← InstitutionalLesson 5 · 4:24
Variance and volatility swaps
Summary
You can read a variance swap's payoff and explain how a strip of options weighted by one over the strike squared builds it. You can say why the 30-day variance strike on real SPX data sat about four points above at-the-money volatility, and how a volatility swap's strike differs by the convexity adjustment.
Key terms
- variance swap
- A contract that pays realized variance minus a fixed strike agreed at the start, in one payment at the end.
- variance points
- Volatility squared, so a strike of 20 is 400 variance points.
- variance strike
- The fixed level a variance swap is agreed at, quoted in volatility terms.
- strip
- A set of out-of-the-money puts and calls at every strike, each weighted by one over the strike squared, that together build a variance swap.
- volatility swap
- A contract that pays realized volatility minus its strike, with no squaring.
- convexity adjustment
- The amount by which a variance strike sits above a volatility strike, which grows as the range of outcomes widens.
Check yourself
Answer each question to see why the right answer is right.
1. An example variance swap has a strike of 20 and pays $10 per variance point. Realized volatility comes in at 10. What happens to the buyer?
2. Why does the desk weight each option in the strip by one over the strike squared?
3. On the real SPX strip for the expiry 25 days away, where did most of the strip's value come from?
4. The 30-day variance strike came out at about 21, while at-the-money volatility was only about 17. What two reasons does the lesson give?
5. Realized volatility will end at either 10 or 30, a coin flip. What are the fair volatility swap strike and the fair variance swap strike?
Finished the video and the quiz? .