7 Equity Variance Swaps PDF

April 2013
Equity Variance Swaps

Trading just volatility
Leo EvansAC
Vice President
Global Asset Allocation

J.P. Morgan Securities plc
leonard.a.evans@jpmorgan.com
+44(0) 20 7742 2537
This presentation was prepared exclusively for instructional purposes only, it is for your information only. It
is not intended as investment research. Please refer to disclaimers at back of presentation.
Equity Variance Swaps
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SWAPS
Trading just volatility
Realised Volatility: Definition and characteristics
Trading volatility via straddles and delta-hedged options: path dependent P&L
Dollar gamma: How to make it constant
Variance Swaps: Mechanics, P&L, vega notional, MtM, caps, pricing, variance swap
indices (VIX, VSTOXX, VDAX)
Variance swap hedging & 2008 crisis
Volatility Swaps
Relative value
Convexity & Vol of Vol
Third generation volatility products: forward variance, conditional variance,

corridor variance and gamma swaps
Realised Volatility: Definition and Characteristics (I)

We define volatility as the annualised standard deviation of the (log) daily return
of a stock (or index) price, and variance as the square of the standard-deviation
252

T
Si
ln
i 1
S i 1
We compute the standard deviation over a fixed period of time (T days) and
then annualise it by multiplying it by the square root of the number of trading
days in a year (252) divided by the number of days in the calculation period.
We assume that the mean of the log daily return is zero in order to simplify
calculations (and because this is the measure used in the payoff of variance and
volatility swap contracts).
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Realised Volatility: Definition and Characteristics (II)

Standard deviation or variance?
Standard deviation is a more meaningful measure of volatility, given that it is

measured in the same units as stock return.
However some volatility products (such as variance swaps) have payoffs in

terms of variance given that variance related-products are easier to replicate
(with plain vanilla options) and therefore to price.
Moreover, when trading vol via delta-hedged options, the P&L is a direct
function of the difference between realised and implied variance.
Variance swaps payoffs are defined in terms of realised variance. However, the
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market standard is to always use volatility for communication (i.e. quoting) purposes.
Realised Volatility: Definition and Characteristics (III)

Principal characteristics of volatility:
It grows when uncertainty increases.
It reverts to the mean.
It goes up and tends to stay up when most assets go down.
It can increase suddenly in spikes.

Long term history of realised volatility (S&P Index)
80%
SPX Index 3m realised vol. (annualised)
70%
60%
50%
SWAPS
30%
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40%
10%
20%
0%
29
34
39
44
49
54
59
64
69
74
79
84
89
94
99
04
09
Source: J.P. Morgan.
Realised Volatility: Definition and Characteristics (IV)
EuroStoxx 50 (SX5E) Index Volatility: Realised vs. (BS) Implied

80%
Realised 3m Vol.
Implied 3m ATM Vol.
70%
60%
50%
40%
30%
20%
10%
0%
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00
01
02
03
04
05
06
07
08
09
10
11
12
Realised vol is a backward looking measure.
Implied vol (from option prices) is a forward looking measure.

Volatility products
First generation:
Plain vanilla options: gain liquidity after Black & Scholes (BS) option pricing
framework (1974).
Second generation:
Variance and volatility swaps emerge in the 90ies. Seminal papers: 1990
Neuberger (Volatility Trading), 1998 Carr & Madan (Towards a theory of
volatility trading), 1999 Derman et al. (More than you ever wanted to know
about volatility swaps).
Third generation:
Conditional variance swaps, corridor variance swaps and gamma swaps.
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How can we trade volatility?

We want to make money if realised volatility (or variance) within a future time
period is higher than a given amount.
We only want to take exposure to realised vol/variance, to nothing else.
Why would we want to do that?
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How can we do that?
Variance Swaps: How we will introduce them

Unlike vanilla options, variance swaps are said to provide pure exposure to
volatility, in the sense that their P&L is only a function of realised volatility:
If you buy a variance swap with notional N and expiry T, your payoff at T will be
equal to N times the difference of realised volatility up to T and a fixed (preagreed) volatility strike.
In order to highlight the differences between vanilla options and variance swaps we
will first illustrate the traditional alternatives to take volatility exposure via options.
Our objective is to find a way to obtain, via options, a volatility exposure similar to
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the one provided by a variance swap.
Apart from being a useful way of introducing the rationale behind variance
swaps, this will illustrate how we can replicate a variance swap via vanilla
options.
This replication strategy is the backbone of variance swaps hedging (by dealers)
as well as pricing.
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Trading volatility via straddles and delta-hedged options
Long ATM Straddle (I)

Buy an ATM call and ATM put. Using BS, its cost depends on: implied vol and time to
expiry (ignoring rates).

Implied volatility exposure: If implied vol increases, other things equal, the position
makes money. However, if the position is kept until expiry, the payoff is independent
of implied vol movements.
What is the exposure of this position to the realised volatility until expiry?
Straddle instantaneous delta
Straddle cost and PnL at expiry

Cost today
60
Delta
100%
PnL at ex piry
50
50%
40
30
0%
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20
10
0
-50%
-10
-20
-100%
50
70
90
110
130
150
50
70
90
110
130
150
X-axis: stock price.

10
Long ATM Straddle (II)

What is the exposure of this position to the realised volatility until expiry?
Imagine realised volatility is very large, but the stock price at expiry is equal to
the strike of the straddle.
We lose money.
This isnt what we wanted.
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Initially, the delta of our position is zero, but once the stock moves away from
the strike price, the delta is not zero anymore and we have exposure to the
underlying price of the stock.
This isnt what we wanted.

We wanted exposure to realised vol, to nothing else.
11
Long delta hedged option (I)

Lets analyse the P&L of buying an option and delta hedging it during a small time
interval (e.g. 1 day) first
In order to compute the delta of the option we need to rely on a pricing model.
BS is the most commonly used
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Notation:
Option price
Ct
Stock price
Interest rate
St
r ( 0)
Implied volatility
Delta
Gamma
Theta
Vega
t
t
t
Vt
For simplicity, we
assume interest rate
and implied
volatility are
constant. This
allows us to ignore
rho and vega.
Moreover, we
assume interest
rates and dividends
are zero.
12
Long delta hedged option (II)

1 day goes by
(in years) and the stock price moves to
We bought a call option and sold
S t t
units of the underlying stock
P&L of our position:
P & Lt Ct t Ct t St t St
The option price depends on the stock price, time to expiry and implied volatility. We
use an (approx.) Taylor expansion on the option price change with respect to the
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stock price, time and vol:
t
t
t
t
t
t
t
t
t
t
i
t St t St
13
Long delta hedged option (III)

Assuming implied volatility stays constant ( i 0) , the P&L can be approximated by
1
2
P & Lt t St t St t t
2
Under BS, there is a one-to-one relationship between theta and gamma (assuming
zero interest rates; see Hull, 6th edition, Chp. 15.7):
1
2
2
t t S t i
2
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This leaves the daily P&L of a delta-hedged call option as:
S S
1
2
t
P & Lt t S t t t
2
St
i2 t
14
St t St
St
Long delta hedged option (IV)
S
ln t t
St
Daily P&L of a delta-hedged option (call or put):
S S
1
2
t
P & Lt t S t t t
2
St
Dollar
Gamma
Daily
return
i2 t
Implied
variance
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Realised minus implied variance

during the day
Thus, buying a delta hedged option we make money if the realised variance is above
the implied one. The P&L is also affected by the dollar gamma of the option.
15
Dollar Gamma
Using BS, we can derive a theoretical closed form solution for the dollar gamma. It
depends on:
t S t2 , w here
d1
t
St i T t
ln( S t / K ) ( r i2 / 2) (T t )
d1
i T t
()
is the density function of a N(0,1), K is the strike price and T is the expiry.
See Hull, 6th edition, Chp. 15.
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where
16
Gamma: Call & Put

Call and put options (same strike, expiry and implied vol) have the same gamma;
thus, the P&L of buying (and delta-hedging) a call or a put option is the same.
Call
Put
60
Cost today
PnL at expiry
40
60
40
20
20
-20
50
70
90
110
130
150
-20
50
120%
Delta
-20%
80%
-40%
60%
-60%
40%
-80%
20%
-100%
0%
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50
4%
70
90
110
130
150
Gamma
90
110
130
150
50
4%
3%
2%
2%
1%
1%
0%
70
90
110
130
150
Delta
-120%
3%
50
70
0%
100%
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Cost today
PnL at expiry
70
90
110
130
150
Gamma
0%
50
70
90
110
130
150
17
Dollar Gamma is not constant

Dollar Gamma & Time to Expiry
Dollar Gamma & Stock Price

Gamma
3%
250
Dollar Gamma (RHS)
2%
200
2%
150
800
1y to ex piry
700
6m to ex piry
600
1m to ex piry
500
400
1%
100
300
1%
50
200
0%
0
50
70
90
110
Strike K
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Example used
Strike
Ivol
Int. rate
Days to expiry
100
20%
0%
252
130
150
100
0
50
70
90
110
Strike K
130
150
Dollar gamma is larger the closer the
stock price is to the strike and the

closer we are to the options expiry
date.
18
For each day
Long delta hedged option (V)

Total P&L of a (dynamically) delta-hedged option (held to expiry) can be
approximated by:
S S
1
t
P & L t S t2 t t
St
t 2
Path dependent
i2 t
Realised minus implied variance during

each time interval (e.g. day)
The total P&L of the trade is a function of the difference between realised and
implied variance. However, this is polluted by the dependence of dollar gamma on
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the time to expiry and stock price.

This causes the P&L to be path dependent and, as a consequence, delta hedged
options are said to provide an impure exposure to volatility.

Anyone can think about examples?
19
Total P&L - Delta-Hedged Option (I)

Consider a long option position on a 6-month ATM call, delta-hedged everyday to
expiry. Implied volatility of the option is set at 30% and we simulate the underlying
stock price evolution based on a realised volatility of 30% (over the 6m holding
period). This simulation is repeated 1,000 times to allow for different possible
evolutions of the underlying price.
If implied and
realised vols are 30%

the expected
(average) P&L is zero.
However, there is a
The return distribution

varies with the hedging
frequency. The more
frequent the re-hedging
the less variable the
returns. However, the
costs of hedging will
increase and so reduce
overall returns.
around the zero

average.
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variability of P&Ls
20
Total P&L - Delta-Hedged Option (II)

The previous example illustrates that dynamically delta-hedging an option in an
environment where realised volatility is equal to implied volatility can generate a

P&L different from zero. Equivalently, it can also be shown that, under certain
scenarios, the P&L of the trade can be negative even if realised volatility is above
implied volatility.
The contribution to the total P&L of (realised minus implied) variance on a given
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day depends on the dollar gamma for that day, which is very sensitive to the time to
expiry and the stock price.
For example, if the stock price is close to the strike during the last part of the
options life, whatever happens during that period has a very large impact on the
total P&L.
If we had bought the option an the stock realises very low volatility during that
period (much lower than the implied), this will have a very negative impact on
the total P&L.
The final P&L can be negative even if the realised volatility since inception to
expiry was very large (making the total realised volatility higher than the implied
one).
21
Total P&L - Delta-Hedged Option (III)

Example: an option trader sells a 1-year call struck at 110% of the initial price on a
notional of $10,000,000 for an implied volatility of 30%, and delta-hedges his position
daily.
The realized
volatility (over
the options
life) is 27.50%,
yet his final
trading P&L is
down $150k.
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Why?
22
Total P&L - Delta-Hedged Option (IV)

The stock oscillated around the strike in the final months, triggering the dollar gamma
to soar. This would be good news if the volatility of the underlying had remained below
the 30% implied vol, but unfortunately this period coincided with a change in the (50
days realised) volatility regime from 20% to 40%.

Negative
total P&L
even though
the realised
volatility
over the year
was below
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30%!
23
Long delta hedged option (V)

Total P&L of a delta-hedged call option:
S S
1
2
t
P & L t S t t t
St
t 2
2
i t
Notice that every single day counts:
For each t, what matters is the combination of (i) dollar gamma for that day
and (ii) difference between stock price % change (squared) and implied vol.
Although realised variance over the life of the option may be higher than realised ...
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There will likely be many days where St t St

St
2
i t is negative.
If those days coincide with a very large dollar gamma, they can have a large
impact on the final P&L.
S S
t
Especially if, for the days where t t
St
gamma happens to be very low.
2
i t is positive, the dollar
24
Total P&L - Delta-Hedged Option (VI)

Example Nov-01/Nov-02; 1y EuroStoxx options.
Index was initially at 3500 (with ATM implied volatility at 28.5%) and up until May
2002 remained in the range 3500-3800, realising around 20% volatility. After May,
the index fell rapidly to around the 2500 level, realising high (around 50%)
volatility on the way. Over the whole year, realised volatility was 36%.
Compare the performance of (buying and dynamically) delta-hedging a 2500 and

a 4000-strike option respectively.
4000-strike option
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2500-strike option
25
Long delta hedged option (VII) - Recap

Suppose a market-maker buys and delta-hedges a vanilla option. If realised volatility is
constant and the option is delta-hedged over infinitesimally small time intervals. Then
the market-maker will profit if and only if realised volatility exceeds the level of
volatility at which the option was purchased.
However, the magnitude of the P&L will depend not only on the difference
between implied and realised volatility, but where that volatility is realised, in
relation to the option strike. If the underlying trades near the strike, especially
close to expiry (high gamma) the absolute value (either positive or negative) of
the P&L will be larger.
If volatility is not constant, where and when the volatility is realised is crucial. The
differences between implied and realised volatility will count more when the
underlying is close to the strike, especially close to expiry.
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For non-constant volatility, it is perfectly possible to buy (and delta-hedge) an

option at an implied volatility below that subsequently realised, and still lose
from the delta-hedging.
For a clear recap of options path dependent volatility exposure: J.P. Morgan, Variance
Swaps, 2006, Sections 4.1-4.3.

26
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Dollar Gamma: How to make it constant
27
Remember: A call and a put option with the same

strike have the same gamma (and dollar
gamma). Thus, we can use one or the other.
Objective: Constant Dollar Gamma (i.e. constant vol exposure)

Total P&L of a delta-hedged call option:
S S
1
2
t
P & L t S t t t
St
t 2
Path
dependent
2
i t
Realised minus implied variance

for each time interval (e.g. day)
Our objective is to create a position which provides pure (i.e. not path dependent)
exposure to realised variance/vol. We have seen that a single (delta-hedged) option

doesnt do the work.
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Can we create a position, via delta-hedged options, which provides a non-path
dependent volatility exposure?
In other words, Is there a way of building a portfolio of options such that its
dollar gamma is constant with respect to the stock price?
28

Lets look first at the dollar gamma of different options. We assume a 20% implied vol,
0% interest rates and 1y to expiry.

Dollar Gamma across strikes
Dollar Gamma: 50 and 150 strike options

400
25
50
75
300
350
125
150
175
250
300
50
350
150
250
200
200
150
150
100
100
50
50
0
0
50
100
150
200
250
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100
50
100
150
200
250
The dollar gamma of an option has a higher peak and a higher width as the strike
increases.
Is there a way of combining a set of options to generate a constant dollar gamma?
29

Lets use options with strikes 75, 100, , 250, 275. Lets buy each one with a notional
equal to 1/strike (1/K).

Total dollar gamma
Dollar Gamma of each option (1/K)

2.5
9
8
7
6
5
4
3
2
1
0
2.0
1.5
1.0
0.5
0.0
50
100
150
200
250
50
100
150
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200
250
Not quite. Each option, weighted by 1/K, has a similar (peak) dollar gamma, but the
portfolio dollar gamma is not constant with respect to the stock price.
Any other idea?
30

Lets use options with strikes 75, 100, , 250, 275. Lets buy each one with a notional
equal to 1/K2.
Total dollar gamma
Dollar Gamma of each option (1/K2)

0.030
0.045
0.04
0.035
0.03
0.025
0.02
0.015
0.01
0.005
0
0.025
0.020
0.015
0.010
0.005
0.000
50
100
150
200
250
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Constant
50
100
150
200
250
Weighting each option by (1/K2) generates a constant dollar gamma exposure.
The area where the dollar gamma of the portfolio is constant depends on the number of
options used; the more the better.

31

To achieve a constant dollar gamma across strikes what kind of portfolio is needed?
One important observation is that (peak) dollar gamma increases linearly with strike
(top-left figure next page).

It may be thought that weighting the options in the portfolio (across all strikes) by the
inverse of the strike will achieve a constant dollar gamma. It does have the property
that each option in the portfolio has an equal peak dollar gamma (top-right figure next
page).
However, the dollar-gammas of the higher strike options spread out more, and the
effect of summing these 1/K-weighted options across all strikes still leads to a dollargamma exposure which still increases with the underlying (bottom-right figure next
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page).
In fact, in can be shown that this increase is linear, and therefore weighting each
option by the inverse of the strike-squared will achieve a portfolio with constant dollar
gamma (bottom figures next page).
32
Dollar Gamma of each option (1/K)
Dollar Gamma of each option (1/K2)
Total dollar gamma
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Dollar Gamma of each option (1)
33

The area where the dollar gamma of the portfolio is constant depends on the number of
options used; the more the better.

In the limit a portfolio of options with a continuum of strikes (from 0 to
infinity) will generate a constant dollar gamma.
This is not possible in practice; it would be very costly even if it was possible.
Using a subset of options will generate a dollar gamma which is fairly constant
on a local area.
We can always increase/reduce the number of options as well as the strike

area to suit our purposes.
Lets look at a couple of examples.
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34
1/Strike2 Using options to get a constant dollar gamma

We move from a portfolio of 75 to 225 strike options (25 apart) to a portfolio of 125 to 325
options (50 apart).
1y expiry, 20% vol, 0% rates.
125 to 325 strikes; 50 apart
75 to 225 strikes, 25 apart

0.025
0.045
0.04
0.035
0.03
0.025
0.02
0.015
0.01
0.005
0
0.02
0.015
Constant
Constant
0.01
0.005
0
50
100
150
200
250
50
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100
150
200
250
The second portfolio generates a lower dollar gamma, in absolute level, so we will have
to do more notional of each option (or use a finer grid).

As time approaches expiry, the dollar gamma profile of the portfolio also changes.
35
1/Strike2 Using options to get a constant dollar gamma
Dollar gamma of a portfolio of 75 to 250 strike options (25 apart).
20% vol, 0% rates.
Dollar gamma as a function of time to expiry

0.09
0.08
0.07
0.06
0.05
0.04
0.03
0.02
0.01
0
1y
50
70
90
110
6m
130
3m
150
170
1m
190
210
230
250
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As expiry approaches, we will likely need to increase the number of options in our
portfolio to maintain the constant dollar gamma exposure (i.e. use a finer grid of
strikes).
36

Remember the total P&L of a dynamically delta-hedged call/put option:
S S
1
2
t
P & L t S t t t
St
t 2
Can make this
constant!!
2
i t
Realised minus implied

variance for each time
interval (e.g. day)
Using a portfolio of options, appropriately weighted, we can generate a constant
dollar gamma exposure.
directly dependent of realised volatility; which is what we were looking for.
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Thus, delta-hedging this portfolio of options will generate a position with a P&L
37

If we could buy the entire strike continuum of options, we wouldnt need to modify
the amount of options.
I.e. static hedge (on the options side; well always have to delta-hedge).
If we assume an initial flat implied volatility skew, the P&L will be just a
function of realised and implied volatility.
S S
1
t
P & L X t t
St
t 2
i2 t
Flat skew:
implied vol is the
same for all
strikes.
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When the initial implied volatility is different across strikes, i.e. no flat skew, this will
have an impact given that we buy options with different strikes.
Thus, the price of a variance swap will be a function of the volatility skew.
38

Assume we put together a portfolio of (delta-hedged) options with constant dollar
gamma. If
is one business day, i.e. 1/252 years, and we run the trade from day 0
to day T
2
S t S t 1
1
2
i t
P & L X
S t 1
t 1 2
2
2
T
T
T
St
St
X
1
X
T
2
2
i
i
ln
ln
2 t 1 S t 1
2 t 1 S t 1
252
t 1 252
2
T
St
X T
252
2
i

ln
2 252 T t 1 S t 1
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X T

Realised var Implied var
2 252
39

A portfolio of options (calls and/or puts) where each option is weighted by 1/strike-
squared, has constant dollar-gamma;

Delta-hedging this portfolio provides constant exposure to the difference between
implied and realised variance regardless of where and when the volatility is realised;
Hence the P&L from delta-hedging this portfolio is proportional to difference between
realised and implied variance.
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This is the idea behind variance swaps: payoff, pricing and hedging.
40
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Variance Swaps
41
What is a Variance Swap?

A variance swap offers straightforward and direct exposure to the variance (and
indirectly volatility) of an underlying stock or index.
It is a swap contract where the parties agree to exchange a pre-agreed variance

level (the implied variance, or strike) for the actual amount of variance
realised by the stock or index (the realised variance) over a specified period.
Cash settled at expiry of the swap; no other cash flows.

Realised
variance
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Variance
Seller
Implied (agreed)
variance
Variance
Buyer
Variance swaps offer investors a means of achieving direct exposure to realised
variance without the path-dependency issues associated with delta-hedging options.

Variance swap mechanics ref.: J.P. Morgan, Variance swaps, 2006, Section 1.
42
Mechanics
The strike of a variance swap, not to be confused with the strike of an option,
represents the level of volatility bought of sold and is set at trade inception.
The strike is set according to prevailing market conditions so that the swap
initially has zero value.

If the subsequent realised volatility is above the level set by the strike, the
buyer of a variance swap will make a profit; and if realised volatility is below,
the buyer will make a loss. A buyer of a variance swap is therefore long
volatility.
Similarly, a seller of a variance swap is short volatility and profits if the level of
variance sold (the variance swap strike) exceeds that realised.
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43
P&L (I)
The P&L, at expiry, of a (long) variance swap is given by:
P & LVar NVar K

2
r
where K is the variance swap strike (expressed in volatility terms),

variance and N Var is the variance notional.
r2
is the realised
Example 1:
An investor wishes to gain exposure to the volatility of an underlying asset (e.g. Euro Stoxx 50) over the next year.
The investor buys a 1-year variance swap, and will be delivered the difference between the realised variance over
the next year and the current level of implied variance, multiplied by the variance notional.
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Suppose the trade size is 2,500 variance notional, representing a P&L of 2,500 per point difference between
realised and implied variance.
If the variance swap strike is 20 (implied variance is 400) and the subsequent variance realised over the course of
the year is 15%2 = 0.0225 (quoted as 225), the investor will make a loss because realised variance is below the level
bought.
Overall loss to the long = 437,500 = 2,500 x (400 225) . The short will profit by the same amount.
44
Quotation
Variance swap strikes are quoted in terms of volatility, not variance; but their
payoff is based on the difference between the level of variance implied by the strike
(in fact the strike squared given that the strike is expressed in vol terms) and the
subsequent realised variance.

When quoting and computing the payoff of a variance swap, we wont use
volatility in % terms; well quote 15% volatility as 15.

Example: you buy a variance swap with a variance notional of 100 and 15 strike. At
expiry, realised volatility is 20% during the period
VARIANCE
SWAPS
Your payoff will be 100 x (202 - 152 ) = 100 x (400 - 225) = 17,500
45
P&L (II)
Definition of realised variance for variance swap payoff:
Si
252

ln
T i 1 S i 1
T
2
r
where
Si
is the stock price and T is the number of days.
VARIANCE
SWAPS
We express variance in annualised terms.
46
Variance Swaps - Recap

Variance swap pays the difference between fixed (implied) and realised variance
variance
2
Payout = variance amount x (realised variance - strike )
swap
seller
Realised variance
Fixed Payment
(implied variance = strike2)
variance
swap
buyer
A variance swap is a pure play on volatility

Example: Buy 2,500 notional of 6-month variance swap @ 30 strike (variance = 900)
if realised vol = 25 (var = 625)
loss
= (625 - 900) x variance amount

= 275 x variance amount
= 687,500
if realised vol = 35 (var = 1225)
profit
= (1225 - 900) x variance amount
VARIANCE
SWAPS
= 325 x variance amount

= 812,500
Realised variance is calculated using the formula :
S
252
ln 2 i
T i
Si 1
47
Vega Notional (I)

Since volatility is a more familiar concept than variance and that most variance swap
investors also have option positions, it is useful to express the notional of a variance
swap in terms of Vega Notional (rather than Variance Notional).
Vega notional is defined as an approximate P&L on a variance swap for a 1%

change in volatility.
Taking the first derivative of the P&L of a var. swap w.r.t realised volatility
get 2 NVar r , which depends on the final realised volatility.
Given that final realised volatility is expected to be equal to the swap strike K , a
good approximation to the P&L of the swap for a 1% change in volatility is 2 N K
Var
Thus, it is market convention to define vega notional as
we
NVega 2 NVar K, which
VARIANCE
SWAPS
makes the final P&L equal to
P & LVar NVar K

2
r
2 K
NVega
2
r
K2
48
Vega Notional (II)

Using variance or vega notional is irrelevant for the P&L of the swap. However,
market participants will speak in terms of vega notional given that it is related to
volatility, which is the standard measure used in options.
The P&L of a variance swap is often expressed in terms of vega notional.
Example 2:
Suppose a 1-year variance swap is struck at 20 with a vega notional of 100,000.
If the index realises 25% volatility over the next year, the long will receive 562,500 = 100,000 x (252 202) / (2 x
20). However if the index only realises 15%, the long will pay 437,500 = 100,000 x (152202) / (2 x 20). Therefore
the average exposure for a realised volatility being 5% away from the strike is 500,000 or 5 times the vega
notional, as expected.
VARIANCE
SWAPS
Note that the variance notional is 100,000 / (2 x 20) = 2,500, giving the same calculation as that used in Example
1.
The P&L of a variance swap is often expressed in terms of vega notional.
In Example 2, a gain of 562,500 is expressed as a profit of 5.625 vegas (i.e. 5.625 times the vega notional).
Similarly a loss of 437,500 represents a loss of 4.365 vegas. The average exposure to the 5% move in realised
volatility is therefore 5 vegas, or 5 times the vega notional.
49
NVega
Variance Swaps are Convex on Realised Volatility
2 K
NVar
Although variance swap payoffs are linear with variance they are convex with realised
volatility.
The vega notional represents only the average P&L for a 1% change in volatility.
A long variance swap position will always profit more from an increase in
volatility than it will lose for a corresponding decrease in volatility (see Recap
example).
This difference between the magnitude of the gain and the loss increases with
the change in volatility. This is the convexity of the variance swap.
VARIANCE
SWAPS
If we differentiate the variance swap final P&L w.r.t realised volatility we obtain:
NVega
P & LVar
2 NVar r
r
r
K
Thus, the sensitivity of the variance swap P&L to volatility is not constant: it is higher
the higher the volatility realised.
50
Volatility Swaps are Linear on Realised Volatility

A volatility swap will have a linear P&L w.r.t. realised volatility, i.e.:
P & LVol Swap NVega r K
In a vol swap the vega notional is not an approximation to the average P&L if
volatility changes 1%, it is an exact (and constant) amount.
If we differentiate the volatility swap final P&L w.r.t realised volatility we obtain:
P & LVol Swap
VARIANCE
SWAPS
NVega
Thus, the sensitivity of the volatility swap P&L to volatility is constant and
independent of the level of volatility realised.
51
Variance Swaps vs. Volatility Swaps

The P&L of a variance swap is linear w.r.t. variance and positively convex w.r.t.
volatility.
The P&L of a volatility swap is linear w.r.t. volatility and negatively convex w.r.t.
variance.
50 strike, 1 vega notional on both var & vol swaps
P&Ls vs. Realised Variance
P&Ls vs. Realised Vol

Var. Sw ap P&L
60
60
40
40
20
20
0
Final realised volatility
SWAPS
-20
VARIANCE
Var. Sw ap P&L
Vol. Sw ap P&L
-40
-60
-60
20%
40%
60%
80%
100%
Final realised variance
-20
-40
0%
Vol. Sw ap P&L
0%
20%
40%
60%
80%
100%
Both with 50% strike (in vol terms) ................................ 50% x 50% = 25% in var terms
52
Variance is additive
T days
t2,T
02,t
Realised variance from 0 to t (annualised)
252
t
Si
ln
i 0
S i 1
t
Realised variance from t to T (annualised)
Si
252

ln
T t i t S i 1
T
In annualised terms, the realised variance between 0 and T is the weighted
VARIANCE
SWAPS
average of the realised variances between 0 and t and 0 and T:
2
0 ,T
t
T t 2
2
0 ,t
t ,T
T
T
53
Mark-to-Market - Exercise I
At time 0, you buy a variance swap with:
Notional
Expiry
Strike
NVar
T
K 0 ,T
Right after you open the trade, the quoted strike for the variance swap moves to
which we assume to be higher than
K0New
,T ,
K 0 ,T
VARIANCE
SWAPS
Questions:
What (offsetting) trade would you have to do in order to lock-in a sure positive
payoff at T?
What is that (sure) payoff at T?
In order to compute the MtM of your original trade at time 0, you would just need to
discount (risk-free) the (sure) payoff at T that you could achieve by doing the offsetting
trade.
54
Mark-to-Market - Exercise I (cont.)

T
02,T
Realised variance from 0 to T (annualised)
Trade 1: Buy variance notional
Payoff at expiry T =
NVar [ 02,T K02,T ]
Trade 2: Sell variance notional
NVar , at time 0, strike K 0 ,T , expiry
NVar , at time 0, strike K 0New

, expiry
,T
2
2
NVar [(K0New
)
,T
0,T ]
VARIANCE
SWAPS
Total (net) payoff at expiry T adding both trades is known with certainty at time 0
2
2
NVar [(K0New
)
K
,T
0,T ]
Thus, trade 1 MtM at time 0:

2
2
NVar [(K0New
)
K
,T
0,T ] DF0,T
55
Mark-to-Market - Exercise II
At time 0, you buy a variance swap with:
Notional
Expiry
Strike
NVar
T
K 0 ,T
VARIANCE
SWAPS
You keep your trade open and, at time
t
t
The (annualised) realised variance from 0 to
The quoted strike for a variance swap starting at t and expiring at
has been
02,t
is
K t ,T
02,t
56
Mark-to-Market - Exercise II (cont.)

What is your MtM at time
t?
Which (new) trade would you do (at time t ) if you wanted to lock-in that MtM for sure?
Lets start by working this out:
VARIANCE
SWAPS
At time
you enter into a new trade (keeping your initial one):
Sell a variance swap with expiry
T; notional NVar; strike K t ,T .
Compute the payoff of both trades, and the net payoff, at time
Does that payoff depend on something which you dont know for sure at time
t
? If it does, then you havent locked-in your MtM.
T.
Which notional should you trade at time t to lock-in your MtM for sure (i.e. to
have a payoff at T which is known with certainty at t )?.
The discounted value of such payoff will be the MtM at

trade.
on your original
57
Mark-to-Market - Exercise II (Solution a)

0
02,t
t2,T
Realised variance from t to T (annualised)
SWAPS
VARIANCE
NVar [ 02,T K02,T ]
NVar , at time t, strike K t ,T , expiry
NVar [ Kt2,T t2,T ]
Total (net) payoff at expiry T adding both trades:
NVar [ 02,T K02,T ] NVar [ t2,T Kt2,T ]

58
Mark-to-Market - Exercise II (Solution b)

Total payoff at expiry T adding both trades:
NVar [ 02,T K 02,T ] NVar [ t2,T K t2,T ]
NVar 02,T K 02,T t2,T K t2,T

1
t
T t 2
NVar 02,t
t ,T K 02,T
T
SWAPS
t T t
2
2

t ,T K t ,T
T
T
t T t

T
T
T t
t
t
NVar 02,t K 02,T

K t2,T K 02,T K t2,T t2,T
T
T
T
VARIANCE
Known at time t
Realised variance between t and T,

unknown at time t
59
Mark-to-Market - Exercise II (Solution c)

Selling variance with a notional
NVar at time t doesnt generate a sure payoff at T.
Rather than selling variance with a notional
Sell variance notional NVar
SWAPS
T t
, at time t, strike K t ,T , expiry
NVar
T
T t
NVar
[ K t2,T t2,T ]
T
VARIANCE
T t
, at time t, strike K t ,T , expiry
T
NVar [ 02,T K02,T ]
NVar at t, try this:
60
Mark-to-Market - Exercise II (Solution d)

Total payoff at expiry T adding both trades:
NVar [
2
0 ,T
2
0 ,T
T t
] NVar
[ t2,T K t2,T ]
T
T t 2
T t
2
2
NVar 0,T K 0,T
t ,T
K t2,T
T
T
VARIANCE
SWAPS
t
T t 2
T t
t T t T t 2
2
2
2
NVar 0,t
t ,T K 0,T
t ,T
K t ,T
T
T
T
T
T
T
T t
t
NVar 02,t K 02,T

K t2,T K 02,T
T
T
Known at time t
61
Mark-to-Market (I)
Marking to market of variance swaps is easy: variance is additive. At an intermediate

point in the lifetime of a variance swap, the expected variance at maturity is simply the
time-weighted sum of the variance realised over the time elapsed, and the implied
variance (i.e. new var swap strike) over the remaining time to maturity.
All that is needed to compute the mark-to-market of a variance swap is:
The realised variance since the start of the swap; and
the implied variance (variance strike) from the present time until expiry.
Since the variance swap is cash settled at maturity, a discount factor between the
present time and expiry is also required
T t
t
2
2
MtM t NVar 0,t K 0,T
K t2,T K 02,T DFt ,T
T
T
VARIANCE
SWAPS
where inception is time 0, t is today, T is expiry, DF is discount factor,
02,t
is the
annualised realised variance from 0 to t, K 0 ,T was the original (i.e. at time 0) strike, and
K t ,T is the current strike.
62
Mark-to-Market (II)
Example: We are short a 12-month variance swap on a stock
Strike
30%
Variance notional
2,500
Vega notional
150,000 ( = 2 x 2,500 x 30)
Assume that over the next 3 months the stock has a realised volatility of 25% and the
variance swap for the remaining 9 months is quoted at 27.

If we then buy a 9 months var swap with strike 27 and var notional 1,875 ( = 2,500 x 9
/ 12), the P&L would be calculated as :

Variance Amount x ( [Strike2 - realised2] x elapsed time + [Strike2 - Newstrike2] x remaining time
VARIANCE
SWAPS
2,500
[302 - 252]
3/12
197 x 2,500
492,500
3.3 vegas = ( 492,500 / 150,000)
[302 - 272]
9/12
63
Mark-to-Market (III)
Example 3: Suppose a 1-year variance swap is stuck at 20 with a vega notional of 100,000 (variance notional of 2,500).
If the volatility realised over the first 3 months is 15%, but the volatility realised over the following 9 months is 25%,
then, since variance is additive, the variance realised over the year is:
Variance = [ x 152 ] + [ x 252 ] = 525 (22.9 volatility). At expiry the P&L would be 2,500 x (22.92 202) = 312,500.
Now, suppose again that realised volatility was 15% over the first 3 months. In order to value the variance swap MtM after
3 months we need to know both the (accrued) realised volatility to date (15%) and the fair value of the expected variance
between now and maturity. This is simply the prevailing strike of a 9-month variance swap. If this is currently trading at
25, then the same calculation as above gives a fair value at maturity for the 1-year variance swap of 312,500.
Although the fair value at maturity (now 9 months in the future) is 312,500, we wish to realise this p/l now (after 3months). It is therefore necessary to apply an appropriate interest rate discount factor.
VARIANCE
SWAPS
If, after 3-months, the discount factor is 0.97, the MtM would be equal to about 303,400.
64
Caps (I)
Variance swaps, especially on single-stocks, are usually sold with caps.
These are often set at 2.5 times the strike of the swap capping realised
volatility at this level.
P&L with caps:
P & L NVar Min r , Cap K K 2

2
Variance swap caps are useful for short variance positions, where investors are then
able to quantify their maximum possible loss.
Capped vs. Uncapped P&L

120
Var. Swap ( strike K = 20% ) P&L
100
Capped Var. Swap 2.5x P&L
100
60
60
SWAPS
Capped Var. Swap 2.5x P&L
80
80
VARIANCE
40
40
20
20
0
-20
-20
0%
10%
20%
30%
40%
50%
60%
70%
0%
5%
10%
15%
20%
25%
30%
35%
40%
20 strike, 1 vega notional on both swaps

65
Caps (II)
In practice caps are rarely hit especially on index underlyings and on longer-
dated variance swaps.

When caps are hit, it is often due to a single large move e.g. due to an M&A
event or major earning surprise on an individual name, or possibly from a
dramatic sell-off on an index.
Single-day moves needed to cause a variance swap cap to be hit are large and
increase with maturity.
A 1-month variance swap struck at 20 and realising 20% (annualised) on all
days except for one day which has a one-off 14% move, will hit its cap.
A similar 3-month maturity swap would need a 1-day 24% move to hit the
cap
The required 1-day move on a 1-year swap would be 46%.
For lower strikes the required moves are also lower.
VARIANCE
SWAPS
66
Caps (III)
A 1-y variance swap struck at 20 and realising 20% (annualised) on all days except for
one day which has a one-off 46% move, will hit its cap.
To hit the cap we need:
252
T
S t 1
ln
t 0
St
T
S t 1
ln
t 0
S t
252
2.5 K
where T = 252 and K = 20, i.e.
2.5 K
We assume that, for all days except one (i.e. 251 days), the stock realises 20% (annualised), i.e.
2
1 day realised (annualised) variance:
252
1
S
ln t 1 20 2
St
, which implies:
S t 1
20 2

ln
S
252
t
for 251 days
How much does the stock need to change in the other day m, i.e. ln(Sm+1/Sm) as a proxy for (Sm+1-Sm)/Sm , for the
final realised variance to be equal to the cap?
SWAPS
VARIANCE
S t 1
St 1
S m 1
S m 1
20 2
2
ln
251
ln
ln
251
ln
2
.
5
20

S
S
S
252
t 0 S t
t
m
m
T
S
ln m 1
Sm
202
2.5 20 251
45.8
252
2
67
Exiting variance swap positions (before expiry)

Possible ways to exit a variance swap:
Go back to the original counterparty to unwind

Tear-up the contract (probably after some payment How much?)
No future cash flows & legal risk.
Enter into an offsetting transaction

If you bought variance with counterparty A, you sell them with counterparty
B; keeping both positions.
What are the complications introduced by the caps?
VARIANCE
SWAPS
Residual risks: counterparty risk if any of the two swaps is not cleared.
68
Offsetting capped variance swaps example

Suppose that an investor buys a 6-month variance swap with a strike of 20. This has
the standard 2.5x cap meaning the exposure to realised volatility will be capped at
50.
The very same day, the (6-month) variance swap trades at a strike of 30 leading to a
significant mark-to-market P&L.

The investor wants to lock in this profit.
With the strike now at 30, the cap on an new variance swap contract will by default
be set at 2.5 x 30 = 75.

Then if the investors sells this 30-strike variance swap in an attempt to close out his
position the difference in caps will mean he takes on a short volatility exposure if the
subsequent realised volatility is above 50% (although capped at 75%).
VARIANCE
SWAPS
In effect, in the course of trying to close out his position, he will have sold a
50%/75% call spread on volatility. Whilst the price he gets for selling the variance
swap will reflect this higher cap, the residual volatility exposure is presumably
unwanted, and the investor would be best either trading directly with the original
counterparty or negotiating a bespoke contract with another counterparty in order to
fully close out his outstanding contract.
69
Net payoff position
Two offsetting var swaps

100

80
Net payoff at expiry
65
45
25
60
40
-15
20
-35
0
-55
-75
-20
0%
5%
10%
15%
20%
25%
30%
35%
0%
40%
5%
Capped Var. Swap P&L (strike K=20; 50 cap)
130
110
45
90
25
25%
30%
35%
40%
50
SWAPS
20%
65
70
VARIANCE
15%
Net payoff position
Two offsetting capped var swaps

150
10%
30
-15
10
-35
-10
-30
-55
-75
-50
0%
10%
20%
30%
40%
50%
60%
70%
80%
0%
10%
20%
30%
40%
50%
60%
70%
80%
Notional on all swaps: 1 vega notional (using the original strike, i.e. 20) i.e. a variance swap notional of 1 / 2 x 20 = 0.025.
70
Net payoff position
Two offsetting var swaps

40
30
65
45
20
25
10
-15
-10
-35
-20
-55
-30
0%
5%
10%
15%
20%
25%
30%
35%
-75
0%
40%
5%
10%
120
45
80
25
60
SWAPS
VARIANCE
40
-20
25%
30%
35%
40%
65
100
20
20%
Net payoff position
Two offsetting capped var swaps

140
15%
-15
-35
0
-55
-75
-40
0%
20%
40%
60%
80%
100%
0%
20%
40%
60%
80%
100%
Notional on all swaps: 1 vega notional (using the original strike, i.e. 20) i.e. a variance swap notional of 1 / 2 x 20 = 0.025.
71
No Exam
Variance Swap Market

Variance swaps were initially developed on index underlyings.
In Europe, variance swaps on the Euro Stoxx 50 index are by far the most liquid,
but DAX and FTSE are also frequently traded.
Variance swaps are also tradable on the more liquid equity underlyings
especially Euro Stoxx 50 constituents, allowing for the construction of variance
dispersion trades.
Variance swaps are tradable on a range of indices across developed markets and
increasingly also on emerging markets.
The most liquid variance swap maturities are generally from 3 months to around 2
years, although indices and more liquid stocks have variance swaps trading out to 3 or
even 5 years and beyond.
VARIANCE
SWAPS
Maturities generally coincide with the quarterly options expiry dates, meaning
that they can be efficiently hedged with exchange-traded options of the same
maturity.
Variance swap market ref.: J.P. Morgan, Variance swaps, 2006, Section 2.
72
Variance Swap Pricing (I)

Pricing a variance swap involves determining its strike price K, i.e. the fixed level
of volatility which will be used to settle the swap (vs. realised volatility) at expiry.
The fair value of the variance swap is determined by the cost, expressed in
volatility terms, of a replicating portfolio.
We illustrated earlier how a portfolio of options, delta-hedged and weighted by the
inverse of their squared strike, generates an exposure with a constant dollar gamma,
i.e. a constant exposure to realised variance (minus implied variance).
Our objective here is not to analytically derive how to price variance swaps. Main
references for those interested on that:

1990 Neuberger (Volatility Trading), 1998 Carr & Madan (Towards a theory of
volatility trading), 1999 Derman et al. (More than you ever wanted to know
about volatility swaps), 2006 Gatheral (The volatility surface), 2006 J.P.
Morgan (Variance Swaps).
VARIANCE
SWAPS
73
Variance Swap Pricing (II)

A variance swap can be replicated by a (dynamically delta-hedged) portfolio of
options with a continuum of strikes weighted by the inverse of the squared strike.
Dollar Gamma: Var. Swap vs. (Imperfect) Replicating options portfolio
Portfolio of options w eighted 1/K2
Var. Sw ap
(Delta-hedged options w ith

strikes from 75 to 250, 25
apart.)
Stock price
VARIANCE
SWAPS
50
70
90
110
130
150
170
190
210
230
250
Pricing-wise, the variance swap price can be thought of as a weighted average
of the entire volatility skew (i.e. implied volatilities for all the option strikes).
Thus, the drivers of variance swap prices are essentially the same drivers as for
options volatilities and skews (plus particular demand-supply issues on the variance
swap market).
74
Skew refers to implied volatility (derived from traded option prices) across strikes.
SX5E 1y Imp. Vol Skew
Flat and linear skews

39%
Flat skew
Flat skew (for Derman's approx.)
90/100 put skew
37%
35%
1y Implied vol vs. Strike (% current index)
40%
35%
ATM Vol
33%
25%
29%
20%
27%
15%
Strike (expressed as % of current stock price)
70
80
90
110
120
10%
40
60
80
100
120
140
160
Call skew
VARIANCE
Put skew
Implied vols for strikes below
100 (% of current stock price)
100
As of Mar-12
30%
31%
25%
SWAPS
45%
75
Variance Swap Pricing (III)
K Theo f i , ATM , Skew i
A variance swap represents a kind of weighted average of volatilities across the
skew curve, with the closer-to-the-money volatilities higher weighted
Rules of thumb:
Given a flat skew, variance swaps should price (theoretically) at the same
level as ATM vol.
High skews will increase variance swap prices

This is the case for both put and call skews (where OTM calls have higher
volatilities than ATM).

ATM volatility will provide the greatest contribution to variance swap
VARIANCE
SWAPS
prices
76
Variance Swap Pricing: Approximations (I)

Whilst it is necessary to have prices available for the entire strip of (OTM) options in
order to calculate the true theoretical price of a variance swap, reasonable

approximations for variance swap prices can be made under certain assumptions
about the skew. (See J.P. Morgan 2006, Sections 2 & 4).
Flat Skew:
In the hypothetical case where the skew surface is flat (i.e. all strikes trade at
identical implied volatilities) the variance swap theoretical level will be the
(constant) implied volatility level.
Linear skew:
If the skew is assumed to be linear, at least for strikes relatively close to the
VARIANCE
SWAPS
money, then Dermans approximation can be used.

Other approximations: long-linear skew, Gatherals formula.
Different (more flexible) assumptions regarding the skew.

77
Variance Swap Pricing: Approximations (II)
Linear skew: Dermans approximation.
KTheo i , ATM 1 3 T Skew2

i, ATM is the implied volatility for the forward strike,
is the years to expiry and
VARIANCE
SWAPS
Skew is generally taken to be the 90/100 put skew.
In practice, this approximation tends to work best for short-dated index variance (up
to about 1-year), where put skews are often relatively linear and call skews
relatively flat, at least close to the money.
As maturity increases and the OTM strikes have a greater effect on the variance
swap price (given the higher prob on ending ITM), the contribution of the skew
becomes more important, but the inability of the approximation to account for the
skew convexity can make it less accurate.
Similarly, for single stocks, where the skew convexity can be much more significant,
even at shorter dates, the approximation can be less successful.
Ref.: Derman et al., More than you ever wanted to know about volatility swaps. 1999.
78
No Exam
VARIANCE
SWAPS
Variance Swap Pricing: Approximations (III)
79
Variance Swap Pricing Insights (I)

The dollar gamma of low strike options is higher at the peak but falls much more
aggressively than the dollar gamma of high strike options.

As a consequence, the dollar gamma of a replicating portfolio (with equally spaced
options) generally tends to fall aggressively as the stock price falls.
Dollar Gamma of two options divided by

their squared strike
75
Dollar Gamma: Var. Swap vs.

replicating options portfolio
150
VARIANCE
SWAPS
Var. Sw ap
(Delta-hedged options w ith strikes

Stock price
from 75 to 200, 25 apart.)

50
100
150
200
250 50
75
100
125
150
175
200
80
Variance Swap Pricing Insights (II)

What does this mean?
In practice, low strike options are generally more important than high strike
options to hedge a variance swap: if one is forced to use only a few options, it
is less risky to use options with lower strikes (or at least to use more of
them).
Generally, put options are more liquid for low strikes.
VARIANCE
SWAPS
81
Variance Swap Pricing: Capped Swaps

A long capped variance swap can be thought of as a standard variance swap plus a
short call on variance, stuck at the cap level.
A standard cap of 2.5x current implied variance strike is relatively far out-of-themoney, assuming that the volatility of volatility is not too large. This means that the
value of the cap should be relatively small compared to the variance swap strike and
should not have a major effect on pricing.
However, for a long position, a
VARIANCE
SWAPS
variance swap with a cap will always

be worth less than an uncapped
variance swap of the same strike.
Therefore capped variance swaps must
trade with strikes slightly below their
uncapped equivalents the difference,
in theory, representing the current
value of the call on variance.

120
Var. Sw ap ( strike K = 20% ) P&L
100
Capped Var. Sw ap 2.5x P&L
80
60
40
20
0
-20
0%
10%
20%
30%
40%
50%
60%
1 vega notional on all swaps

70%
82
SX5E Variance Swaps Term Structure
SX5E Variance Swaps

70%
6m Variance Swap
1y Variance Swap
4%
60%
2%
50%
0%
40%
-2%
30%
-4%
20%
-6%
10%
-8%
0%
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
-10%
Jan-07
SWAPS
VARIANCE
Implied 1y ATM Vol.
1y Variance Swap
25%
50%
20%
40%
15%
30%
10%
20%
5%
10%
0%
0%
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
SX5E 1y Var Swap vs. Implied ATM Vol

60%
1y minus 6m Var Swaps
-5%
Jan-07
1y Var Swap minus Implied ATM Vol.
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
83
SX5E 1y Imp. Vol Skew

25%
45%
1y Var Swap minus Implied ATM Vol.
40%
20%
35%
15%
30%
10%
20%
0%
15%
-5%
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
SX5E 1y 90/100 Implied Vol Skew

3.8%
40
60
80
100
120
140
160
vol.
3.4%
This is due, among other things, to the
3.2%
existence of the volatility skew (given

that the variance swap price can be
thought of as a weighted average of the
3.0%
2.8%
2.6%
2.4%
entire volatility skew).
2.2%
2.0%
Jan-07
10%
Variance generally prices above ATM
1y 90/100 Skew
3.6%
SWAPS
Asof
ofDec-10
Mar-12
As
25%
5%
VARIANCE
1y Implied vol vs. Strike (% current index)
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
84
SX5E Term Structure:

Var Swap vs. ATM Implied Vol
SX5E and S&P Var Swap Term Structure

35%
35%
30%
30%
25%
25%
20%
20%
SXE5
15%
S&P
15%
10%
ATM Implied Vol.
12m
18m
10%
0m
3m
6m
9m
12m
15m
18m
21m
24m
0m
3m
6m
9m
15m
21m
24m
As of March 2012
VARIANCE
SWAPS
Var Swap
85
Variance Swap Indices (I)

The VIX, VSTOXX and VDAX indices represent the theoretical prices of 1-month
variance swaps on the S&P500, Euro Stoxx and DAX indices respectively, and are
calculated by the exchanges from listed option prices, interpolating to get 1month maturity.
Widely used as benchmark measures of equity market risk, even though they
are only short-dated measures and are not directly tradable.
The short-dated nature of these variance swaps indices means the
VARIANCE
SWAPS
principal driver of the volatility index level is recent realised volatility.

In reality, longer dated (e.g. 1-year) variance, spreads of implied to
realised variance, skew levels or even ratios of put to call open-interest
would perhaps be a better proxy for the level of risk-aversion present in
the market.
The design of these indices is based on the square root of implied variance and
incorporates the volatility skew by incorporating OTM puts and calls in the
calculation. A rolling index of 30 days to expiration is derived via linear interpolation
of the two nearest option expiries.
86
Variance Swap Indices (II)
VIX minus Implied Vol
VIX vs. Implied Vol

90%
VIX
80%
S&P 1m ATM Implied Vol.
14%
12%
70%
10%
60%
50%
8%
40%
6%
30%
4%
20%
2%
10%
Mar-04
Mar-06
Mar-08
Mar-10
0%
Mar-02
Mar-04
Mar-06
Mar-08
Mar-10
VARIANCE
SWAPS
0%
Mar-02
VIX minus 1m ATM Implied Vol
87
Variance Swap Indices (III)

VIX and VSTOXX serve as underlying for listed future and option contracts (Eurex
and CBOE)
Futures
Trading forward variance.
These futures do not expire on the normal index (futures) expiry dates,
but 30 calendar days beforehand. This expiry is chosen because on that

date, the listed options have exactly 30 calendar days remaining maturity
and the VSTOXX calculation does not need to interpolate from any other
maturities.
VARIANCE
SWAPS
Reference: J.P. Morgan VDAX, VSTOXX and VSMI Futures, 2005.
88
Variance Swap Indices (IV)

VIX and VSTOXX serve as underlying for listed future and option contracts (Eurex
and CBOE)
Options:
Trading vol of vol.
In April 2005, options on the VIX index were launched. These represented
the first available exchange traded options on variance. As for the futures,
these expire 30 days before an index expiry and are listed to expire 30
days before the corresponding quarterly options expiry dates for the
underlying.
Reference: J.P. Morgan Options on implied volatility, 2010.
VARIANCE
SWAPS
The exact calculation of the VIX index can be found at:
http://www.cboe.com/micro/vix/vixwhite.pdf
See also J.P. Morgan Cross-asset hedging with VIX, 2012.
89
VARIANCE
SWAPS
Variance Swaps: Hedging and 2008 Crisis
90
Variance Swap Hedging in Practice (I)

A variance swap can be statically hedged with a portfolio of (European-style) options,
weighted according to the inverse squares of their strikes.

This makes it easy, in theory, to perfectly hedge a variance swap with options,
assuming option prices are available across the entire range of strikes.
In practice, traded strikes are not continuous, although for major liquid indices they
are closely spaced (0.4% notional apart for the S&P, 1% for the FTSE, 1.4% for the Euro
Stoxx).
A more serious limitation is the lack of liquidity in OTM strikes, especially for puts,
as these provide a relatively large component of the variance swap price in the
presence of steep put skews.
S&P options are listed down to a strike of 600, FTSE to 3525 and Euro Stoxx
down to 600, although in reality, liquidity does not even reach this far.
VARIANCE
SWAPS
91
Variance Swap Hedging in Practice (II)

In practice, market-makers will not attempt to hedge with the entire strip of options
but typically will use only a few.

One problem with this kind of approach is that the partial hedge is no longer static,
and must be dynamically managed.
The constant dollar gamma would be maintained by a combination of holding a

portfolio which has roughly constant dollar gamma if the underlying does not
move too much, and re-hedging by trading more options if the underlying does
move significantly.
Thus, market makers are unable to buy the complete theoretical hedge, and instead
VARIANCE
SWAPS
have to use a portfolio comprised of a limited number of options. The resulting
portfolio hedges the variance swap well within a range of asset levels near the spot at
inception, but not outside this range
See J.P. Morgan, Variance Swaps, 2006, Section 4.8for an explanation of how to construct a replicating
portfolio, i.e. absolute amount of each option traded to generate the variance notional of the variance swap.
92
Variance Swap Hedging in Practice (III)
Assume the client goes long variance and the dealer sets up an (imperfect) replicating
portfolio In the event that the market falls significantly and realised volatility is higher
than the variance swap strike, the overall hedge will lose money (if its not rebalanced).

Client (long
variance) gets
this P&L
The replicating
hedge gives the
dealer this P&L
Var. Sw ap

Stock price
VARIANCE
SWAPS

50
75
100
125
150
175
200
One can imagine what happened in 2008/2009 market crash For a detailed
explanation, see J.P. Morgan, Volatility Swaps, 2010, Section 4.

93
2008 Crisis & Variance Swap Hedging (I)

2008: Market makers books were generally short single stock variance swaps
Why? Due to investors selling index correlation to capture the implied

correlation premium.
We will review these trades in a later lecture, but essentially, if an investor

wants to short index correlation he sells index vol (via var. swaps) and buys
single stocks vol (via var. swaps). This leaves dealers long index variance swaps
and short single name variance swaps.
In order to hedge their variance swap books, market makers were holding portfolios of
single stock options and delta-hedging daily.

We saw in the previous slide what can go wrong if a dealer has sold a variance swap
VARIANCE
SWAPS
and hedges it with a partial hedge.

The 2008 crisis led to large drops in single stock prices, and many market makers
found themselves unhedged in the new trading range
94
2008 Crisis & Variance Swap Hedging (II)

By selling single stock variance swaps, traders had committed to deliver the P/L of a constant
dollar gamma portfolio, irrespective of the spot level, but their replicating portfolio did not
have sufficient dollar gamma at the new spot levels. Market makers were therefore forced to
buy low strike options at the post-crash volatility level, which was much higher than the one
prevailing when they sold the variance swap and therefore incurred heavy losses.
VARIANCE
SWAPS
95
2008 Crisis & Variance Swap Hedging (III)

Not re-hedging the gamma risk was not a possibility, as this would have left the books
exposed to potentially catastrophic losses if the stock prices declined further, and
volatility continued to increase.
This situation led to large losses for many market-makers in the single stock variance
swap markets. In turn this led banks to re-assess the risk of making markets in these
instruments and to a substantial reduction of the liquidity in the single stock variance
swap market.
Index variance swap markets did not experience a similar disruption and were actively
compared to single stock options. Additionally, the 'gap risk' of a sudden large decline
is significantly lower for indices than for single stocks.
VARIANCE
SWAPS
traded throughout the crisis, despite a widening of their bid-ask spreads. Index
variance swaps continued to trade because of the high liquidity and depth of the
index options markets. A wider range of OTM strikes are listed for index options
96
VARIANCE
SWAPS
Vol Swaps
97
Volatility Swaps (I)

Following the de facto shutdown of the single stock variance swap market in the
aftermath of the 2008 credit crisis, volatility swaps gained liquidity as an instrument
for providing direct exposure to volatility for single stock underliers.
Why?
Although pricing and hedging volatility swaps is more complex than variance
swaps, when hedging volatility swaps with options traders are a lot less
exposed to tail risks (i.e. extreme moves in the stock price and volatility).
There is not a static hedge for volatility swaps, thus hedging them requires
dynamicaly trading options.
VARIANCE
SWAPS
Reference: J.P. Morgan, Volatility Swaps, 2010.
98
Volatility Swaps (II)

A common complaint about variance swaps is that they pay-off based on realised
variance (volatility squared) and not simply realised volatility.
Remember that the strike of variance swaps is actually quoted in terms of

volatility, and the notional of variance swaps is generally measured with
respect to the (average) sensitivity of the swap to volatility (vega notional).
Why dont we then just trade volatility swaps directly? I.e. a product with a
payoff linear in volatility, not in variance?
The P&L for a (long) volatility swap is given by:
VARIANCE
SWAPS
P & L NVega r K
where K is the volatility swap strike, r is the realised volatility and

the vega notional (i.e. P&L for each realised volatility point).
NVega
is
99
Volatility Swaps (III)

Whilst volatility can be seen as more of an intuitive measure (being a standard
deviation it is measured in the same units as the underlying), variance is in some

sense more fundamental especially because it is additive.
The exposure of delta-hedged options to volatility, after accounting for the dollar
gamma, is actually an exposure to the difference between implied and realised

volatility squared. In this sense, a variance swap mirrors a kind of ideal delta-hedged
option whose dollar gamma remains constant. Furthermore, variance swaps are
relatively easy to replicate. Once the replicating portfolio of options has been put in
place, only delta-hedging is required; no further buying or selling of options is
necessary.
The main theoretical difficulty with volatility swaps is that they cannot be
VARIANCE
SWAPS
statically replicated through options.
100
Volatility Swaps (IV)

Delta-hedging options leads to a P&L linked to the variance of returns rather than
volatility. To achieve the linear exposure to volatility (which volatility swaps

provide) it is therefore necessary to dynamically trade in portfolios of options,
which would otherwise provide an exposure to the square of volatility.

There doesnt exist a neat and simple hedging strategy for volatility swaps as it
does for variance swaps (using delta-hedged options with a notional of 1 / strike
squared).
A volatility swap can be replicated using a delta-hedged portfolio of options,

where the portfolio of options is dynamically rebalanced (on the option side,
not only on the delta side) to replicate the vega and gamma profile of the
volatility swap across the range of spot prices.
VARIANCE
SWAPS
101
No Exam
Volatility Swaps (V)

Why does the hedging of volatility swaps expose traders to lower risks in extreme
price movements?
Dollar Gamma of a Volatility Swap & a Strangle
The dollar gamma of
volatility swaps decreases as

the stock price moves away
from par, as opposed to the
dollar gamma of variance
swaps, which is constant for

all stock prices.
The dollar gamma of
VARIANCE
SWAPS
volatility swaps is similar
to the dollar gamma of

option strangles.
80-120% 1.9x 1 Ratio
strangle consists on selling
1.9 80% strike puts and
selling one 120% call.
102
No Exam
Volatility Swaps (VI)

For traders proxy hedging volatility and variance swaps, volatility swaps appear to
be easier to manange than variance swaps as the dollar gamma decreases following
large moves in the spot.
VARIANCE
SWAPS

Dollar Gamma: Vol. Swap vs.

strangle
Var. Sw ap

Stock price

50
75
100
125
150
175
200
103
No Exam
Volatility Swaps (VIII)

Given the impossibility of pricing volatility swaps via replication arguments, volatility
Stochastic volatility models, such as Heston and GARCH models, have been
proposed by the academic literature.
However, as of today, there is no general consensus on which model best

reflects the behaviour of volatility.
Market participants use their in-house stochastic volatility model specifications

and constantly modify them to improve their reliability and performance.
Moreover, implied volatility of volatility, key in these models, is not easily

observable (as implied option volatility is), which makes calibration of these
models particularly difficult.
J.P. Morgan, Volatility Swaps, 2010, p. 19, offers an introduction to volatility
swap pricing and the relationship between volatility and variance swap prices.
VARIANCE
SWAPS
swap pricing models need to incorporate the behaviour and evolution of volatility,
i.e. the vol of vol.
104
Var vs. Vol Swap Strikes

As opposed to products with linear exposure to volatility, like volatility swaps or
delta-hedged options, variance swaps are convex in volatility and the variance swap
buyer should fairly pay for this convexity, meaning that variance swaps trade above
implied ATM volatility.

Variance swaps trade above ATM volatility because you pay extra for the convexity
of the variance swap: the gain from an increase in volatility is more than the
corresponding loss from a decrease in volatility. This does not come free.
Buy a variance swap;
Sell a volatility swap.
How does the P&L look like with respect to realised volatility at expiry?
VARIANCE
SWAPS
Lets see whats the P&L of the following trade:
105
Var vs. Vol Swap Strikes (I)

Trade: Buy a variance swap & Sell a volatility swap.
Assume first the strike of both variance and volatility swaps are the same
Total trade

30
60
Vol. Swap ( strike K = 50% ) P&L
P&L Long Var. Swap vs. Short Vol. Swap
25
40
20
20
15
VARIANCE
SWAPS
-20
10
-40
-60
0%
20%
40%
60%
80%
100%
0%
20%
40%
60%
80%
100%
If the var. swap strike is equal to the vol. swap strike, you are paying nothing for the
convexity that the variance swap gives you (vs. the vol. swap), and the trade will be
profitable for sure.
106
Var vs. Vol Swap Strikes (II)

In order to account for the convexity the variance swap provides, variance swap
strikes trade above vol swap strikes. We next show the case of a var. swap strike of
50% vs. a vol swap strike of 40%.
Total trade

60
40
10
20
5
SWAPS
-20
-5
-40
-10
-60
-15
0%
20%
40%
60%
P&L Long Var. Swap vs. Short Vol. Swap
15
Vol. Swap ( strike K = 40% ) P&L
VARIANCE
20
80%
100%
0%
20%
40%
60%
80%
100%
The difference between the variance swap strike and the vol swap strike is the price to pay for
the convexity (w.r.t. realised vol) of the variance swap. Thus, trading variance vs. volatility
swaps is a way of trading the vol of vol (the implied vol of realised vol to be precise). Options
on a variance index, like VIX, are another way of trading vol of vol.
107
Var vs. Vol Swap Strikes (III)

Direct link between volatility of volatility and the payoff of the spread of variance
swaps to volatility swaps .
Spread defined as a trade where we buy a variance swap & sell a volatility
swap.
If volatility of volatility is low then the spread is likely to have a relatively small
payoff at expiry, as the volatility level will likely be close to the strike and the gain
from the convexity of the variance swap compared to the linear volatility swap will be
modest.
In the (unrealistic) limit case where the volatility of volatility is zero, the spread
between the payoffs will be zero.
VARIANCE
SWAPS
On the other hand, if volatility of volatility is elevated it is more likely that the
spread will deliver a large payoff at expiry.

Given that the fair value of volatility swaps and variance swaps will reflect these
dynamics, an increase in the implied volatility of volatility will increase the discount
of volatility swaps relative to variance swaps.

108
VARIANCE
SWAPS
Trading strategies
109
No Exam
Trading Strategies: Outright

Outright variance swaps provide exposure the difference between realised and
implied volatility, with several advantages over other ways to gain volatility
exposure.
Example 1: Investors who expect a quiet market, which may gradually trend up, may
want to find ways of boosting their alpha based on this view. Straddles are not perfect
since a low volatility market often displays trending behaviour; even delta-hedging
the straddles will prove sub-optimal as the market moves away from the strikes and
the (favourable) exposure to volatility is reduced through the decreased gamma.
However, selling variance is an efficient, and non-path-dependent, way of capitalising
on this low volatility view.
VARIANCE
SWAPS
Example 2: Suppose a pharmaceutical company is due to announce the results of a
drug trial, but the result of the trial is in the balance. This could be a catalyst for
large moves in the stock price in either direction depending on the outcome, which is
difficult to capitalise on using the underlying alone. Whilst straddles could be
attractive, they may fail to capitalise e.g. if the underlying trends up before the
event and then afterwards sells-off suddenly back towards the straddle strike. In this
instance variance swaps can be used to implement a view on the uncertain outcome,
but otherwise known timing, of an event.
110
Y: 1y Var Swap. X: SX5E index
SX5E: 1y Var Swap vs. Index

60%
1y Variance Swap
Index (RHS, Inverted)
50%
40%
30%
20%
10%
0%
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
60%
500
55%
1000
50%
1500
45%
2000
40%
2500
35%
3000
30%
3500
25%
4000
20%
4500
15%
5000
10%
2000
Jan-12
70%
1y Variance Swap
Stock Price (RHS, Inverted)
60%
50%
VARIANCE
SWAPS
40%
30%
20%
10%
0%
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
3000
3500
4000
4500
5000
Y: 1y Var Swap. X: BP Stock
BP: 1y Var Swap vs. Stock

80%
2500
Jan-12
80%
100
70%
200
60%
300
50%
400
40%
500
30%
600
20%
700
10%
250
350
450
550
650
750
Source: J.P. Morgan. 111
No Exam
Trading Strategies: Volatility Term Structure / Fwd Variance

One of the strengths of variance swaps is the ease of pricing and constructing
forwards.
Investors can use forward variance to trade the future volatility of an underlying.
For a forward volatility position, the P&L before the forward date will be entirely
driven by changes in expectations of volatility, as captured in the implied volatility
term structure.
BP
SX5E
4%
6%
4%
2%
2%
0%
0%
VARIANCE
SWAPS
-2%
-2%
-4%
-4%
-6%
-6%
-8%
-8%
-10%
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
-10%
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
Source: J.P. Morgan.112
BP: 1y 6m Var Swap vs. Stock Price
BP: 1y 6m Var Swap vs. 1y Var Swap

6%
6%
1y - 6m Variance Swap
4%
4%
2%
2%
0%
0%
-2%
-2%
-4%
-4%
-6%
-6%
-8%
-10%
1y Variance Swap
-12%
15%
-8%
Stock Price
-10%
25%
35%
45%
55%
65%
75%
250
350
450
550
650
750
BP: 1y 6m Var Swap vs. 5y CDS Spread

6%
4%
2%
0%
VARIANCE
SWAPS
-2%
-4%
-6%
-8%
-10%
5y CDS (bp)
-12%
0
200
400
600
800
SX5E: 1y 6m Var Swap vs. 1y Var Swap

4%
SX5E : 1y 6m Var Swap vs. Index Price

4%
2%
2%
0%
0%
-2%
-2%
-4%
-4%
-6%
-6%
-8%
1y Variance Swap
-10%
15%
25%
35%
45%
55%
65%
-8%
-10%
1500
Index Level
2000
2500
3000
3500
4000
4500
5000
SX5E : 1y 6m Var Swap vs. 5y iTraxx

4%
2%
0%
VARIANCE
SWAPS
-2%
-4%
-6%
-8%
5y iTraxx Main (bp)
-10%
0
50
100
150
200
250
Historically
iTraxx Main vs. SX5E ATM Vol.

155
26%
145
26%
135
125
115
105
95
85
2Y
3Y
4Y
5Y
6Y
7Y
180
50%
25%
160
45%
25%
140
40%
24%
120
35%
100
30%
80
25%
60
20%
40
15%
20
10%
24%
SX5E Vol (RHS)
23%
8Y
9Y
05
10Y
iTraxx 3s5s
SX5E 3m ATM Vol (RHS, Inverted)
30
20
25%
10
SWAPS
VARIANCE
5%
15%
35%
-10
45%
-20
-30
55%
-40
05
06
07
08
09
10
06
07
08
09
10
11
12
Term Structures: iTraxx vs. SX5E Vol
iTraxx 3s5s vs. ATM Vol

40
60%
SX5E 3m ATM Vol (RHS)
55%
23%
1Y
iTraxx 5y
200
iTraxx Curve
75
220
11
12
40
iTraxx 3s5s
4%
SX5E 3-6m Vol Term Str.
30
2%
20
0%
-2%
10
-4%
-6%
-10
-8%
-20
-10%
-30
-12%
-40
-14%
05
06
07
08
09
10
11
12
Vol Term Structures: iTraxx vs. SX5E Vol
iTraxx vs. SX5E: 3m ATM Vol

220
iTraxx 5y
60%
SX5E 3m ATM Vol (RHS)
200
55%
180
50%
160
45%
140
40%
120
35%
100
30%
80
25%
60
20%
40
15%
20
10%
06
07
08
09
10
11
12
10%
iTraxx 3-6m Vol Term Str.

SX5E 3-6m Vol Term Str. (RHS)
10%
5%
0%
0%
-10%
-5%
-20%
-10%
-30%
-15%
05
06
07
08
09
10
11
12
VARIANCE
SWAPS
05
20%
References
JPMorgan
Volatility vehicles, 2001.
Just what you need to know about variance swaps, 2005.
Variance swaps, 2006.
Conditional variance swaps, 2006.
Volatility swaps, 2010.
Academic
Volatility trading, 1990, A. Neuberger.
More than you ever wanted to know about volatility swaps, 1999, E. Derman et
at.
VARIANCE
SWAPS
Towards a theory of volatility trading, 1998, P. Carr & D. Madan.
117
VARIANCE
SWAPS
3G Volatility Products
118
No Exam
3G Volatility Products
Forward variance swaps
Conditional variance swaps
Corridor variance swaps
VARIANCE
SWAPS
Gamma swaps
119
No Exam
Forward Variance Swaps (I)

Forward-start variance swaps are variance swaps whose variance is calculated
between two future dates
T1
and
T2 (expressed in days from today).
Today
T2
T1
(0)
The P&L of a forward variance swap (at the swap expiry date) is given by
VARIANCE
SWAPS
P & L NVar K
2
r
Si
252

ln
T2 T1 i T1 1 Si 1
2
r
T2
120
No Exam
Forward Variance Swaps (II): Forward Strike

The standard variance swap has an inception equal to the time is traded: the investor
is exposed to volatility since today until the swap expiry.

Suppose we know the strikes for a short-maturity variance swap expiring at time
and a longer maturity variance swap expiring at time T2 . We want to find the
expected realised variance between time T1 and time T2 .
T1 ,
Since variance is additive, the longer maturity variance swap is simply the time-
weighted sum of the short maturity variance and the expected variance over the
forward period, thus enabling us to compute this expected forward variance. This
equates to the fair strike of the forward-starting variance swap F :
T1
T2 T1
2
K 0,T1
F2
T2
T2
VARIANCE
SWAPS
2
0 ,T2
121
No Exam
Conditional Variance Swaps (I)

Conditional variance swaps allow investors to take exposure to the variance of an
underlying instrument when it trades within a pre-specified range.
They are similar to variance swaps but P&L (i.e. the difference between
realised variance and the strike) is only accrued when the underlying (stock or
index) price is within a pre-specified range.
If the underlying spends all the time within the range, then the P&L of a
conditional variance swap will be the same as the one of a general

variance swap.
If the underlying spends all the time outside the range, then the P&L of a
conditional variance swap is zero.
For more information on volatility swaps: J.P. Morgan, Conditional Variance Swaps,
VARIANCE
SWAPS
2006.
122
No Exam
Conditional Variance Swaps (II)

The conditional variance swap P&L is calculated as the difference between the
variance realised in the range and the square of the conditional variance strike,
multiplied by the percentage of time spent in the range.
Alternatively it can be viewed as a daily accrual of the variance spread within the
VARIANCE
SWAPS
range:
123
No Exam
Conditional Variance Swaps (III)

P&L of a conditional variance swap at expiry:
P & LCon NVar K

2
r
2
Con
T
2
S i
252
1Si1Range

ln
D i 1 Si 1
T
2
r
K Con
is the variance strike,
NVar is the variance notional, T is the total
number of days, D is the number of days spent within the specified range.
VARIANCE
SWAPS
where
124
No Exam
Conditional Variance Swaps (IV)

While investors are free to specify the range associated with a conditional variance
swap, the two principal types are up and down conditional variance swaps (upvariance and down-variance).
Up-variance accrues realised volatility only when the underlying is above a prespecified level (i.e. no upper barrier), while down-variance is accrued only
when the underlying is below the specified barrier (i.e. no lower barrier).
Conditional variance swaps can be useful for expressing views on volatility contingent
on market level.
For example investors seeking crash protection may purchase conditional downvariance, which only becomes activated in the event of a market sell-off. That
VARIANCE
SWAPS
is, if the market stays above the down-barrier, P&L is zero.
125
No Exam
Conditional Variance Swaps (V)

Payout from a conditional variance swap
with a 20 strike, as a function of

realised volatility (within the range), for
different % of days spent within the

range.
down-variance will normally price above
up-variance for close to ATM barrier

levels.
Indicative Strikes (K)
VARIANCE
SWAPS
P&Ls Conditional Var. Swap
In the presence of a positive put-skew,
126
No Exam
Conditional Variance Swaps (VI)

Conditional Down-Variance Indicative Strikes (K) As of April 2006
Down-barrier: P&L is accrued if the index is below
this barrier (expressed as % of current index price)
Expiry
VARIANCE
SWAPS
Percentage of time expected to be in the range

(i.e. below the barrier for a down-variance swap)
Conditional down-variance strikes exceed normal variance strikes, and increase as the
barrier decreases. For high (in-the-money) barriers, the conditional down-strike will
tend towards the vanilla variance strike.
What about up-variance strikes?
127
No Exam
Corridor Variance Swaps (I)

Corridor variance swaps are similar to variance swaps but if the underlying stock
(or index) price is outside a pre-specified range (corridor) its daily return is
taken to be zero.
In conditional variance swaps, such return was discarded if the stock price was
outside the range. In corridor variance swaps is taken to be zero.
P&L of a conditional variance swap at expiry:
P & LCorr NVar K

2
r
2
Corr
S i
252
1Si1Range

ln
T i 1 Si 1
T
VARIANCE
SWAPS
2
r
where
K Corr
is the variance strike,
NVar is the variance notional, T
is the total
number of days.
128
No Exam
Corridor Variance Swaps (II)

Conditional variance swaps are similar to corridors, but instead of counting as zero
the realised variance occurring outside the boundaries, the returns that close
outside the range are just discarded.
The biggest risk on a long conditional variance swap is that the underlying asset
trades within the range but with a low volatility.
A long risk corridor variance swap:

Not only suffers if the underlying asset trades with low volatility within the
range,
VARIANCE
SWAPS
But suffers even more if the underlying asset is outside the corridor
(because it assumes a zero realised variance in this case, whereas if the

underlying asset remains within the range volatility may be low, but not
zero).
For the same range, underlying and expiry date: Would you expect the strike of
a corridor to be higher, equal or lower than the strike of a conditional var. swap?
129
No Exam
Corridor Variance Swaps (III)

Payout from a corridor variance swap
Payout from a conditional variance
with a 20 strike, as a function of


range.

range.
P&Ls Conditional Var. Swap
P&Ls Corridor Var. Swap
VARIANCE
SWAPS
swap with a 20 strike, as a function of

130
No Exam
Corridor Variance Swaps (IV)

Example:
Suppose a down-corridor variance swap is purchased on the Euro Stoxx 50, with
a barrier close to current spot.
If the index does not close below the barrier between inception and expiry, the
realised variance will be zero and the long will lose the strike squared.
However if a conditional down-variance swap is bought with the same barrier

and the index does not trade below it, the net P&L will be zero. If it does close
within the range the P&L will be the difference between the realised volatility
in the range and the strike squared, scaled by the proportion of time spent
within the range.
VARIANCE
SWAPS
131
No Exam
Gamma Swaps (I)

In gamma swaps, the realised volatility accrued is proportional to the underlying
asset price (unlike in variance swaps, where it accrues independently of it).

P&L of a gamma swap at expiry:
P & LGamma NVar K

2
r
2
Gamma
Si Si
252

ln
T i 1 S i 1 S 0
T
VARIANCE
SWAPS
2
r
where K Gamma is the variance strike,

total number of days.
NVar is the variance notional, T
is the
132
No Exam
Gamma Swaps (II)

In gamma swaps, the realised volatility accrued is proportional to the underlying asset
price (unlike in variance swaps, where it accrues independently of it).

As a consequence, gamma swaps underweight big downward index moves relative
to variance swaps.
This means that if the distribution of stock returns is skewed to the left, gamma
swaps minimize the effect of a crash, thereby making it easier for the trader to
hedge.
In this case, hedging does not require additional caps, unlike variance swaps
which need to be capped.
VARIANCE
SWAPS
133
Disclaimer
JPMorgan is the marketing name used on research issued by J.P. Morgan Securities Inc. and/or its affiliates worldwide. J.P. Morgan Securities Inc. (JPMSI) is a
member of NYSE, NASD and SIPC. This presentation has been prepared exclusively for the use of attendees at Imperial College Structured Credit and Equity
Products" Course and is for information purposes only. Additional information available upon request. Information has been obtained from sources believed to be
reliable but JPMorgan Chase & Co. or its affiliates and/or subsidiaries (collectively JPMorgan) does not warrant its completeness or accuracy. Opinions and estimates
constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results. This material
is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Securities, financial instruments or strategies mentioned herein may
not be suitable for all investors. The opinions and recommendations herein do not take into account individual client circumstances, objectives, or needs and are
not intended as recommendations of particular securities, financial instruments or strategies to particular clients. The recipient of this report must make its own
independent decisions regarding any securities or financial instruments mentioned herein. JPMorgan may act as market maker or trade on a principal basis, or have
undertaken or may undertake an own account transaction in the financial instruments or related instruments of any issuer discussed herein and may act as
underwriter, placement agent, advisor or lender to such issuer. JPMorgan and/or its employees may hold a position in any securities or financial instruments
mentioned herein.
VARIANCE
SWAPS
Copyright 2012 JPMorgan Chase & Co.All rights reserved.
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April 2013

Equity Variance Swaps

Global Asset Allocation

Equity Variance Swaps

Trading just volatility

Realised Volatility: Definition and characteristics

Dollar gamma: How to make it constant

Variance swap hedging & 2008 crisis

Convexity & Vol of Vol

Third generation volatility products: forward variance, conditional variance,

Realised Volatility: Definition and Characteristics (I)

Realised Volatility: Definition and Characteristics (II)

Standard deviation is a more meaningful measure of volatility, given that it is

However some volatility products (such as variance swaps) have payoffs in

Realised Volatility: Definition and Characteristics (III)

It grows when uncertainty increases.

It reverts to the mean.

It goes up and tends to stay up when most assets go down.

It can increase suddenly in spikes.

SPX Index 3m realised vol. (annualised)

Source: J.P. Morgan.

Realised Volatility: Definition and Characteristics (IV)

EuroStoxx 50 (SX5E) Index Volatility: Realised vs. (BS) Implied

Implied 3m ATM Vol.

Realised vol is a backward looking measure.

Implied vol (from option prices) is a forward looking measure.

Conditional variance swaps, corridor variance swaps and gamma swaps.

How can we trade volatility?

period is higher than a given amount.

We only want to take exposure to realised vol/variance, to nothing else.

Why would we want to do that?

How can we do that?

Variance Swaps: How we will introduce them

the one provided by a variance swap.

Trading volatility via straddles and delta-hedged options

Long ATM Straddle (I)

expiry (ignoring rates).

Straddle instantaneous delta

Straddle cost and PnL at expiry

X-axis: stock price.

Long ATM Straddle (II)

This isnt what we wanted.

Long delta hedged option (I)

interval (e.g. 1 day) first

Long delta hedged option (II)

(in years) and the stock price moves to

We bought a call option and sold

units of the underlying stock

P&L of our position:

stock price, time and vol:

Long delta hedged option (III)

zero interest rates; see Hull, 6th edition, Chp. 15.7):

This leaves the daily P&L of a delta-hedged call option as:

Long delta hedged option (IV)

Daily P&L of a delta-hedged option (call or put):

Realised minus implied variance

See Hull, 6th edition, Chp. 15.

Gamma: Call & Put

Dollar Gamma is not constant

Dollar Gamma & Stock Price

Dollar Gamma (RHS)

X-axis: stock price.