Since the naïve weights are inversely proportional to the strike K.: SWAPS VARIANCE w( K ) where c is a constant.2. A perfect hedge with a constant aggregate gamma for all underlying levels would take infinitely many options struck along a continuum between 0 and infinity and weighted inversely proportional to the squared strike.e.2.2. then the modified weights w(K) = w(K) / K will produce a constant aggregate gamma. as the static hedge is both space (underlying level) and time independent.Exhibit 2. This is etablished rigorously in Section 3. i. Note that this is a strong result. the correct weights should be chosen to be inversely proportional to the squared strike. c K2 ABOUT Exhibit 2.3 shows the results of this approach for the individual and aggregate dollar gammas. we obtain a constant region when the underlying level stays in the range 75135. As expected.

2. no particular modeling assumption is needed to determine its fair market value. the perfect static hedge for a variance swap would be a combination of the log-asset (a derivative which pays off the log-price of the underlying stock). In other words. b. and ln(.) the natural logarithm. Dollar gamma is the standard gamma times S2: $ VARIANCE (S ) 2 S2 f S2 where f. respectively. c are constants.3.Exhibit 2. The only model choice resides in the computation of the vanilla option prices a task which merely requires a reasonable model of the implied volatility surface. 2. Thus. S are the prices of the derivative and underlying. Assuming that one has computed the prices p0(k) and c0(k) of Nputs out-of-the money puts and Ncalls out-of-the-money calls respectively. a constant dollar gamma means that for some constant a: 2 ABOUT S f 2 a S2 a ln(S ) bS c The solution to this second-order differential equation is: KNOW f (S ) NEED TO where a.3 Dollar gamma of options weighted inversely proportional to the square of strike Dollar Gamma Constant Gamma Region K = 100 Aggregate 0 25 50 75 100 125 150 175 200 225 250 275 300 Underlying Level (ATM = 100) Interpretation SWAPS One might wonder what it means to create a derivative whose dollar gamma is constant. Valuation Because a variance swap can be statically replicated with a portfolio of vanilla options. the underlying stock and cash. a quick proxy for the fair value of a variance swap of maturity T is given as: JUST WHAT YOU 16 .

1% 12. PV0(T) is the present value of $1 at time T. the total hedge cost of the replicating portfolio is 2.08% 0.7% 21.47% 3.935.935.668.935.17% 5.74% 2.76 2.7014% (=2/T * i(wipi)). Exhibit 2.9% 11.4% 20.375.701.935.53.02 2.20% 8.935.02 2.054.02 2.3.9% 12.02 2.27% 0.1 below illustrates this calculation. JUST 17 .01 1.788.83% 10.1.02 3. or 270.13% 3.935.92% 6.VarSwap 0 2 T N puts i 1 p 0 ( k iput ) put ki (k iput ) 2 VS 2 k iput 1 N calls i 1 c 0 (k icall ) call ki ( k icall ) 2 k icall 1 PV0 (T ) ( K ) where VarSwap0 is the fair present value of the variance swap for a variance notional of 1.75% 1.02 2. in this example. SWAPS For a variance notional of 10.935.52 3.935.37% 1.15% 0.51 1.494.88. KVS is the strike.935.02 2.935.02 2.38% 2.02 2.20% 2.15% 0.94% 5.081.02 2.2% 11.01 2.79% 2.89% 7.54% 2.26 2.701. Thus.2% 24.4% Price (%Notional) 0.02 3.02 4.01% VARIANCE 2.0% 18.1 Calculation of the fair value of a variance swap through a replicating portfolio of puts and calls In this example.27 3.06% 0. In the typical case where the strikes are chosen to be spaced equally apart. weighted by the inverse of the squared strike.02 2. the variance swap has a value close to 0.01% 0.76% 0.54%.02 2.9% 13.6% 26.02 2.53% 13.815. as mentioned in Section 1.402.5% 12.8% 13.35% 0.51 2.355.935.96% 2.00% 16.77 3. say every 5% steps.50% 4.935.27 4.02 2.761.3% 16.3%).614.000.397.02 2.54% 4.935.26 1. the fixed leg is worth 2.50% 2.3.81% 0.81% 6. with the convention k0 = 0.935.62%.02% 0.78% 3.348.935. the fair strike is around 16.02 2.52 1Y 1Y 1Y 1Y 1Y 1Y 1Y 1Y 1Y 1Y 1Y 1Y 1Y 1Y 1Y 1Y 1Y 1Y 1Y 1Y 1Y 1Y WHAT YOU NEED TO KNOW ABOUT Source: JPMorgan.8% 14. times the 5% step. For a strike of 16. the expression between brackets is the sum of the put and call prices.02 2.55% 2.02 2.04% 0.467.46% 0.02 2.935.0% 14.109.935.22% Underlying SX5E SX5E SX5E SX5E SX5E SX5E SX5E SX5E SX5E SX5E SX5E SX5E SX5E SX5E SX5E SX5E SX5E SX5E SX5E SX5E SX5E SX5E Call / Put P P P P P P P P P P P C C C C C C C C C C C Forward Strike Strike (%Forward) 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100% 100% 105% 110% 115% 120% 125% 130% 135% 140% 145% 150% Maturity Implied Volatility 27.522.7% 12.935.02 2.17% 1.9% 12.02 2.228. Exhibit 2.935.76 2.02 1. and a 1-year present value factor of 0.4% 25.977368853.67% 3.935.02 2.03% 0.8% 11.0% 22.962.935.641.625 volatility points. this means that the floating leg of the variance swap is worth 2.02 2.907.74% 5.74% 3.51 2.26 2. when a more accurate algorithm gave 16. We also see that the fair strike is close to the 90% implied volatility (17.14 variance points.77 3.77 4.935.201.7% 17. Weight = 5% Strike%2 20.255.935. k i put and k icall are the respective strikes of the i-th put and i-th call in percentage of the underlying forward price.935.89% 11.52 3.

S t . )dt (t . ln S ln S t Define for all 0 t T: t t 0 NEED TO 1 dS u Su 1 ln S . the idealized definition of variance becomes: W0 . S t . Let us introduce some notation: By S. More details on the impact of c However. Moreover. This definition is idealized in the sense that we implicitly assume that it is possible to monitor realized variance on a continuous basis. ln S . ln S 2 t 1 dS u .T 1 ln S . ln S ln S . ln S t for all 0 t T. we assume in this section that dividends are zero and that the underlying price process S is a diffusion process. which is closely related to the payoff of a variance swap. in the presence of jumps.T is given by: W0 . In this case.1. where V0 is the initial value of the strategy. can be replicated by continuous trading of the underlying and cash according to a self-financing strategy (V0. Idealized Definition of Variance An idealized definition of annualized realized variance W0.2. This definition applies in particular to the classic Ito process for stock prices: dS t St (t . . VARIANCE 3. Hedging Strategies & Pricing For ease of exposure. )dWt where the drift µ and the volatility are either deterministic or stochastic. ln S] denotes the quadratic variation of ln S.4.T SWAPS 1 T T 0 2 (t . Moreover. S t . we denote the non-discounted spot price process and by ABOUT S S B we denote the discounted spot price process. where B refers to the deterministic money market account. It is important to note that when rates are deterministic. t and t the quantities to be held in the underlying and cash at time t. often denoted jumps can be found in Section 3. It can be shown that the discrete definition of realized variance given in Section 1. Su WHAT We now explain how T . 2 ln S t t 0 YOU 1 ln S . ln S T . the integral above only represents the continuous contribution to total variance. ln S T T where S denotes the price process of the underlying asset and [ln S.1 converges to the idealized definition above when moving to continuous monitoring. ). let us assume that rates are deterministic.3. The strategy is said to be self-financing because its mark-to-market value Vt V0 t St t Bt verifies: JUST 18 . the continuity of KNOW S together with Ito's formula yields: ln S . )dt . Theoretical Insights 3.

Pricing Having identified a self-financing strategy we can proceed to price a variance swap by taking the risk-neutral expectation of T / BT: TO NEED E since BT T E 1 [ln S . it should be noted that this representation is valid only as long as we assume that the underlying stock price process is continuous and rates are deterministic. for t. the assumption that rates are deterministic is crucial.dVt t dS t t dBt (In other words the change in value of the strategy between times t and t + dt is computed as a mark-to-market P&L: change in asset price multiplied by the quantity held at time t. Whence: E 1 W0.T BT 2 1 E ln S T T BT WHAT JUST At this point. ) is self-financing: V0 t 0 1 BT S t t 0 t 1 dS u B S T u 1 BT Let us point out a few important things: SWAPS The self-financing strategy only replicates the terminal payoff t for t < T. It is indeed easy to see that T = VT: T but it does not replicate VT However t V0 T ST T BT 1 S T B S T T T 0 BT S u 1 dS u 1 BT BT 1 dS u Su T 0 1 dS u Su T VARIANCE > Vt for t < T: Vt BT S t 1 St T 0 BT S u 1 dS u 1 Bt BT Bt BT T 0 Bt BT t t KNOW ABOUT For the self-financing strategy to be predictable (i.) Self-financing strategy One can verify that the following choice for (V 0. As soon as 19 . There is no addition or withdrawal of wealth. . t to be entirely determined based solely on the information available before time t). ln S ]T 2 BT 1 ln S T BT E T 0 BT S u 1 dS u 0 YOU S is assumed to be martingale under the risk-neutral measure.e.

3 and 3. This phenomenon results in a higher variance when the stock price is not adjusted for dividends. the annualized realized variance can be replicated by an infinite sum of static positions in puts and calls.we deviate from this assumption.3 for an example.4. 20 . perfect replication is not possible since options for all strikes are not available. For details we refer to the Appendix in Carr-Madan (2002). Choosing f(y) = ln(y) and taking expectations yields: E S 1 ln T BT FT 1 0 1 Put ( y )dy y2 1 1 Call ( y )dy y2 SWAPS where y now denotes forward moneyness. For this purpose. For further details in this regard. However in general it is not possible to trade log contracts. Representation as a sum of puts and calls In the previous paragraphs we showed that the annualized realized variance can be replicated with a static position in a log contract on the discounted stock price. see Sections 3. we have FT = S0BT. and Put(y) or Call(y) the price of a vanilla put or call expiring at time T. note that a twice differentiable payoff f(S) can be re-written as follows: f ST f FT f ( FT ) ( ST FT 0 FT ) ( FT FT ST ) f ( y)( S T y) dy f ( y )( y ST ) dy Here ST denotes the spot price of the underlying and FT denotes the forward price10. Whence: E VARIANCE 1 W0. which is most often the case. there are three standard ways to approach dividends: continuous dividend yield. From a modeling standpoint.3. A more accurate representation would thus be a discretized version of the above (see Section 2. Impact of Dividends When a stock pays a dividend. q is a deterministic dividend yield. and discrete dollar dividend. discrete dividend yield. In the following paragraphs we only focus on the first two cases: For continuous dividend yield. Thus we need to obtain an alternative representation for the price of the variance swap using standard put and call options. we consider the price process: NEED TO KNOW YOU dS t (rt qt ) S t dt t S t dWt is either WHAT where r is a deterministic interest rate. JUST 10 Since we assume zero dividends in this section. arbitrage considerations show that its price should drop by the dividend amount. Clearly.T BT 2 T 1 0 1 Put ( y) dy y2 1 1 Call ( y)dy y2 The interpretation of this formula is as follows: In case the stock price process S is a diffusion process.) ABOUT 3. additional adjustments have to be made. deterministic or stochastic.

For discrete dividend yield. . For this purpose. JUST 21 . tM. ln S T T S S F is the spot price normalized by the forward price. define the total return process ABOUT S t exp tj t reinvested in the stock. The hedging strategy also remains the same.T where 1 ln S .T 1 ln S .2 where the stock price process S is now replaced by G. Discrete Monitoring Consider a set of sampling dates assume that the time intervals KNOW 0 ti t0 ti N t1 tN T . . and d1. dM are M discrete continously compounded dividend yields11 paid at dates t1. Continuous Monitoring A continuous dividend yield has no impact on variance when monitoring is continuous. let us consider the impact of discrete dividends. is either deterministic or stochastic. The discounted total return process G G / B being a martingale we can use a similar hedging strategy as in Section 3. we consider the price process: dS t rt S t dt t S t dWt d tj t d j St j where r is a deterministic interest rate. Recall the TO NEED t i 1 are all constant and equal to S ti 2 discrete definition of annualized variance without mean: Variance 1 T YOU i 1 ln S ti 1 WHAT 11 Note that we consider here gross yields rather than annualized yields in the discrete dividend case. we t . ln S T T Gt 1 d2 j T tj T d j where dividends are Let us have a closer look at the hedging strategy in the context of discrete dividend yields. Hence. ln S T T 1 ln S . observe that: W0. ln S T T 1 c ln S . This is because the dividend yield q is assumed to be deterministic. there is clearly no impact due to continuous dividends12. In this regard. In this case the stock price process S follows: SWAPS dS t We now have: rt S t dt t S t dWt d tj t d j St j VARIANCE W0. For simplicity of presentation. Next.

We now specialize our considerations to the case of discrete dividends. the contribution of discrete dividends does not converge to zero for t 0 . it should be noted that even in the case where interest rates and dividends are assumed to be zero. we obtain some drift contribution in case of discretization. r ln 2 ti . for t there is no contribution due to interest rates and continuous dividend yields as already pointed out in the continuous monitoring case. In other frameworks (such as local volatility) volatility may depend on S and would thus be impacted by dividends. Squaring the above yields: 2 2 2 1 2 t 2 z2 t 2 z r q 1 2 2 3/2 t Because the expectation of z is nil and its variance E(z2) is one.1). Moreover. 22 . We also obtain that the relative contribution of the interest rate and the continuous dividend yield within a time interval t amounts to: KNOW TO NEED r 1 dj t 2 1 2 2 2 t WHAT YOU 12 JUST Note that this statement is true within a deterministic or stochastic volatility framework. Assuming that a discrete dividend dj is paid between times ti-1 and ti and carrying out similar calculations as in the previous paragraph yields the following expression for the expectation of the log return: ABOUT VARIANCE E ln 2 S ti 1 S ti r 1 dj t 1 2 2 2 2 t 2 t As can be seen from this equation. This is due to 0 . q S (t i ) S (t i 1 ) r q q ti 1 .Contrary to the continuous monitoring case. a continuous dividend yield has an impact on variance when monitoring is discrete. we obtain: E ln 2 S (t i ) S (t i 1 ) S (t i ) S (t i 1 ) 2 r q 1 2 1 2 2 2 2 2 t 2 t The relative impact of discrete monitoring on variance is thus: E ln 2 r q 2 t t SWAPS At this point. the above expression implies that the 2 term in the numerator. r q 1 2 2 t 1 z t z ~ N (0. Consider the log return between ti-1 and ti: ln where S (t i ) S (t i 1 ) rti 1 .

i.3. we ignore interest rates and dividends: dS t St or: t dt t dWt d Nt n 1 (Yn 1) d ln S t t 1 2 2 t dt t dWt d Nt n 1 ln(Yn 1) where W. the drift term µt is chosen such that annualized realized variance: S S is a martingale. . W is a standard Brownian motion.1) Parameters k. ln S ]C T T 1 2 1 T t k . T ln 2 (Yn 1) And the expected variance under the risk-neutral measure becomes: JUST WHAT YOU NEED TO KNOW ABOUT E[W0 .4. can be interpreted as follows: k is the average jump size.: 1 [ln S .T ] ln(1 k ) 2 2 2 23 .) Furthermore. identically distributed log-normal variables: dWt ~ N (0. Gn ~ N (0. Impact of Jumps The purpose of this section is to analyze the impact of jumps. ln S ]T T 1 E W0CT . we no longer assume that the stock price process S follows a diffusion process and instead consider a jump diffusion process.T 1 [ln S . dt ) dN t ~ P ( dt ) Yn SWAPS (1 k )e Gn 1 2 2 . N is a Poisson process with intensity and (Yn) are independent. N and Y are independent. For ease of exposure.e. and is the jump size uncertainty (standard deviation. controls the frequency of jumps. i. We then have for the NT n 1 VARIANCE W0.e.

as illustrated in Exhibit A1. stock prices are believed to follow a random walk. and the distinction might be relevant. In this case. maturity) must have the same implied volatility. an estimate is given as: Historical 252 n (rt n 1t 1 r )2 where r 1 n n t 1 rt is the mean return. For each strike and maturity there is a different implied volatility which can be interpreted as the markets expectation of future volatility between today and the maturity date in the scenario implied by the strike. For historical daily returns r1. and 252 is an annualization factor corresponding to the typical number of trading days in a year. however. Thus. All the other parameters: strike.) is the natural logarithm. the implied volatility of out-of-the money puts is thus higher 24 JUST WHAT YOU NEED TO KNOW ABOUT . This makes the distinction between volatilities implied from call or put prices irrelevant. maturity. as illustrated in Exhibit A2. Historical volatility is also called realized volatility in the context of option trading and variance swaps. put-call parity does not always hold. the estimate is shown to be unbiased with vanishing error as the number of daily observations n increases. there is a one-to-one correspondence between an options price and the Black-Scholes volatility parameter. forward value. Because of put-call parity. Implied volatility is the value of the parameter for which the BlackScholes theoretical price matches the market price. European calls and puts with identical characteristics (underlying. rn. For instance. and is commonly measured by the standard deviation of its returns. a stock) is the level of its price uncertainty. interest rate. this is not because the option has more chances of being in-the-money. strike.g. Implied volatility Vanilla options on a stock are worth more when volatility is higher. out-of-the money puts are natural hedges against a market dislocation (such as caused by the 9/11 attacks on the World Trade Center) which entail a spike in volatility. and ln(. Contrary to a common belief. volatility is the only parameter which is left to the appreciation of the option trader. r2. SWAPS The daily returns are typically computed in logarithmic terms in the context of options to remain consistent with Black-Scholes: rt ln VARIANCE Pt Pt 1 where Pt is the price of the asset observed on day t.Appendix A A Review of Historical and Implied Volatility Historical Volatility The volatility of a financial asset (e. In a Black-Scholes world. Here it is assumed that the returns were independent and drawn according to the same random law or distribution in other words. but because the stock has more chances of being higher in-the-money. In the case of American options. are determined by the contract specifications and the interest rate and futures markets. .

than in-the-money puts. as though the market expectations of uncertainty were skewed towards the downside. b) volatility is implied a) Spot Price Spot Price Spot Price Spot Price b) ABOUT Strike Price Strike Price Black Option Price Option Price Strike Price Strike Price Black Option Price Option Price Maturity Maturity Maturity Maturity KNOW Interest Rate Interest Rate Scholes Interest Rate Interest Rate Implied Implied Volatility Volatility Scholes Volatility Volatility JUST WHAT YOU NEED TO 25 . Exhibit A1 Simulated payoffs of an at-the-money call when the final stock price is log-normally distributed and the volatility is either 20% or 40%. Simulated Payoff Distribution of Final Stock Price Final stock price (% initial price) SWAPS 0% 50% 100% 150% 200% 250% 300% VARIANCE Exhibit A2 Black-Scholes and Volatility: a) volatility is an input. An example of a volatility surface is given in Exhibit A3. This phenomenon is known as volatility skew.

Exhibit A3 Volatility Surface of EuroStoxx 50 as of December 2004 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% 5400 SWAPS 250 2100 2550 2900 3800 Source: JPMorgan. JUST WHAT YOU NEED TO KNOW ABOUT VARIANCE 26 .

Appendix B Relationship between Theta and Gamma An intuitive approach Consider the reduced P&L equation (Eq. (Remember that implied volatility is given on an annual basis.1 Daily P&L = 1 2 ( S )2 ( t) (Eq. 27 . S) is the value of the derivative at time t when the stock price is S. and by linearity of differentiation any portoflio of such derivatives. JUST Here we actually deal with conditional expectation upon the information available at a certain point in time. This leaves us with: t 1 2 E ( S)2 S 2 S 2 S where E[. the first term on the right-hand side is often negligible. the expected daily P&L is nil. VARIANCE By the books Consider the Black-Scholes-Merton partial differential equation: rf f t rS f S 1 2 2 S2 f S2 2 (Eq. whence: In the case of a delta-hedged portfolio. and we have the approximate relationship: WHAT 1 2 13 2 S2. Equation (B2) holds for all derivatives of the same underlying stock.) Replacing the expected squared return by its expression and dividing both sides of Equation B1 by t finally yields: SWAPS 1 2 2 S2. B1) t The quantity S 2 S 1 2 S E 2 S S 2 is the squared daily return on the underlying stock. we have NEED r 1 2 2 S2 YOU Because the short-term rate is typically of the order of a few percentage points. 2) In a fair game. B2) ABOUT where f(t. 2) from Section 2.] denotes mathematical expectation13. taking expectation gives the stock variance over one day: 2 t . and r is the short-term interest rate. we can rewrite Equation B2 as: KNOW r rS TO 1 2 2 S2 = 0. Identifying the Greek letter corresponding to each partial derivative. Writing S 2 yields: (Eq.

5 2 2T 2 T )2 In Exhibit C1 below we can see that the dollar gamma has a bell-shaped curve which peaks slightly after the 100 strike. the dollar gamma of a vanilla option with strike K. K ) S exp 2 T (ln(S / K ) 0. It can indeed be shown that the peak is reached when S is equal to: S* Ke T 2 T /2 Exhibit C1 Gamma and Dollar gamma of an at-the-money European vanilla Gamma VARIANCE SWAPS Dollar Gamma S* 0 50 100 150 200 250 JUST WHAT YOU NEED TO KNOW ABOUT 28 .Appendix C Peak Dollar Gamma When the interest rate is zero. maturity T and implied volatility is given in function of the underlying level S as: $ (S .

Rutkowski (1997). Harris (2001). More Than You Ever Wanted To Know About Volatility Swaps. A Beginner's Guide to Credit Derivatives. Derman. Goldman Sachs Quantitative Strategies Research Notes.References & Bibliography Allen. Vaillant (2001). Zou (1999). Volatility Vehicles. JUST WHAT YOU NEE D TO KNOW ABOUT VARIANCE SWAPS 29 . Jarrow Risk Books. Futures & Other Derivatives 4th edition. Kamal. Options. NYU Courant Institute. Gatheral (2002). Nomura International. Madan (1998). Working Paper. Wiley. Springer. Martingale Methods in Financial Modelling. Case Studies in Financial Modelling Fall 2002. Discrete Hedging in The Theory and Practice of Financial Engineering. Demeterfi.A. Towards a Theory of Volatility Trading in VOLATILITY. Hull (2000). R. Wilmott (1998). JPMorgan Equity Derivatives Strategy Product Note. Carr. Musiela. Prentice Hall.

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