Pricing A Variance Swap
Let’s look at how risk-neutral pricing of a variance swap can be constructed with this elegant formula:
Static Portfolio Replication
proposition Let be twice continuous differentiable so that for any and any , then,
proof We will prove the case in which ; similar proof can be sketched for the other case. When , we have . The the second integral can be simplified as:
Using integration by part:
And,
The above formula shows that any
twice-differentiable continuous time-T payoff can be replicated using a static portfolio
of:
In practice, discrete set of strike can be used to approximately replicate. For example, given and payoff function . Here we choose to replicate with (Though we can theoretically replicate the payoff with any , a close to is typically chosen) and a discrete set of option strikes with increment of capping at . In this replicating portfolio we will hold:
Variance Swap
A variance swap
is an over-the-counter financial derivative that allows a party to trade on the future variance of a given underlying security. For example, a trader would pay the realized variance
of log-price changes in exchange of a fixed payment called variance strike
, normalized by the vega notional
into dollar terms. The payoff of the VS is:
We can calculate the variance strike which results in a zero discounted expectation of the payoff (per unit of vega notional).
Assuming that the underlying process follows a geometric Brownian motion with local volatility :
Therefore the realized variance
of is:
Furthermore, if we combine the SDE of and ,
Taking integral on both sides,
Combining with the formula for the realizead variance of ,
Using the proposition proven above, we can create a static replication portfolio and replicate the payoff.
If we choose the cutoff as the forward price , we can largely simplified the formula as follow:
In conclusion, if we assume a GBM underlying process, the fair-value variance strike can be calculated as the sum of calls and puts across a continuum of strikes.
Practical Consideration
In practice, variance swap is costly to implement, requires constant hedging and an entire array of options. The advantage of a variance swap is that it is purely exposed to volatility risk
, as oppose to an option which contains directional risk.
The P&L of a variance swap depends directly on the difference between realized and implied volatility. Since historically the implied volatility has been above realized volatility, a.k.a. variance risk premium
, volatility arbitrage (rolling short variance trade) can be carried out with variance swaps.
Reference
- Variance and Volatility Swaps, FinancialCAD Corporation, http://docs.fincad.com/support/developerFunc/mathref/VarianceSwaps.htm