Forward contracts are a crucial part of hedging and speculation for investors. These contracts allow two parties to buy or sell an asset at a specific price and future time. Usually, they also include the commodity, delivery date, and amount for the agreement. Forward contracts may come in many forms and factors. A common type of these contracts includes swaps.
A swap is a derivative instrument that allows two parties to exchange their cash flows. Usually, they are common in areas where hedging and speculation are necessary. As forward contracts, swaps can apply to various situations or conditions. Two of these instances include variance and volatility swaps.
What is a Variance Swap?
A variance swap is a type of forward contract that allows the holder to speculate on an asset’s future volatility. It is an over-the-counter financial derivative that helps investors hedge or speculate risks related to various movements. With these derivatives, investors can use the price movement of an underlying asset in their hedging or speculation strategies.
Primarily, variance swaps use the variance in several movements to allow investors to speculate or hedge risks. These movements include the volatility of any underlying product. Usually, they cover stock indices, interest rates, and exchange rates. Variance swaps provide a cheaper alternative to options as they don’t require investors to purchase a strip of options. However, these swaps can also be risky during significant price fluctuations.
With variance swaps, one party must pay an amount based on the realized variance of the price changes in the underlying product. The other party must pay a fixed amount, known as the strike price. Usually, investors prefer variance swaps for their purity. Variance swaps are similar to volatility swaps. However, these swaps focus on variance rather than volatility. Variance swaps are more common in the equity market.
What is a Volatility Swap?
A volatility swap is a forward contract that considers the realized volatility of the underlying asset. This swap involves a payoff based on that volatility. Usually, investors use volatility swaps to hedge the volatility of an asset directly. Volatility swaps are similar to variance swaps, as mentioned above. However, these swaps consider the realized volatility of the underlying asset.
With volatility swaps, investors can trade the volatility of an asset. However, they don’t involve the asset itself. Similarly, it does not require an exchange of cash flows. These features differentiate volatility swaps from other traditional swaps in the market. Volatility swaps allow investors to speculate or hedge the direction and degree of movement of the underlying asset’s volatility. This movement must not depend on price movements or changes of that asset.
The payoff in this swap depends on three factors. These include the realized volatility of the asset, the volatility strike, and a predetermined notional amount. Like variance swaps, investors prefer volatility swaps for their purity. They provide an alternative to investing in options. For those options, the volatility has a price dependency. However, volatility swaps offer direct exposure to volatility only.
Conclusion
Forward contracts allow investors to hedge or speculate on investments. A common type of these contracts is swaps, which involve the exchange of cash flows over a period. Variance and volatility swaps are prevalent in the equity markets. Variance swaps allow investors to speculate on the future price movements on an underlying asset. Volatility swaps, in contrast, relate to the volatility of that asset.
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