Variance Swap – How Is It Useful International Transactions ?
What is variance swap ?
In all essence, a variance swap is a virtual entity. It is the result of speculations that are arrived at by taking into account a number of factors that allows one to calculate the risks associated with fluctuations in the stock market that has a direct impact on the value of bonds or hedge funds that is involved in the swap. The factors that are considered in the calculation are stock index fluctuations, exchange rate, rate of interest or other factors that cause a variance in the swap component. In variance swap, one counter party pays the swapping amount on the basis of variance figure.
How is Variance Swap evaluated ?
Since there is a constant change in the stock market on a daily basis, variance swap amount also changes everyday. However, the price of stock market at closing on the day of swap agreement is considered for speculating variance swap. While one party of the swap pays amount based on variance swap, the other party offers a fixed amount that is independent of variance in the swap and is based on the amount that is agreed upon in the swap agreement. So, there will be difference in the two lending amounts. This difference is balanced at maturity of the swap. The manner in which the variance is balanced is agreed upon between the two parties.
What is the use of Variance Swap ?
There are a number of uses of variance swap. This is a somewhat precise and a more tangible way of speculating on the risks associated with a currency swap or interest rate swap. The reason why variance swap is considered important is because it provides a clear and clean idea about the risks that the underlying price might to expose in comparison to options trading. It is a more tangible entity because it is a mathematical difference between two precise figures – implied volatility and realized volatility. Both these entities play a major role in swap agreement.
The final payout at maturity is always based not on the speculated price but on the realized price, although the quoted strike will be calculated based on the speculative figures. Another thing to note is that variance swap is always calculated on the worst conditions. Therefore, the implied risk is always more than realized risk. This way, the swapping will be safer for both the parties since dip margins is lower.