Definition of Variation SWAP
The variance swap is a forward contract in which the underlying is the measured or realized variance of the underlying asset over the life of the swap, and the forward rate (or swap rate) is the variance set on the trade date.
Explanation of Variance Swap
Variance swaps are natural instruments for investors taking directional bets on volatility:
Realized volatility: Unlike the trading P&L of a delta-hedged option position, a long variance position will always benefit when realized volatility is higher than implied at inception, and conversely for a short position.
Implied volatility: Similar to options, variance swaps are fully sensitive at inception to changes in implied volatility.