💲A variance swap is a financial derivative used to hedge or speculate on the magnitude of a price movement of an underlying asset. Assets can be exchange rates, interest rates, or index prices. Variance is the difference between expected and actual outcomes. A variance swap is like a volatility swap, but it uses realized volatility instead of variance. A variance swap is a pure-play on an underlying asset's volatility. Options also give an investor the possibility to speculate on an asset's volatility. But options carry directional risk and their prices depend on many factors, including time, expiration, and implied volatility. Therefore, the equivalent options strategy requires additional risk hedging to complete. Variance swaps are also cheaper to put on since the equivalent of an option involves a strip of options. 🔵Similar to a plain vanilla swap, in a variance swap, one party pays based on the asset’s actual price variance. The other party pays a fixed amount, the strike, set at the contract's start. The strike is typically set at the onset to make the net present value (NPV) of the payoff zero. 🔵At the end of the contract, the net payoff to the counterparties will be a theoretical amount multiplied by the difference between the variance and a fixed amount of volatility, settled in cash. Payments may occur during the contract if its value exceeds limits set by margin requirements.Mathematically, a variance swap is the average of squared differences from the mean. The square root of variance is standard deviation. Thus, a variance swap’s payout is larger than a volatility swap’s, since it uses variance, not standard deviation. ☑️Variance swaps are ideal for speculating or hedging on volatility. Unlike options, they don't need extra hedging. Options might need delta-hedging. The payoff to the long holder is positive at maturity if realized volatility beats the strike. Traders should know that big price jumps in the underlying asset can skew variance and cause unexpected results. Learn more about the future of financial technology at daoti.io.