How do banks make money off swaps?

Swaps OTC and over exchanges are designed so that the expected value of the swap is 0. So for example, if you do an interest rate swap of a fixed payment for LIBOR +50 bp, then E(Libor+50 bp)=fixed payment. If you have a variance swap E(realized variance)=strike.

How do BBs make money by initiating these swaps? Do they just charge a spread or adjust the fixed and floating legs so that they make an expected profit?

 

There is a spread. For vanilla fixed-float swaps in advanced currencies the spread is on the order of 1bp. So a 100 mill USD notional vanilla swap earns a bank ~0.50.0001100mill = 5000 dollars a year

Think about that the next time somebody tells you that the banks rip off their customers on OTC deals

 

haha thank you I'm getting ready for interviews and studying variance swaps(which unfortunately I put on my resume as something I worked with) and I understand the hedging and theory behind it and the uses of traders but I was a little confused about how issues actually made money from these things... any idea what a spread is like on a 1 mo var swap on the S&P 500?

 

The information I have on that is proprietary. I'm sorry, I can't divulge it. I can say that it depends on what the swap is on (lowest spread on the s&p, much higher on individual names)

 

As I'm sure you know, the vol curve from vix and the vol curve from a variance swap are not exactly the same (both for theoretical reasons as well as for liquidity reasons)

The spread on the two is quite different as well

 
nnamehere:
As I'm sure you know, the vol curve from vix and the vol curve from a variance swap are not exactly the same (both for theoretical reasons as well as for liquidity reasons)

The spread on the two is quite different as well

Well, it's on the same curve. One is on the forward curve, one is on the zero coupon. There's not a perfect hedge between the two, but there's a fairly clear arbitrage strategy. Since you're willing to give away more info than I am, I really am not in a position to argue with you about spreads.

Obviously the vol implied by the VIX isn't going to be the vol implied by variance swaps isn't going to be the vol implied by options on the SPX. There's no perfect arbitrage between them. But if I didn't have that info at my disposal, that's where I would start. That's really the only place you can start...

 

Technically the vix settles at the weighted average of option implied vols, which is slightly different than the vol derived from a variance swap (though because they are the main instruments used to hedge each other, the spread always swallows the difference between the two curves)

 
Best Response
trade4size:
Im lost... haha atleast i admit it. wtf is a variance swap? Swap trading on volatility?

Two types of swaps used to trade volatility:

Variance swaps and Volatility Swaps (affectionately known as Var and Vol Swaps)

sample: Buy Variance Swap

Strike: 20% Payout: =Variance Notional * (Realized Volatility ^ 2 - Strike ^ 2)

Buy Volatility Swap

Strike: 20% Payout: =Vega Notional * (Realized Volatility - Strike)

you can see that if realized volatility is above the strike vol, you make money (as a buyer) and lose money (as a seller)

as people who are familiar with them will know, sellers of variance swaps were absolutely demolished during the crisis, why? convexity of variance swap profile (note, the square roots) means the payout grows rapidly as vol rises, and decreases less rapidly as vol falls--with volatility swaps the profile is linear

Now, as for spreads being proprietary? hardly... var swaps on the SPX are some of the most liquid vol products out there

most shops quote them 1 to 2 vols wide.

example: 1m Variance swap will be about: 17.5%/19.0% 1m vol swap will be about 17.0%/18.5%

 

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