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The variance swap is an equity derivative with payoff the realized variance of the underlying
equity or index. The Black-Scholes-Merton tradition of continuous delta hedging under
diffusion confuses it with the log contract. As a consequence, it suggests the variance swap is
redundant with the vanilla options.
However, what the variance swap truly is (what it is, over and above the vanillas) is a play on
the possible underlying jumps. Learn why, here.
We believe variance swaps mark a new age in volatility arbitrage. For this reason, we price
them from scratch, independently of the diffusion assumption or even the idea that vanilla
options may have ever been a play on variance:
We price the variance swaps under our generalized jump-diffusion model with
stochastic volatility and stochastic jumps, also known as the “regime-switching
model.”
We also price the log contract. This way, you can measure the difference due to the
jumps.
It doesn't matter whether jumps (in the equity or the index) have been known to occur
or not to occur in the past. (A jump to default couldn't have occurred in the past.)
What matters is whether the market anticipates such jumps.
The empirical disconnect between the market price of the variance swap and the
theoretical price of the log contract (a.k.a. the strip of vanillas), apparent even on the
index, points in that direction.
We even calibrate the regime-switching model against the market prices of variance
swaps of different starting dates and maturity dates, independently of the vanillas.
Indeed, the variance swap is not redundant with the vanillas and its price carries
additional information on the underlying process (as does the price of any path-
dependent option, generally).