Definition
Variance swaps allow pure exposure to volatility without delta risk. The buyer receives the realized variance minus the strike variance (squared implied volatility), multiplied by the notional. If realized variance exceeds implied, the buyer profits. Variance swaps are convex in volatility—large moves pay disproportionately more than expected.
functions Formula
Payoff = Notional × (Realized Variance − Strike Variance)
lightbulb Example
Strike variance is (20%)² = 0.04. Realized variance turns out to be (25%)² = 0.0625. On $1M vega notional, payoff = $1M × (0.0625 - 0.04) / (2 × 0.20) = $56,250.
verified_user Key Points
- Pure volatility exposure without delta risk
- Convex payoff—large moves pay disproportionately
- Variance strike typically exceeds expected realized vol
- Used by hedge funds and volatility traders