Unearthing Value in Variance Swap Contracts: A Volatility Risk Perspective

The Hidden Opportunity in Variance Swap Contracts

Variance swap contracts are increasingly becoming popular in the financial market as a means of obtaining variance risk exposure. These contracts, which pay at expiry the difference between the realized return variance and a fixed variance rate, have been actively traded over the counter on major equity indexes. But what opportunities do they present for investors?

The Dynamics of Variance Risk

Variance swap rates quotes on major equity indexes are now readily available from several broker dealers. By analyzing the term structure of these variance swap rates, we can infer direct information about the variance risk dynamics and market pricing of variance risks. Preliminary analysis suggests that a two-factor variance risk structure, where the instantaneous variance rate reverts to a stochastic central tendency, performs significantly better than a one-factor risk structure in capturing the term structure of variance swap rates.

Volatility: The Real Risk for Option Players

For option players, understanding volatility dynamics is crucial as the options market is essentially a market for volatility. A covered long position on options is primarily a bet on volatility increase, while a covered short position is on volatility fall. For very long-dated options, the volatility risk, i.e., the volatility of volatility, becomes the major concern for risk management.

Portfolio Implications: Risks and Opportunities

Incorporating variance swap contracts can significantly improve an investor's utility and alter their allocation to primary securities such as C, TIP, BAC, VTI, MS. However, it is essential to understand the associated risks and opportunities. On the flip side, shocks on the instantaneous variance rate impact mainly short-term variance swap rates, while shocks on the stochastic central tendency dominate the variation of long-term variance swap contracts.

Taking Advantage of Variance Swap Contracts

Variance swap contracts present a unique opportunity for investors to gain exposure to variance risk and manage volatility risk more effectively. By understanding the dynamics of variance risk and market pricing, investors can make informed decisions about incorporating these contracts into their portfolios.