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frolloos
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Variance swaps for vega hedging

November 18th, 2015, 5:36 pm

Why would anyone use varswaps for hedging vega? I understand that from the sell-side perspective there may be commercial incentives to sell and market these instrument as vol hedge instruments, but personally I don't see the use of varswaps for hedging vega (linear exposure). Am I missing something? I would understand varswaps as a speculation instrument but not as a hedge instrument.
Last edited by frolloos on November 17th, 2015, 11:00 pm, edited 1 time in total.
 
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VolMaster
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Variance swaps for vega hedging

November 28th, 2015, 7:52 am

VarSwap hedges a vega exposure with a strike-less instrument that is purely a volatility bet. At the inception the entire value (and therefore the P&L) is determined by the difference between the strike vol (that is set to the spot volatility/variance at the inception, to ensure 0 cashflow of the swap). The meaning of that, is that on day-1 the vega part of the exposure accounts for the entire risk of the swap, if volatility goes up and you are long the varswap, you will gain on the varswap (and lose if you are hedging that bet with another instrument). As the time passes the realized variance will account for greater part of the value (i.e., the gamma part). If the variance realizes below the implied (market) variance (or vol) you will essentially bleed value as time passes (and vice versa if market realizes above).Bear in mind that variance swap exposes to more that volatility. VarSwap creates a convexity exposure, as the payout is non-linear by its nature.
 
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frolloos
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Variance swaps for vega hedging

December 5th, 2015, 1:23 pm

QuoteOriginally posted by: VolMasterVarSwap hedges a vega exposure with a strike-less instrument that is purely a volatility bet. Which / what vega, how do you define vega?
Last edited by frolloos on December 4th, 2015, 11:00 pm, edited 1 time in total.
 
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tw
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Joined: May 10th, 2002, 3:30 pm

Variance swaps for vega hedging

December 5th, 2015, 3:32 pm

QuoteOriginally posted by: frolloosWhy would anyone use varswaps for hedging vega? I understand that from the sell-side perspective there may be commercial incentives to sell and market these instrument as vol hedge instruments, but personally I don't see the use of varswaps for hedging vega (linear exposure). Am I missing something? I would understand varswaps as a speculation instrument but not as a hedge instrument.Imagine a portfolio which, for example is long low delta calls and short variance swaps so thevega of the implied vol of the calls is equal and opposite to the vega (to realised vols) of the variance swaps.In what circumstances would you expect this portfolio to make money? When would it lose?
 
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VolMaster
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Variance swaps for vega hedging

December 12th, 2015, 12:47 pm

QuoteOriginally posted by: frolloosQuoteOriginally posted by: VolMasterVarSwap hedges a vega exposure with a strike-less instrument that is purely a volatility bet. Which / what vega, how do you define vega?The definition of Vega is the exposure of your portfolio to a change of the implied/market volatility.
 
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frolloos
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Variance swaps for vega hedging

December 12th, 2015, 2:28 pm

If you define vega as sensitivity to a particular implied vol, the varswap doesnt really hedge that given that it's a strip of implied variances. If you define vega as the sensitivity to the instantaneous variance parameter in a stoch vol model I still don't see how a varswap can hedge that since the variance swap vega is the sensitivity of a varswap to the varstrike, which is not the instantaneous variance.
Last edited by frolloos on December 11th, 2015, 11:00 pm, edited 1 time in total.
 
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ashkar
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Variance swaps for vega hedging

April 22nd, 2016, 12:00 pm

In my view varswap is a good skew hedge particularly because your gamma is not pinned around any particular strike. I think most finance book authors don't have practical vol trading experience to make the distinction.
 
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frolloos
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Variance swaps for vega hedging

April 24th, 2016, 5:48 pm

QuoteOriginally posted by: ashkarIn my view varswap is a good skew hedge particularly because your gamma is not pinned around any particular strike. I think most finance book authors don't have practical vol trading experience to make the distinction.Agree with you regarding lack of books on managing a *book* of options or vol products, interaction of flow desk with exotics desk, supply and demand etc. We can theorize about sticky strike or sticky delta, local or stoch vol, which is all very useful and interesting to know, but I am starting to believe more and more that it's structured products re-hedging, institutional buy side hedging, hedge fund flows, balance sheet costs, etc that really drives smile and funding dynamics and pricing in general.
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