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What are Volatility Swaps? Financial Derivatives - Trading Volatility - YouTube
Channel: Patrick Boyle
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hi my name is Patrick Boyle welcome back
to my youtube channel. Today's video is
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on the topic of volatility swaps. I am
back to my usual video format today
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which is shorter videos that quickly
explain financial topics. I aim to
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keep them 5 to 10 minutes long with no
filler material in them. Last week I
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posted a series of 6 longer slideshow
style lectures each one was about an
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hour long that I put together as a
playlist.
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I think it's called revision lectures. A
few people had emailed me asking for
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longer lectures they basically felt it
was easier for them to study that way so
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I put those ones together um you know as
revision aids for students who are
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preparing we'll say for an exam or
something like that. let me know what you
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think of those videos and of these
videos tell me which style you prefer
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because obviously the more feedback I
get the better I can make these videos
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and my goal is of course for you guys to
find them as helpful as possible. Anyhow
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on to today's topic, which is volatility
swaps. If you want to have a long
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position in future realized volatility
(or to be long vol as option traders say)
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Delta hedging a single option is not
always a perfect approach as soon as the
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stock price changes your sensitivity to
further changes in volatility is altered
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because of gamma - in theory the returns
associated with Delta hedging an option
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are fixed and are entirely based on the
difference between the implied
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volatility of the option when it was
purchased or sold and the realized
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volatility of the underlying over the
life of the option. In the real world
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with discrete rather than continuous
Delta hedging (which means that traders
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occasionally re-hedge rather than
constantly rehedging at every second
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throughout the life of the option) this
turns out not to be the case. Variance
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and volatility swaps were created to
allow investors
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to hedge volatility risk or to speculate
on implied volatility in a clean manner
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without the need for continuous Delta
hedging which can be both expensive and
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inefficient. The naming of these products
as swaps is somewhat misleading as
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they're more like forwards this is
because their payoff occurs at maturity
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where swaps have intermediate payouts
over the the life of the contract. So
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what are volatility swaps? A volatility
swap is an over-the-counter financial
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derivative which allows investors to
trade future realized volatility against
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current implied volatility. It acts like
a forward contract on the future
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realized volatility of a given
underlying asset. Volatility swaps allow
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investors to trade the volatility of an
asset directly much as they would trade
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a stock or an index. At inception of the
trade the strike is usually chosen such
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that the fair value of the swap is zero.
The volatility notional is the notional
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amount paid or received per volatility
point or per 1% shift in realized
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standard deviation. The payout of a
volatility swap is the notional
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multiplied by the difference between the
realized volatility and the volatility
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strike agreed at inception. The profit
and loss on a volatility swap relates
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only to the realized volatility of the
underlying and is unaffected by any
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directional moves
thus it gives you a simpler and more
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pure volatility exposure than Delta
hedging an option does. So how do we
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replicate and hedge volatility swaps?
Well there's no simple replication
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strategy for a volatility swap. Variance
rather than the volatility exposure is
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what you get from hedged options trading.
From a derivatives point of view
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variance can be viewed as the primary
underlying and volatility swaps are best
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regarded
as derivative securities on variance
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volatility being the square root of
variance is a nonlinear function and is
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therefore more difficult both
theoretically and practically to value
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and hedge the main difficulty with
pricing and hedging volatility swaps is
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that they require a volatility of
volatility (or vol of vol) model and if
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this model is not representative of the
real world your pricing will be wrong.
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Volatility swaps are very difficult to
hedge and so market participants moved
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towards trading variance swaps as
variance swaps can be statically
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replicated. Volatility swaps cannot be
hedged by a static portfolio of options
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but they can be hedged with variance
swaps for small moves the payouts of
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volatility and variance swaps can be
similar. On screen right now you can see
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the payoff of a volatility swap and a
variance swap as a function of realized
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volatility. For more on this topic take a
look at the textbook for this course a
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link to it is in the description below
hopefully you found the video helpful if
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so click the like button and click the
subscribe button if you'd like to see
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more videos like this. Tomorrow's video
will be on the topic of variance swaps
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see you then and have a great day bye
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