The Financial Engineer

What is it?

• An OTC transaction in which an investor takes a view on the realized variance of some instrument, usually an index, over a specified time period. However observations are only counted toward the valuation if the underlying level the previous day satisfies some “condition”.

How is it constructed?

• Exactly the same as a variance swap except for an agreed condition.
• However observations are only counted toward the valuation if the underlying level the previous day satisfies some condition.
• An up-var and a down-var swap with the same trigger equate to a normal variance swap.

Payoff = (σR^2 – X2) * M (same as the variance swap but only includes the observations that satisfy the condition)

When is it used?

•  To get exposure to volatility  with directional overlay.
• Were created in the Autumn of 2006 to increase popularity of an already popular trading tool in the standard variance swaps.
• Hedge Funds are by far the most active clients for variance swaps.
• Sophisticated complex product that can be tailored to give an exact risk exposure and return profile

What are the benefits?

• The payout is linear to variance rather than volatility. Therefore, the payout will rise at a higher rate than volatility.
• All the hedging is performed by the provider, saving time and money.
• Losses are limited, however gains are magnified.

What are the risks?

• Payoffs can be reduced depending on the number of observations that satisfy the condition.
• This is a more significant risk when the conditional variance swap is used to hedge some other position.
• More risk for the market marker who would find it harder to hedge when near the trigger as it would be equally likely for it to move above (hedging) or move below (no hedging).