What is a variance swap?

A variance swap is a financial derivative used to hedge or speculate on the magnitude of a price movement of an underlying asset. These assets include exchange rates, interest rates, or the price of an index. In plain language, the variance is the difference between an expected result and the actual result.

What is an example of a swap?

A swap is a derivative contract where one party exchanges or "swaps" the cash flows or value of one asset for another. For example, a company paying a variable rate of interest may swap its interest payments with another company that will then pay the first company a fixed rate.

How do volatility swaps work?

Volatility is derived from an asset’s variance. Generally, in percentage terms, an asset with higher volatility can be expected to be transacted more frequently. Variance swaps function in a manner that resembles a plain vanilla swap.

What is an interest rate swap?

In an interest rate swap, the parties exchange cash flows based on a notional principal amount (this amount is not actually exchanged) in order to hedge against interest rate risk or to speculate.