Vol vs. Var Swaps in FX
This is a summer I've had since the summer, and no one I asked at the BB was able to answer this question. I just can't get over it.
Question: So obviously var swaps are preferred and hence more liquid in equities because they're easier to replicate with options, but why are vol swaps more popular in FX?
Some have told me maybe that's just the convention, but they aren't sure. Any other guesses?
Well, vol swaps are more popular in FX as opposed to equities because FX has the deepest vol market of any product.
If you mean why are they preferred to var swaps within FX? They aren't really. Variance swaps are easy to replicate, true, but to hedge them would essentially mean trading every possible strike... which isn't feasible in reality. Normally you'd just cover the vol and do some flies at the onset to imitate your surface risk.
In some ways vol swaps (while not really replicable) are more benign due to the fact that they are linear wrt vol, whereas variance swaps are convex.
That answers my question... I wonder why the VP I asked in FX wasn't able to answer that, i mean, it makes sense.
Sigh, guess it's because he's in sales hahaha...
I second everything Revsly said except this:
Truth is the S&P vol market is multiple times deeper than the EURUSD or USDJPY vol market. Brevan Howard runs over the unlucky shop who wins their vanilla deals on a regular basis because their size is often market moving, it would take much more size to move SPX vol. Moreover, equities guys trade options on implied vol. (in the fx market we`re still stuck at options on realized vol). Equities guys quote options on vol swaps, options on straight ATM vol, and options on variance swaps... but that's because they have an active broker market for var swaps themselves. In other words, they trade var swaps like they are delta! (the way fx guys trade spot as delta).
Very good point, as a whole fx is deeper, but on a specific level equity indicies have more liquidity.
The low vol basis is also true, not going to be much fun when your 10d flies become 35d overnight from vols exploding hah, need to look hard at your dgov/dvol and even higher to have any sense of what would happen to your position.
Oh and comeon, I haven't been run over yet... This week...
Also, customers and dealers in FX are very wary of trading variance for another simple reason: the low vol base of FX.
Variance Swaps have Vol of Vol (ie. dVega/dVol), and the vol itself is already on a very low base. e.g. 1m EURUSD is say 11%. Whereas in equities, vol bases tend to be much higher, e.g. 20% handles or 30% handles are seen on many underlyings.
Imagine what would happen if EURUSD absolutely blew up and was on a 40 handle... the Vol of Vol would destroy you e.g. you could go from being short 500k Vega to short 2.5 million vega as vol screams higher over night. whereas with a Vol swap you would only ever be short 500k vega (this goes to Revsly's point about the more "benign" nature of Vol Swaps).
Accusamus fugiat rerum maxime voluptas est veritatis. Deleniti qui consectetur et in vero corrupti.
Velit alias ut dolorem. Voluptate repellendus ea excepturi itaque non unde et. Ut aliquam molestiae in sed. Dignissimos earum delectus sit consequatur quos modi sit. Similique ea ut tenetur explicabo aspernatur consequatur.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...