Volatility Swap

A volatility swap is a financial derivative contract in which the buyer pays a fixed premium to the seller in exchange for the right to receive a payoff based on the realized volatility of an underlying asset over a specified period of time. The seller of the volatility swap is obligated to pay the buyer the difference between the realized volatility and the strike volatility, which is the volatility level that was agreed upon at the inception of the contract.

Volatility swaps are often used by investors to hedge against the risk of changes in the volatility of an underlying asset. For example, an investor who is long a stock may enter into a volatility swap to protect against the possibility that the stock's volatility will increase. In this case, the investor would pay a fixed premium to the seller of the volatility swap, and in return, the seller would agree to pay the investor the difference between the realized volatility and the strike volatility. If the stock's volatility increases, the investor will receive a payout from the seller of the volatility swap.

Volatility swaps can also be used for speculation. For example, an investor who believes that the volatility of an underlying asset will increase may enter into a volatility swap to profit from this increase. In this case, the investor would receive a payout from the seller of the volatility swap if the realized volatility exceeds the strike volatility.

Volatility swaps are typically traded over-the-counter (OTC) between two parties. However, some volatility swaps are also listed on exchanges, such as the Chicago Mercantile Exchange (CME).

Volatility swaps can be used to hedge or speculate on the volatility of a wide variety of underlying assets, including stocks, bonds, commodities, and currencies. However, volatility swaps are complex financial instruments and should only be used by investors who understand the risks involved.