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Volatility vs Variance Swap vols
When entering into Variance Swap vs Volatility Swap for same underlying security (say SPX) and same tenor, should one expect to get a different vol quote?From my understanding Volatility Swaps cannot be perfectly hedged so broker dealers just increase the bid/ask spread when quoting for Volatility Swap vs Variance Swap.Can someone please confirm if this is still the case? Or is there a different/better model available to extract Volatility Swap vols. Thanks.
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- EndOfTheWorld
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Volatility vs Variance Swap vols
If you draw the payoff of short varswap and short volswap versus volatlity level on expiry assuming that K volswap = K varswap, you will see that PnL varswap < PnL volswap. Hence you should have always Volswap Strike < Varswap Strike to compensate the loss due to convexity.
Last edited by EndOfTheWorld on December 6th, 2010, 11:00 pm, edited 1 time in total.
Volatility vs Variance Swap vols
That is true. How is it systematically handled? How much strike to reduce for Vol Swap?
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- EndOfTheWorld
- Posts: 4
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Volatility vs Variance Swap vols
Using your favourite vol model, you replicate the varswap with option prices and price the volswap with MC.Alternatively, there are a few approximations:- volswap = ATMF- using the Derman Formula: varswap = volswap * sqrt( 1 + 3 * T * Skew ^2), where skew = (vol (K1) - vol (K2) / (K1- K2) (downside skew seems better to used)