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A variance swap is an over-the-counter derivative that offers exposure to the future volatility of an underlying asset such as an interest rate or an equity index, without the investor taking directional exposure to that asset.
Variance swaps give investors a payout equal to the difference between realised variance (the square of the standard deviation) and a pre-agreed strike level. Due to the convexity that is inherent in a variance swap, an investor going long the instrument will benefit from increased gains and reduced losses compared with a direct exposure to volatility.
That means the fair strike of a variance swap is typically higher than that of a volatility swap, making the product attractive to volatility sellers who can sell at a higher strike. Sellers of the instruments are exposed to greater losses if volatility surges.
Variance swaps have become popular risk recycling tools among dealers whose large structured products businesses leave them short correlation. Dealers can buy back correlation from hedge funds via dispersion trades, in which hedge funds take a short variance swap on an index, while buying variance swaps on the constituent single stocks.
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