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It is measured in terms of the standard deviation of the price from an average.also known as historic volatility and is the actual variance in the price of an option over time. the option's strike (contract) price. calculated based on the actual stock price. time to expiration and other known variables • REALIZED VOLATILITY-.Volatility • Volatility is a measure of the rate & magnitude of the change of prices (up or down) of the underlying. • IMPLIED VOLATILITY—It is the market prediction of future volatility. .positive or negative but with the amount of change. • Volatility is not concerned with the direction of the change.

VAR-SWAP CASHFLOWS— • • .Variance Swap • A var-swap is an OTC derivative contract in which two parties agree to buy or sell the realized volatility of an index or single stock on a future date. Var-swap contracts were first mentioned in 1990.

trade size is generally expressed in terms of vega. $ 100.. Contract Period: The most liquid variance swap maturities are generally from 3 months to around 2 years.Key Terms. • SWAP-STRIKE : Pre-determined price .000 vega exposure means that the swap value will change by $ 100.(volatility is scaled by a factor of 100. • • VEGA = 2*Volatility(strike)* Notional . although indices and more liquid stocks have variance swaps trading out to 3 or even 5 years and beyond.000 for each percentage point change in the volatilty of the underlying index. Observation Days: All trading days which are not disrupted.represents the level of volatility bought or sold & is set at trade inception.) Variance SWAP Vega : It is the dollar-change in swap value for each percentage –point movement in volatility. • • • • SWAP expiration date : The date on which contract expires. for example a strike of 20 represents a volatility of 20%. For eq.

Strike Level2) • Seller Payoff= Notional*(Strike Level2 .Calculation • Buyer Payoff= Notional*(Realized volatility2.Realized volatility2 ) .

. Indexi= Closing level of underlying index.Realized Volatility= 252=Annualization Factor n= no. of observations excluding the initial observation on trade date but including valuation date.

• Calculation :- .Mark to Market Variance SWAP • If an investor wishes to close out a variance swap position before maturity they must also consider any change in value of the exposure to volatility over the remainder of the variance swap term.

We are realising this pay-off now i.60 . 9-month LIBOR is 4%. Volatility realised over following 9 months = 25% Variance = [ ¼ x 152 ] + [ ¾ x 252 ] = 525 (≈22.500 x (22.9 volatility) At expiry. One Year Var_swap with STRIKE 20% & Vega Notional $100.e after 3 months & before 9 months .92 – 202) = $312.500 Note :. the discount factor applied would be 1/(1+¾ x 0. Volatility realised over first 3 months= 15% 4.0000/(20*2)= $ 2500 3.Payoff= 2.04) = 0.Example :1. Var Notional = 10.therefore we need to apply an appropriate INTEREST RATE DISCOUNT FACTOR.000 2.97 Variance = [ ¼ x 152 ] + [ (¾ x 252)*0.If after 3-months.97 ] = 22. So.

19%)) . 2. Disrupted days :. Further margin calls will be made during the course of the trade as necessary.600 (Here.84% gain(Net-loss1.16.9% loss is followed by 1. 15th day.(net loss 1.Variance swaps are usually margined in a similar manner to options.06%)if 16th day is declared as disrupted.800(Index Close) 16th day.Var SWAP Contract Specifications 1. 2 . Settlement is calculated at maturity and cash-flows exchanged shortly afterwards.(T+2). Margins and collateral :.The realised variance used in a variance swap payout is calculated from closing (or official observed) prices on observation dates (scheduled trading days which are not disrupted) over a specified period. with an initial amount to be posted as collateral.300 17th day-16.16.

05% & NOT (94/100-1=-6%) . Dividend adjustments :.e the return on the ex-dividend date is calculated after adjusting for the dividend. This means that index variance swaps (especially longdated ones) will be exposed to the risk of index reconstitution. potentially with different volatility characteristics than when it was originally traded. and the variance swap may end with an exposure to a very different set of stocks. (By convention index variance swaps are not usually adjusted for dividends) Eq-If a stock is worth $100 on the day before dividend .the return used in calculating realized volatility for var-swap payout will be 94/95-1= -1.pays a dividend of $5 & closes at $94.3. on its ex-dividend day. Index reconstitution risk :. 4.Variance swaps on indices are defined to pay out on the returns of the index and not on the weighted returns of the basket of current constituents.i.Variance swaps on single names are typically adjusted for dividends.

Max Loss for short= .5. Variance swap caps :. Variance swap caps are useful for short variance positions. especially on single-stocks (and sector indices). where investors are then able to quantify their maximum possible loss. These are often set at 2.5 times the strike of the swap capping realised volatility above this level. are usually sold with caps.Variance swaps.

Advantages • Variance swaps offer investors a means of achieving direct exposure to realized variance without the path-dependency issues associated with delta-hedged options. . • variance swaps are convex in volatility: a long position profits more from an increase in volatility than it loses from a corresponding decrease.

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