1125128, 741 PM \Volatlty Swap -Definion, Explained, Example, Vs Variance Swap > WallStreetMojo Q Home Darius esis uazser Volatility Swap. Article by — What is OptiésieTbudingeviewed by Aswathi Jayyghandien Fuddeakgiti Dheeraj Vaidya, CFA, FRM Credit Default Swap > Volatility’ SWap" Definition A volatility swap is a forward contract where parties decide in advance to exchange cash flows based on the changes in the overall level of uncertainty or risk in the market. Through this volatility derivative, investors can make money by correctly anticipating and taking advantage of these swings in volatility. Volatility Swap Arrangement ay CS) _ PT ar EC) Pays Pay on volatility Neg ive Payment Price fluctuation or b uncertainty Party B FP warsteevice (2) You are free to use this image o your website, templates, etc, Please provide us with an attribution link htipsitwww.wallstrestmojo.comivlatity-swap! ane.1125128, 741 PM \olatlity Swap -Definion, Explained, Example, Vs Variance Swap } watistreetwojo [ota income auring tne period SSS x ities expenses T 7 , SS c-<_$£ @ —<——— Feces, is a measure of uncertainty and the risks involved. They are the easiest way to trade volatility. A volatility swap can trade spreads between implied volatility and realized volatility levels by speculating on future volatility levels. It can also hedge the volatility exposures of other businesses or positions. Table of contents © Volatility Swap Definition © Volatility Swap Explained © Examples. © Advantages And Disadvantages_ © Volatility Swap Vs Variance Swap_ © Frequently Asked Questions (FAQs). © Recommended Articles Key Takeaways * A volatility swap is a forward contract that provides exposure to pure volatility, making it a straightforward instrument to trade the up and tips:ifmew.wallstreetmojo.comivolatiiy-swapl zie1125128, 741 PM \Volatlity Swap - Definition, Explained, Example, Vs Variance Swap > WallStreetMojo Q Sie aru par ae ue Kur aLes CAP aUUT 1s CarLUaveu vascu UNF ie implied and realized volatility differences in this swap. © TradeBeadstured tGirrdegn the future index or stock volatility levels can spa SWAP.IPaRSheS or long on realized volatility. © TheseWbntradrarter Stre epdsure to volatility, making them the most straighttirware WAY W trade volatility. Credit Default Swap > What is Open Interest? > Financial Modeling & Valuation Courses Bundle (25+ Hours Video Series) ->> If you want to learn Financial Modeling & Valuation professionally , then do check this Financial Model g_& Valuation Course Bundle (25+ hours of video tutorials with step by step McDonald's Financial Model). Unlock the art of financial modeling and valuation with a comprehensive course covering McDonald's forecast methodologies, advanced valuation techniques, and financial statements. Volat! ty Swap Explained Volatility swaps are forward contracts. In the swap, according to the contract, the buying party pays the selling party the difference between the realized volatility and the predetermined strike volatility of an underlying asset. It is also called realized volatility forward contracts based on annualized volatility. These contracts provide pure exposure to volatility and become the most efficient way to trade the fluctuating movements of asset prices. The amount paid at the contract's expiration is calculated based on the implied and htipsitweww.wallstreetmoja.comivolatity-swapy 321125128, 741 PM ‘Volatility Swap - Definition, Explained, Example, Vs Variance Swap > WallStreetMojo Q Different variations include receiver volatility swaps and FX volatility swaps. In a receiv@ewaniitad Gaithedpuying party pays the selling party the difference Retveee anaindenying asset's realized volatility and the predetermipagstriksivalatilisaidbese swaps are commonly used to hedge or speculate orhdowawatdreevements in volatility. Credit Default Swap > On the othenbendbaatkivalatiity swap focuses on the volatility of foreign exchange rates. It allows market participants to trade and manage exposure to fluctuations in currency volatility. It involves exchanging cash flows based on the specified currency pair's realized or expected volatility levels. Traders can use this volatility derivative to take positions on the future index or stock volatility levels, either going short (selling) or long (buying) on realized volatility. A long position in this swap receives annualized realized volatility as floating amounts, while a short position works oppositely. Traders can also take advantage of the spread between implied and realized volatility levels by unwinding the swap before expiration. These strategies can be beneficial during turbulent times and help navigate market downturns. Examples The following examples will help understand the concept even better. Example #1 Let's say, Dave, a trader, is engaged in a volatility swap with a notional amount of $2,000,000. He has taken a long position with a volatility strike of 20%. At the end of the contract, the realized volatility is estimated to be 30%. To calculate the volatility swap payoff, we can use the following formula. Payoff = Notional Amount * (Realized Volatility - Volatility Strike) htipsitwww.wallstrestmojo.comivlatity-swap! aia1125128, 741 PM > WallStreetMojo Simplifying the equation: ‘Volatility Swap - Definition, Explained, Example, Vs Variance Swap Q Payoff = $2,000,000 * 0.10 = $200,000 “ye Br uides Therefore, Whue's Gali{@rfiion? the volatility swap is $200,000. What is Options Trading? > Exampl@-#2e Futures? > / Credit Default Swap > a Let's take wate dxecthetiaexamele. Daniel is another trader who invested in swaps. Recently elections were held in his country and much negative news spread. The political picture did not look good since the government was accused of corruption, embezzlement, etc. Given the weak stock markets and anticipated financial and political turmoil, Daniel takes a short volatility position. It means he expects the volatility levels to decrease or remain low during this period. Taking a short volatility position can be a suitable strategy in market unpredictability and uncertainty situations. Advantages And Disadvantages Let us have a look at the benefits and limitations of volatility swaps below: It provides a straightforward way to trade volatility, allowing investors to profit from price fluctuations without owning the underlying asset. Traders can tailor their risk exposure by taking long or short positions on realized volatility, enabling them to hedge existing positions or speculate on future market movements. It can generate returns in rising and falling markets, making them versatile instruments that can be utilized in different market environments htipsitweww.wallstreetmoja.comivolatity-swapy Valuing this swap requires an accurate estimation of future volatility levels, which can be challenging due to the unpredictable nature of markets. As with any derivative contract, it carries counterparty risk. If the counterparty defaults or fails to fulfill its obligations, it can lead to financial losses for the investor. These swaps may face liquidity issues, especially for less liquid underlying assets or in times of market stress, which can impact the ease of entering or exiting positions. siz1125128, 741 PM ‘Volatility Swap - Definition, Explained, Example, Vs Variance Swap > WallStreetMojo Q Including it in a porttolio can benetit Accessibility may be limited to contident diversification and serve as a risk management investors, requiring access to specialized tool by offsetting potential losses during markets or platforms, potentially excluding market down@atured Guides retail investors. What is Call Option? > Volatility Swaps Variance Swap What are Futures? > Volatility anc: vaubaitnel Sovayps are different financial instruments that expose investors tWtetatilayeWhitertsey both relate to volatility, the two have essential differences. A variance swap is a forward contract. The arrangement is based on the difference . . These are contracts that are Concept __ between a predetermined variance delivery , . . i based on volatility. price and the realized variance in the desired period. f The variance swap is annualized on variance, _It is the annualized standard ssence the square of the volatility realized. deviation of a stock's returns. At settlement time, the realized variance during The amount is settled at Settlement te Period is calculated, and the difference is___maturity after estimating the settlement then multiplied by the contract notional for differences between realized estimation volatility and the strike. Frequently Asked Questions (FAQs) 1. How to price volatility swap? Here is how the price is calculated. The notional value is multiplied by the difference in value between the actual volatility and the estimated volatility (volatility strike). Then, it is represented by the formula: volatility swap payoff = notional amount *(volatility-volatility strike). 2 2. What is the payoff of a vola htipsitweww.wallstreetmoja.comivolatity-swapy eira1125128, 741 PM ‘Volatility Swap - Definition, Explained, Example, Vs Variance Swap > WallStreetMojo Q executing this volatility derivative. A payoff happens when the values of realized volatility and volatility strike differ. 3. Is VIX avOBtHhy Sapides No, the VIMV@velatifiey! Metéans not a volatility swap. Instead, the VIX measures tHe thir Ratioaxgpkedingh df future volatility, specifically for the S&P 500 indaRtsHhEGHE BEST the next 30 days. While both are related to measuring or trading volatility, they are distinct financial instruments with What is Open Interest? > different purposes, Methodologies, and underlying assets. Recommended Articles This has been a guide to what is Volatility Swap. Here, we explain it with its differences with Variance Swap, examples, advantages and disadvantages. You can learn more about it from the following articles - © Bermuda Swaption ¢ Market Volatility * Swaption Leave a Reply Your email address will not be published. Required fields are marked * Comment * 4 htipsitweww.wallstreetmoja.comivolatity-swapy m21125128, 741 PM \olatlity Swap -Definion, Explained, Example, Vs Variance Swap > WallStreetMojo Q Email* Featured Guides What is Call Option? > What is Options Trading? > Website What are Futures? > Credit Default Swap > What is Open Interest? > O Save my name, email, and website in this browser for the next time | comment. 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