Variance Swap

A variance swap is a financial derivative contract in which the buyer pays the seller a fixed amount in exchange for the right to receive the difference between the realized variance of an underlying asset and a predetermined strike level. The seller of the variance swap is obligated to pay the buyer the difference between the realized variance and the strike level, if the realized variance is greater than the strike level.

Variance swaps are often used by investors to hedge against the risk of volatility in an underlying asset. For example, an investor who is long an asset may enter into a variance swap to protect against the risk of the asset's price falling. The investor would pay the seller of the variance swap a fixed amount, and in return, the seller would agree to pay the investor the difference between the realized variance and the strike level, if the realized variance is greater than the strike level. This would protect the investor from the risk of the asset's price falling, as the investor would be compensated for the difference between the realized variance and the strike level.

Variance swaps can also be used by investors to speculate on the volatility of an underlying asset. For example, an investor who believes that an underlying asset is going to become more volatile may enter into a variance swap to profit from the increase in volatility. The investor would pay the seller of the variance swap a fixed amount, and in return, the seller would agree to pay the investor the difference between the realized variance and the strike level, if the realized variance is greater than the strike level. This would allow the investor to profit from the increase in volatility, as the investor would receive the difference between the realized variance and the strike level.

Variance swaps are a complex financial instrument and should only be used by investors who understand the risks involved.