# Variance vs. Volatility Swaps: Definitions, Differences, and Mechanics

![A business person uses a computer pad to search for available derivative contracts to hedge the company's currency exchange rate risk.](https://www.investopedia.com/thmb/55eb6RbuEoskXrI87AZuo_9IQBU=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/VarianceSwap-07912994176c4bccb7c4f6207c0ba109.jpg)

*— shapecharge / Getty Images*

## What Is a Variance Swap?

A variance swap is a financial [derivative](https://www.investopedia.com/terms/d/derivative.asp) used to [hedge](https://www.investopedia.com/terms/h/hedge.asp) 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](https://www.investopedia.com/terms/v/volatilityswap.asp), but it uses realized volatility instead of variance.

### Key Takeaways

*   Variance swaps involve two parties who exchange amounts based on an asset’s price volatility, where one pays based on actual variance and the other on a fixed amount called the strike.
*   These swaps are useful for hedging or speculating on volatility without the directional risk associated with options, offering a simpler and cheaper alternative.
*   Unlike options, variance swaps do not require additional hedging strategies like delta-hedging and are settled in cash based on the difference between the actual variance and the fixed strike.
*   Variance swaps cater to three main groups: directional traders speculating on volatility levels, spread traders betting on realized versus implied volatility, and hedger traders managing short volatility positions.

## Understanding the Mechanics of Variance Swaps

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](https://www.investopedia.com/terms/n/npv.asp) (NPV) of the payoff zero.

At the end of the contract, the net payoff to the [counterparties](https://www.investopedia.com/terms/c/counterparty.asp) will be a theoretical amount multiplied by the difference between the [variance](https://www.investopedia.com/terms/v/variance.asp) 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](https://www.investopedia.com/terms/s/standarddeviation.asp).

A variance swap is a pure-play on an underlying asset's [volatility](https://www.investopedia.com/terms/v/volatility.asp). Options also give an investor the possibility to speculate on an asset's volatility. But [options](https://www.investopedia.com/terms/o/option.asp) 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.

There are three main classes of users for variance swaps.

1.  Directional traders use these swaps to speculate on the future level of volatility for an asset.
2.  Spread traders merely bet on the difference between realized volatility and [implied volatility](https://www.investopedia.com/terms/i/iv.asp).
3.  Hedger traders use swaps to cover [short](https://www.investopedia.com/terms/s/short.asp) volatility positions.

## Key Characteristics of Variance Swaps

Variance swaps are ideal for [speculating](https://www.investopedia.com/terms/s/speculation.asp) or hedging on volatility. Unlike options, they don't need extra hedging. Options might need [delta-hedging](https://www.investopedia.com/terms/d/deltahedging.asp). The payoff to the long holder is positive at [maturity](https://www.investopedia.com/terms/m/maturity.asp) if realized volatility beats the strike. Traders should know that big price jumps in the [underlying asset](https://www.investopedia.com/terms/u/underlying-asset.asp) can skew variance and cause unexpected results.