Variance Swap

A variance swap is a forward contract on the future realized variance of an underlying asset, such as a stock index, single stock, or cryptocurrency. The payoff for the long party (volatility buyer) is determined by the difference between the realized variance over the contract's life and the pre-agreed variance strike. This structure provides pure, linear exposure to volatility itself, unlike options where the relationship between price and volatility (vega) is non-linear and affected by other factors like the underlying price.

The mechanics are defined by a specific formula. At maturity, the realized variance is calculated as the sum of squared daily log returns of the underlying asset's price. The variance notional—a contract multiplier—determines the cash value of each variance point. The settlement amount is: Variance Notional * (Realized Variance - Variance Strike). If realized volatility is higher than the strike, the long party receives a payment from the short party, and vice versa. This makes it a direct tool for hedging volatility risk or speculating on future market turbulence.

Key advantages of variance swaps include their purity of exposure. They isolate volatility risk without the path-dependency and delta-hedging complexities of options portfolios. They are often used by institutional investors and hedge funds to hedge tail risk in equity portfolios or to express a view on future market stability. In crypto markets, variance swaps on major indices like the Bitwise 10 or single assets like Bitcoin allow for sophisticated volatility trading strategies, capitalizing on the asset class's characteristically high and variable volatility.

A variance swap is an over-the-counter (OTC) financial derivative that allows two parties to exchange fixed and floating payments based on the realized variance of an underlying asset over a specified period. The buyer of the swap pays a predetermined strike variance (the fixed leg) and receives the realized variance (the floating leg) calculated from the asset's daily logarithmic returns. The core mechanism is a pure play on volatility, as the payoff is determined solely by the magnitude of price changes, not their direction. Settlement occurs in cash at maturity, with the net amount transferred from one counterparty to the other.

The payoff formula for the variance swap buyer is: Notional * (Realized Variance - Strike Variance). The variance notional is typically quoted in 'vega notional,' representing the profit or loss for a one-point (1%²) change in variance. The realized variance is calculated as the annualized sum of squared daily log returns, often with a mean adjustment set to zero. A critical contractual detail is the use of a convexity adjustment or volatility strike, which converts the quoted volatility strike (e.g., 20%) into a variance strike (e.g., 400 = 20²) for the formula, making the payoff convex in volatility.

Key operational components include the observation schedule for calculating daily returns, the handling of dividends and corporate actions, and the definition of the underlying reference, such as a specific stock index or single stock. Disruptions like market closures are addressed by the contract's market disruption events clause. Unlike a volatility swap, whose payoff is linear in volatility, the variance swap's convex payoff means its value is more sensitive to large price moves (volatility of volatility), making it a preferred instrument for hedging or speculating on tail risk and volatility dispersion.

A variance swap is an over-the-counter (OTC) financial derivative that allows two parties to exchange payments based on the realized variance of an underlying asset's price versus a pre-agreed strike variance. Unlike options which hedge directional price moves, this contract is a pure play on volatility—the magnitude of price fluctuations, regardless of direction. The payoff for the long variance position is proportional to the difference between the realized variance and the strike variance, typically settled in cash at the contract's expiration. This makes it a fundamental tool for volatility traders and hedgers in TradFi markets.

The core mechanics involve calculating realized variance, which is the sum of squared logarithmic returns of the underlying asset over the contract's life. This is contrasted with the implied variance embedded in the strike price, which reflects the market's volatility expectation at inception. Settlement uses the variance notional, a multiplier that converts the variance difference into a monetary amount. A key feature is its convexity; its value increases more than linearly with volatility, creating a different risk profile than linear instruments like futures. This structure provides direct exposure to volatility as an asset class.

In decentralized finance (DeFi), the concept is re-engineered for trustless execution. Protocols create on-chain variance swaps using oracle-fed price data to calculate realized volatility and smart contracts to automate settlement. Instead of a single counterparty, liquidity is often pooled from many users, and positions may be tokenized as volatility tokens. However, significant challenges remain, including oracle manipulation risks, the need for robust and frequent price feeds, and managing the collateral and margin requirements in a non-custodial system. These DeFi constructs aim to democratize access to sophisticated volatility trading strategies.

The evolution from TradFi to DeFi highlights a shift in infrastructure and counterparty risk. TradFi variance swaps require credit lines, ISDA agreements, and face bilateral counterparty risk with a bank or dealer. DeFi versions replace this with over-collateralization and automated, transparent smart contract logic on a public blockchain. This transition unlocks access for a broader set of participants but introduces new technical and financial engineering challenges, such as designing incentive-compatible mechanisms for liquidity providers and ensuring the economic security of the volatility calculation itself.