Volatility Seminar, Imperial College

Some notes on Variance Swaps and Volatility

derivatives
Antoine Jacquier∗
Birkbeck College, University of London
Zeliade Systems

May 2007

Abstract
We review here the theoretical approaches as well as the practical use
of volatility derivatives. A clear focus will be made on variance swaps,
for historical and logical - the most liquid of any volatility instruments -
reasons. Instead of going into all the details of the calculations, we will
try to point out the useful papers on different subtopics.

Contents
1 Variance and volatility swaps 1
1.1 Replication via Vanilla options . . . . . . . . . . . . . . . . . . . 2
1.2 Comments on the replication result . . . . . . . . . . . . . . . . . 3

2 ”Exotic” Variance swaps 7

2.1 Forward Variance Swap . . . . . . . . . . . . . . . . . . . . . . . 7
2.2 Gamma Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
2.3 Entropy Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
2.4 Corridor and Conditional Variance Swaps . . . . . . . . . . . . . 8
2.5 Generalised Variance Swaps . . . . . . . . . . . . . . . . . . . . . 8
2.6 Moment Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
2.7 Dispersion and correlation trading . . . . . . . . . . . . . . . . . 9

3 Volatility derivatives 9
3.1 Options on realised variance . . . . . . . . . . . . . . . . . . . . . 9
3.2 VIX and options on the VIX . . . . . . . . . . . . . . . . . . . . 9
3.3 Forward-Started options and Cliquets . . . . . . . . . . . . . . . 10
3.4 Advanced Volatility Derivatives . . . . . . . . . . . . . . . . . . . 11
∗ a.jacquier@ems.bbk.ac.uk.

1
1 Variance and volatility swaps
Variance swaps are products with the following payoff at maturity :

 
1 T 2
Π=N σ dt − K
T 0 t

Where N is a notional, K the strike, expressed in variance (squared volatility)

points, and T is the maturity of the option and σt2 represents the squared return
over the infinitesimal period [t, t + dt]. As any swap, its price is such that the
option has zero value at inception, i.e. :
  
T
∗ 1
K =E 2
σ dt/F0
T 0 t

1.1 Replication via Vanilla options

The idea of replication relies upon  the formula by Breeden  &Litzenberger (1978)
t ,K,t,T )  ∂ 2 P (St ,K,t,T ) 
2
: p (ST , T ; St , t) = ∂ C(S∂K 2  = ∂K 2  , where C (St , K, t, T )
K=ST K=ST
(resp. P ) stands for the undiscounted call option price at time t written on the
stock S with maturity T and strike K. Then the value of any claim with payoff
g reads (for any F ≥ 0)
 ∞
E [g (ST ) /Ft ] = p (K, T ; St, t) g (K) dK
0
 F  ∞
∂2P ∂2C
= g (K) dK + g (K) dK
0 ∂K 2 F ∂K 2

Integrating twice by parts and using the Put-Call parity relationship (we refer
to formula (11.1) for details), we obtain :
 F  ∞

E [g (ST ) /Ft ] = g (F ) + P (K) g (K) dK + C (K) g  (K) dK
0 F

Now, consider the following stock price process : dS t

St = rdt + σt dWt as well as
the traditional Black-Scholes assumptions, except for the volatility, which needs
not be constant. Using Ito’s lemma, we get :
   T  T 
ST dSt 1 T 2
log = d log (St ) = − σ dt
S0 0 0 St 2 0 t
Hence, the realised variance over the period [0, T ] reads :
 T  T  
1 2 dSt 2 ST
σt2 dt = − log
T 0 T 0 St T S0

Taking expectations on both sides, and noting that E dS St

t
= rdt, as well as
the following identities, for any S∗ > 0 :
   S∗  ∞  
ST ST − S∗ dK dK S∗
− log = − + (K − ST )+ 2 + (ST − K)+ 2 − log
S0 S K K S0
  ∗  
0
 ∗
S

Short 1/S∗ fwd contracts Long position in Calls and Puts struck at K

we eventually get
 
      ∞ 
T S∗
1 2 S0 rT S∗ dK dK
E σt2 dt = rT − e − 1 − log +e rT
P (K) + C (K)
T 0 T S∗ S0 0 K2 S∗ K
2

1.2 Comments on the replication result

• the term S∗ can be chosen arbitrarily. For practical reasons, it is usu-
ally taken as the at-the-money forward, which corresponds to a liquidity
threshold : above this strike, the calls are more liquid, below, the puts are
more liquid.
• This formula shows that the realised variance, i.e. the strike of a variance
swap, can be replicated by a portfolio of options, each of them weighted
by the squared strikes.
• It can be shown that such a weighting scheme makes the portfolio’s vega
be independent of the stock price. This is a very convenient feature, as
the variance swap can hence be considered as a pure volatility product.
For a proof of this statement, see [14].
• The whole replication above has been done within the Black-Scholes frame-
work, which means in particular, no jumps and flat skew. Let us start by
the problem of the skew, i.e. the influence of the skew on the price of the
variance swap. We are here mainly inspired from [14]. We state here a
few results and refer to [14] for details on the derivations.
– Skew linear in strike
Let suppose that the implied volatility has the following parameter-
isation :
K −S
σimp (K) = σ0 − β
S
Where σ is the fair volatility in the flat world. The higher the β, the
steeper the slope of the skew. Then, the fair value of the variance
swap is modified as
 
KVar = σ02 1 + 3T β 2 + . . .

3
 – Gatheral approach
Interestingly, Gatheral (see in the book, page 139) points out two
things: first, that the fair value of the variance swap can indeed be
expressed as a weighted average of implied variance ; then he presents
a different results for the impact of the skew : according to him, the
slope of the skew has no impact, whereas the curvature of the smile
does affect (in the same direction) the price of the variance swap. He
indeed gets the following formula :
   
1 T 2
E σ dt = dzN  (z) σBS
2
(z)
T 0 t R

Where N is the cumulative distribution function

 of the Gaussian and
S
z is a level of log-moneyness : z = log K .
• In the replication above, one of the main assumptions was the existence
of a continuum of options for all strikes, which is of course not observed
on the market. So one is only able to trade in a limited range of strikes.
It is easily shown that this limited replication has a lower value than the
full replication. See [14] (section 5) for details.
• Here, we only consider the pricing of a variance swap at the inception
of the contract. Thanks to the additive properties of the variance, it is
fairly easy to decompose the variance swap at an intermediate time into a
realised variance and a future variance. For more details on this, see [10].
• In the derivation of the replicated portfolio, we assumed the continuity
of the stock price. Suppose that a jump occurs and that the stock price
jumps downwards (J < 0) or upwards (J > 0) from S to S (1 + J). Then,
because of the additivity of variance, we have, in discrete time :
 2  2  2
1  ∆S 1  ∆S 1 ∆S
= +
T S T S no jump T S jump
 2 J2
And T1 ∆S S jump = T
Now, the replication strategy reads
N   
2  ∆Si Si
RS = − log
T i=1 Si−1 Si−1

So the influence on the jump on the replicating strategy is worth 2

T (J − log (1 + J)).
And so, the P&L due to this jump is worth
2 J2
P &LJump = (J − log (1 + J)) −
T T
Taylor expanding the log function around J (assuming J is small enough),
we get :
2 J3
P &LJump ≈ −
3 T

4
 This means that a big move upwards (J > 0) leads to a loss for the variance
swap seller, and vice versa. For more details on this, see [14] (Section 5).
• Convexity adjustment for volatility swaps
Volatility√ swaps look like variance swap. The payoff of a volatility swap
isN
√  
vol ( V − Kvol ). At first, we can use the following approximation :
E x ≈ E(x). Therefore, we can replicate a volatility swap (Kvol ,Nvol )
using a variance swap (Kvar ,Nvar ), where Nvol is noted in units of currency
per volatility point, and Nvar in units of currency per variance point. We
must take care that :  2
 Kvar = Kvol
 Nvol
Nvar = 2Kvol

The second equality is explained as follows :

√ V − Kvol
2
1  
V − Kvol = √ ≈ V − Kvol
2
V + Kvol 2K vol

But, in fact, there is a convexity bias between the volatility swap and the
variance swap due to the non linearity of the square root function.
As explained in Brockhaus and Long [1], we can have a much better ap-
proximation of a volatility swap using the results found
√ with a variance
swap. Given the square-root function F : x → x, the second order
Taylor expansion around x0 gives us
1
F (x) ≈ F (x0 ) + F  (x0 )(x − x0 ) + F  (x0 )(x − x0 )2
2
√ x − x0 1 (x − x0 )2
F (x) ≈ x0 + √ − 
2 x0 8 x30
x + x0 (x − x0 )2
F (x) ≈ √ − 
2 x0 8 x30
Applying this formula with x = v and x0 = E[v] and taking expectations,
we have
√   V[v]
E v ≈ E[v] − 
8 E3 [v]
This formula gives us the approximate value of the convexity bias, which
is thus equal to √V[v]3 .
8 E [v]
The convexity bias needs either a specified model for the dynamics of
the volatility or an assumption on the level of the forward volatility and
variance. In terms of replication, there is no static hedging. But, as in the
tradional Black-Scholes framework, we can produce a dynamic hedging
for these volatility swaps, using variance swaps all along the life time of
the swaps so that it becomes instantaneously independent on the moves

5
 in the volatility. Mathematically, we want to find (α, β) minimizing the
function Φ defined as :
 2

Φ (α, β) = E σt − ασt2 − β

When differentiating the above function, we get

 ∂Φ  
 ∂α (α, β) = E 2ασt4 − 2σt3 + 2αβσt2
  
∂Φ
∂β (α, β) = E 2β − 2σt + 2ασt2

which finally gives

  
 E [σt ] = αE σt2 + β
      
E σt3 = αE σt4 + βE σt2

This two-equalities result hence needs the forward levels of volatility and
variance. This explains why variance swaps are nowadays much more
liquid than volatility swaps. Furthermore, despite the fact that we can’t
calculate a mark-to-market price for volatility swap without a specified
stochastic volatility model, Morokoff, Akesson and Zhou established in
[18] the existence of lower and upper bounds for such products, using
arbitrage arguments. Carr and Lee [5] also found an interesting result
: the volatility swap admits a robust supereplication using a variance
swap and has a lower bound equal to the at-the-money implied volatility
(ATMIV). They also provide an approximation using this ATMIV and the
total variance which is
a2 +σ̄2
4+ 02 0T
E0 σ̄T ≈ a0
4 + a20 T
where a0 represents the at-the-money implied volatility at time 0.
In a similar way to variance swaps, the hedge for volatility swaps isn’t
static but has to be dynamically rebalanced using the log-contracts. How-
ever, the large number of options needed to synthetically create this hedge
makes the transaction costs too much.
For practical as well as technical details on the convexity adjustment, see
[21].
• P&L and ”Cash” Gamma
Let us consider an option Vt (for example a Vanilla Call option or a Vari-
ance Swap). Using Black-Scholes method for constructing a delta-hedged
portfolio, one can easily show that the P&L of such a portfolio on the
period [t, t + dt] reads
 2 
1 2 dSt
P &L[t,t+dt] = ΓSt − σt dt
2
2 St

6
 Proof : We briefly sketch the proof
We have
1
P &L[t,t+dt] = Delta P&L+Gamma P&L+Theta P&L = ∆ (∆S)+ Γ (∆S)2 +Θdt
2
But Θ ≈ − 12 ΓS 2 σimp
2 2
, where σimp stands for the implied volatility. Hence,
when delta-hedging the portfolio,
 2 
1 2

1 ∆S
P &L[t,t+dt] = Γ (∆S) − σimp 2
S 2 dt = S 2 Γ − σimp
2
dt
2 2 S

The first-term in the bracket corresponds to the realised variance, and the
second term to the implied variance. For more insights on this, see [4]
(part 8)
Now, the Gamma of the Variance Swap reads (see [17] for the greeks of a
Variance Swap)
2
ΓVarSwap = 2
St T
Plugging this into the P&L formula, we find
 2 
1 ∆S
P &L[t,t+dt] = − σimp dt
2
T S

This means that the P&L of a Variance Swap over a small period of time
does not depend on the level of the stock price. This is why it is called a
constant ”Cash” Gamma. In fact, the P&L, as we can see it, only depends
on the difference between implied and realised variance.
• A finite-difference approach for thepricing of Variance Swaps has also been
developped, see [16].

2 ”Exotic” Variance swaps

2.1 Forward Variance Swap
2.2 Gamma Swaps
We saw that the vega of the variance swap does not depend on the level of the
stock price, and also that the Variance Swap had a constant ”Cash” Gamma.
Suppose the stock price jumps downwards ; the Gamma of the variance swap
does not change, nor its Vega. If one uses variance swaps for hedging purposes,
this could be a problem. Hence, it would be quite convenient ot be get a Vega
which adjusts itself automatically with the level of the stck price, so as to reduce
the potential exposure to volatility. The Gamma swap is an answer to this and
its payoff reads   
1 T 2 St
V=N σ dt − K
T 0 t S0

7
With this definition, Gamma Swaps will be replicated exactly like Variance
1
Swaps, but with a weighting scheme equal to K instead of K12 . Practically
speaking, Gamma Swaps have a constant ”Share” Gamma , and, as they are
weighted by the level of the stock, they do take into account the possibility of
jumps.

2.3 Entropy Swaps

The Entropy Swap has been considered by Buehler in [3]. It looks like a Gamma
Swap, though it is much less common. Its payoff reads
 T  T
St d log (St ) = St σt2 dtdt
0 0

We refer to [3] for details on this product. Its replication is very similar to that
of the Gamma Swap.

2.4 Corridor and Conditional Variance Swaps

Corridor and conditional Variance Swaps allow investors to take exposure on
some future level of volatility given that the underlying has traded in a speci-
fied range. This conditionality makes these products less expensive than pure
Variance Swaps. There are basically two types of conditional variance swaps
: up-variance swaps accrue realised volatility when the underlying stock or in-
dex is above a certain threshold, whereas down-variance swaps have gets higher
when the underlying remains below a pre-specified level. The two products are
very similar, up to two small differences :
• In the Conditional Variance Swap, the accrued variance is divided by the
number of days spent in the specied range, whereas it is divided by the
total number of days for a Corridor Variance Swap.
• (Consequence of the first point) : the P&L of the Conditional Variance
Swap is scaled to the proportion of time spent within the range.
More formally, we can write :
 
D S
P &LCond = − KCond
T D
   
S D
= − KCond + KCorr − KCond
T T
     
Corridor VS Range accrual

From a pricing point of view, the replication scheme is almost the same than the
one used for pure Variance Swaps : the weights are identical, but the integrals
are truncated at the levels specified by the barriers(down or up).
General references

8
 • A.Sepp, Variance swaps under no conditions, (Risk, March 2007)
• P.Carr, K.Lewis, Corridor variance swaps, [7]

2.5 Generalised Variance Swaps

This is just a generalisation of the Vanilla Variance Swaps and the so-called ”ex-
otic” Variance Swaps. In fact, instead of considering the discrete-time realised
variance, consider the following :
T −1  
1  2 St+1
S= Ft log
T t=0 St

Then, one can see that

• If Ft = 1, then this represents a pure Variance Swaps.
• If Ft = St
S0 , then this is a Gamma Swaps

1, if L ≤ St−1 ≤ U
• if F = , then we are back to a Corridor Variance
0 otherwise
Swap. (The down-Variance Swap assumes U < ∞, and for the up-Variance
Swap, we have U = ∞).

2.6 Moment Swaps

This product has been proposed by Schoutens (see [20]). The payoff of such an
option reads
  
n
1 T dSt
Π=N −K
T 0 St
Where N represents the notional of the product, K the strike, T the maturity,
and n the exponential power. Using Taylor expansion method, Schoutens shows
that a nth-order Moment Swap can be replicated by trading log-contract (i.e.
a portfolio of European options), a dynamic strategy in Futures and a series of
moment swaps of order strictly smaller that n. For now, it seems like this kind
of product has been purely of theoretical interest.

2.7 Dispersion and correlation trading

3 Volatility derivatives
3.1 Options on realised variance
The natural extension of Variance Swaps is an option on the realised variance,
basically a call option, with payoff
  
1 T 2
σ dt − K
T 0 t
+

9
Carr & Lee [5] found a replication strategy for such an option under zero cor-
relation between the spot price and the volatility. In particular, they were able
to replicate any payoff of the form of the exponential of the quadratic variation.
See also [6] for very recent results on the replication of volatility derivatives,
using variance and volatility swaps as hedging instruments.
For pricing methods of options on realised variance under Levy processes, we
refer the reader to [9].

3.2 VIX and options on the VIX

The VIX is a volatility index launched by the CBOE in 1993. Its purpose was
to replicate the one-month implied volatility of the S&P 100 index. In 2003,
the calculation method was changed and expanded to replicate the S&P 500.
Options on the VIX are quite recent :
• March 2004 : VIX Futures listed by the CBOE.
• 2004 : Variance Futures listed by the CBOE.
• 2005 : New volatility indices, VDAX, VSTOXX, VSMI.

• 2005 : Volatility Futures on thesevol indices.

• 2006 : Options on the VIX were launched.
The mathematical definition of the VIX is as follows
 2
2  ∆Ki 1 F
2
σ = Q (Ki ) − −1
T n Ki2 T K0

Where


 σ = V100
IX

F : forward index level derived from index option prices
 Ki : Strike of the ith option


Q (Ki ) : Midpoint of the bid-ask spread for an option with strike Ki

Now, let us consider a stock price with spot volatility σt . Then one can derive
the following formula :
  t+τ 
Q 1
V IXt = Et
2 2
σs ds
τ t

Where τ represents the one-month period. Using this result, closed-form or

semi-closed form formula can be found for options (in particular Futures) on
the VIX, if one assumes a stochastic volatility model.
For details on the pricing of VIX Futures, see [22], [15] for closed-form solutions
under various stochastic volatility models or directly on the VIX website for
practical details : http://www.cboe.com/micro/vix/vixoptions.aspx

10
More advanced results on lower and upper bounds for VIX Futures have been
obtained in [8] and [11]. In particular, the bounds obtained by Carr and Wu in
[8] can be expressed in terms of a portfolio of European options (for the upper
bound) and of a Forward-tart ATM call option (for the lower bound), which are
directly observable.

3.3 Forward-Started options and Cliquets

We don’t detail anything here, as these products have already been studied in
a previous talk. Just to mention that, if one considers a Forward-Start Call-
Spread, with payoff (ST /St − K1 )+ − (ST /St − K2 )+ , then one can see that its
delta is theoretically zero (hence pure volatility product), and that it purely
depends on the skew between the two strikes K1 and K2 . They are in fact the
underlying blocks of cliquet options, which heaviley rely on the forward level of
variance. See [2] for some details on this.

3.4 Advanced Volatility Derivatives

References
[1] O. Brockhaus, D. Long. Volatility swaps made simple, Risk Magazine, Jan-
uary, 2000.
[2] H. Buehler. Stochastic volatility models and products, Risk Training Course,
Hong Kong, 2004
[3] H. Buehler. Volatility Markets, Consistent modeling, hedging and practical
implementation, PhD Thesis, 2006
[4] P. Carr. FAQ’s in option pricing theory, Courant Institute, NYU, 2002
[5] P. Carr, R. Lee. Robust replication of volatility derivatives, Courant Insti-
tute, NYU, Stanford University, 2003
[6] P. Carr, R. Lee. Realized Volatility and Variance: Options via Swaps, Risk,
2007
[7] P. Carr, R. Lee. Hedging variance options on continuous semimartingales,
Courant Institute, NYU, Stanford University, 2006
[7] P. Carr, K. Lewis. Corridor variance swaps, Risk, February 20004, 2006
[8] P. Carr, L. Wu. A tale of two indices, Journal of Derivatives, Spring 2006.
[9] P. Carr, H. Geman, D. Madan, M. Yor. Pricing options on realised variance,
Finance and Stochastics, 2005, issue 4
[10] N. Chriss, W. Morokoff. Market Risk for Volatility and Variance Swaps,
Risk, July 1999

11
[11] B. Dupire. Model free results on volatility derivatives, Bloomberg, 2006
[12] Chicago Board Options Exchange. VIX-CBOE Volatility Index, 2003,
http://www.cboe.com/micro/vix/vixwhite.pdf
[13] P. Friz, J. Gatheral. Valuation of volatility derivatives as an inverse prob-
lem, Quantitative Finance, 2005
[14] K. Demeterfi, E. Derman, M. Kamal, J. Zou. More than you ever wanted
to know about variance swaps, Goldman Sachs, Quantitative Strategies Re-
search Notes, 1999.
[15] Y. Lin. Pricing VIX Futures on Affine Stochastic Volatility Models with Si-
multaneous Sate-Dependent Jumps both in the S&P 00 Price and Variance
Processes, Working paper, 2006.
[16] T. Little, V. Pant. A finite difference method for variance swap, Working
paper, 2001.
[17] D.E. Kuenzi. Variance swaps and non constant Vega, Risk, October 2005.
[18] W. Morokoff, F. Akesson, Y. Zhou. Risk management of volatility and vari-
ance swaps, Risk Quantitative Modeling Notes, Goldman Sachs, 1999.
[19] A. Neuberger. The log contract, Journal of Portfolio Management, 20(2):74-
80, 1994.
[20] W. Schoutens. Moment swaps, Working paper, 2005.
[21] C. Youssfi. Convexity adjustment for volatility swaps, Merril Lynch presen-
tation, 2005.
[22] Y. Zhu, J.E. Zhang. Variance term structure and VIX Futures pricing,
International Journal of Theoretical and Applied Finance, Vol. 10, No. 1
(2007) 111-127.

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