Risk Latte - Options on Variance Swaps

Options on Variance Swaps

Team Latte
Jan, 2005

Currently, a lot of hedge funds have been using S&P 500 variance swaps as a method for shorting volatility. Pricing and trading options on these variance swaps are not straight forward. For example, suppose you wanted to sell someone the right to put you into a variance swap at a fixed strike. As an example: you sell a 2-month option on a 1 year swap. The buyer has the right to put you into a short variance swap at a fixed strike anytime during the next 2 months. If worthwhile to the buyer, he exercises and you are in that variance swap at that strike.

Here are some points to consider:

  1. This product may amount to pricing the "volatility of volatility (vvol)". As such, there would not appear to be a way to price this by arbitrage. A model/process that describes the vvol would be needed.

  2. The higher the vvol, the more this option is worth. Thus, since vvol is higher for shorter dated volatility, this option is more valuable if the underlying swap has a short time to expiration.

  3. The option itself is worth more to the extent the holder has more time to exercise it. The product is interesting since hedge funds may want to short volatility at higher levels and this is a means of getting paid now to potentially be short volatility at higher levels.

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