Volatility Swap (Volswap) is an OTC derivative instrument mostly used for hedging or directional purpose by market participants. Indeed, a volatility swap offers to investors and traders some exposure on future expected volatility on a specific underlying (equity index, interest rates, etc.). At maturity, the difference between the realized volatility and the volatility strike will define the amount to be paid or received by the vol swap buyer.
A volatility swap is built with the following features:
– A volatility strike (K, fixed leg)
– The realized volatility (at expiration, K-realized, floating leg)
– The vega notional (notional amount at inception, which is not exchange, like for varswap)
At maturity, the payoffs of a volswap are the following:
Vega notional * (K realized – K)
Volatility swaps have become more and more popular among market participants, especially hedge funds that are seeking a pure volatility exposure without directional risk (meaning that at expiration, only realized volatility matters, the underlying price movements will not affect the volswap’s payoffs).
Additionally, a volatility swap allows the market participants to trade the underlying volatility without trading the underlying itself. Like for a varswap, a volswap is a perfect volatility hedging tool mostly used by traders to cover their short volatility positions. The main advantage is the pure exposure to volatility compared to options trading, where the maturity, the underlying price, and the underlying implied volatility matter and should be taken into consideration when entering the trade. Hedge funds and exotic desks are the main users of this kind of instruments, mostly to hedge their exotic books.