Published by: FINCAD
Date: 2008
“Rather than gaining exposure to the market’s volatility through standard call and put options, investors can take views on the future realized volatility directly by trading derivatives on variance and volatility. The simplest such instruments are variance and volatility swaps.
“A volatility swap is a forward contract on future realized price volatility. Similarly, a variance swap is a forward contract on future realized price variance, variance being the square of volatility. At expiry the receiver of the “floating leg” pays (or owes) the difference between the realized variance (or volatility) and the agreed upon strike. At inception the strike is generally chosen such that the fair value of the swap is zero. This strike is referred to as fair variance (or fair volatility).”
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