Volatility Swap
A volatility swap is an OTC derivative that exchanges the realized volatility of an underlying asset over a set period for a fixed volatility strike, providing linear exposure to volatility — unlike a variance swap, whose payoff is convex in volatility.
The volatility swap is conceptually the simpler of the two pure-volatility derivatives: the holder receives the realized volatility of the underlying minus the fixed strike agreed at trade initiation, multiplied by a vega notional amount. If realized volatility ends up at 22% and the strike was 18%, the buyer collects four volatility points on the notional. The payoff is linear and symmetric, making position sizing intuitive compared to a variance swap.
The practical difficulty of volatility swaps is that they cannot be perfectly replicated by a static portfolio of vanilla options. Variance swaps can be hedged precisely through a log-contract replication, but volatility swaps require dynamic adjustments because volatility itself does not have a model-free static hedge. Dealers therefore carry more model risk when pricing and hedging volatility swaps, which is reflected in slightly wider bid-ask spreads relative to comparable variance swap contracts.
Despite this complexity, volatility swaps are actively used by asset managers who want clean, linear volatility exposure for hedging equity portfolios. A pension fund holding a large equity book may buy volatility swaps struck at current implied volatility levels to offset losses during a market drawdown, since volatility and equity returns are strongly negatively correlated over short horizons — a phenomenon quantified in the leverage effect literature.
In the United States, volatility swaps on the S&P 500 and major index underlyings are cleared through CME Group or traded bilaterally in the CFTC-regulated swap market. Reporting requirements under Dodd-Frank Title VII mandate that OTC volatility swap transactions be reported to a swap data repository, improving post-trade transparency in this market segment.
Volatility swaps on single-name equities are also traded around earnings announcements, allowing market participants to express views on whether realized volatility during the earnings window will exceed or fall short of the implied volatility priced into the options market. The comparison between volatility swap strikes and at-the-money straddle prices for the same expiry is one way traders assess relative value between implied and realized vol heading into corporate events.