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)
Why the fuck would you lie about working with variance swaps unless you actually had? Seems like a bit of a bad idea.
Are you applying for quant or straightup trading?
That info is definitely going to be pretty darned proprietary.
The CBOE has a VIX futures market, but most of the time banks get the call because they can offer deeper liquidity than the exchange. But the CBOE might be a good place to start to at least get an idea of the order of magnitude on the spreads.
libor-ois spread, yield curve shaping.
worked with as in I gave a presentation as an intern on variance swaps not worked in as in traded them lol sorry for the confusion and I'm applying for trading SA positions
and by unfortunately, I mean that I understood variance swaps pretty well but it's been a while and I have to brush up on the math/concepts. I'd much rather go through fit question after fit question rather than getting grilled about variance swaps at interviews
Take a look at the VIX markets.
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
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...
from what I understand the vix just tracks the price of 1 mo var swaps on the index no?
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)
the portfolio of vanilla options are weighted to create constant dollar gamma in order to replicate a variance swap can someone give me a definition of dollar gamma... I can't seem to find any information about it...
http://ederman.com/new/docs/gs-volatility_swaps.pdf
Should have more than enough info in there. Remember having to read that during my SA. For anyone who doesn't want to read through 52 pages of quant notes, I will be writing a post soon that describes pricing and hedging in a more simplified way.
Interesting to see the GS quant notes. Will try to plow through that in the morning, hitting bed now.
Im lost... haha atleast i admit it. wtf is a variance swap? Swap trading on volatility?
what FX trader said, basically a way to trade volatility without the path dependence of regular options with discrete delta hedging
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%
anyone know what dollar gamma is? beyond its mathematical equation
On my desk we use whats called gamma notional, which might be the same thing as dollar gamma but its your gamma so that if the underlying moves up or down 1%, your gamma P&L is = dollar gamma * 0.01
The reason why dealers make money on swaps is that the interdealer market is at X and they sell them to a customer at X+something. Its no different then any other market, the dealers make money by marking them up a bit.
There is nothing magical or complicated going on here.
What is the difference between variance and vega? They sound synonymous.
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