dw1009in 10/5/06 2:25 PM Page 10

Derivatives Week www.derivativesweek.com October 9, 2006

LEARNING CURVE®
Introduction To Conditional Variance Swaps
Conditional variance swaps are similar to swap strike (not the conditional strike). Due to the scaling back
standard variance swaps but variance exposure is of exposure by percent of occurrences the eventual exposure
limited to a predefined range of underlying levels. may be significantly less than the normal variance swap and
As an illustration, the graph below shows how conditional depends on the path of the underlying.
variance swaps only include variance observations on those days
where yesterday’s closing price satisfied the condition—in this Motivation For Conditional Variance Swaps
case, above the 3800-trigger for the up-variance swap Traditional variance swaps allow investors to benefit from the
considered here. competitive advantage of broker dealers in accessing option
4000
Trigger level
markets and the active management of a specific delta-hedged
3900 options portfolio. Conditional variance swaps take this benefit
3800
one step further and provide a formulaic return for skew
Index Level

3700
trading that helps investors isolate a specific volatility view—
3600
and importantly skew—in an easily tradable form.
3500 Variance observations for 3800-strike up-variance swap taken in green zone
As a typical equity skew implies lower volatility for strikes at
3400
higher underlying levels, truncating the variance exposure from
Mar-06
Jan-06

Apr-06
Feb-06

Date
downside underlying levels should therefore cheapen the up-
Variance counted if yesterday's close was above trigger variance swap versus the normal variance swap level. As an
observations count toward variance.
3900
Other observations are ignored. illustration, the graph below shows this effect with an up-
3850 variance swap level that is below the standard swap level.
Index Level

3800
Comparison of implied volatility pricing vs underlying level
25% Implied volatility
3750
By strike

3700 V ariance swap level

(1/K^2 weighting)
1-Mar
3-Mar
5-Mar
7-Mar
9-Mar

2-Apr
4-Apr
6-Apr
8-Apr
11-Mar
13-Mar
15-Mar
17-Mar
19-Mar
21-Mar
23-Mar
25-Mar
27-Mar
29-Mar
31-Mar

10-Apr
12-Apr
14-Apr
16-Apr
18-Apr
20-Apr

20%
Implied volatility

Source: Citigroup 3800-UPconditional variance swap level

Date (1/K^2 weighting truncated)

The payoff at expiry of a conditional variance swap is: 15%

Payoff = Multiplier x ( FCRV – Strike ) x PO

The Final Conditional Realized Variance (FCRV) is 10%

calculated as: 2400 2800 3200 3600 4000

Underlying level
4400 4800 5200

Source: Citigroup
2
252 n Pt
FCRV = 10,000 ln Ct
NR t =1 Pt -1 Conditional Var Swap Pricing: Initial,
Final And Mid-Life
where “Pt” is the closing price level on the current Conditional variance swap models take from option prices both
observation day, and Ct equals 1 if the condition LowerBarrier the implied volatility skew of an underlying as well as the
≤ Pt-1 ≤ UpperBarrier is met, and 0 otherwise. The percentage expected number of trading days the underlying should meet
of occurrences (“PO”) is the ratio of number of days where the the conditional criteria.
conditional criteria is realized, NR, over the expected number The conditional variance swap expiry settlement calculation
of observation days over the life of the trade. is essentially the same as for a standard variance swap, except
The multiplier calculation converts the desired vega exposure that it only includes observations that satisfy the conditional
to variance units, but it is calculated using the normal variance criteria. Thus, the realized variance calculation reflects a scaling
down of the standard variance swap exposure by the percent of
Vega
Multiplier = observations that satisfy the conditional criteria.
2 NormVar 100 The mid-life valuation calculation adds another level of

Derivatives Week is now accepting submissions from industry professionals for the Learning Curve® section. For details and guidelines on writing a Learning Curve®,
please call Elinor Comlay in New York at 212-224-3208 or Matthew Tremblay in Hong Kong at 852-2912-8097.

10 Copying prohibited without the permission of the publisher.

dw1009in 10/5/06 2:25 PM Page 11
October 9, 2006
complexity to normal variance swap valuations. This is because
it is difficult to model the future distribution of realized
variance when this is conditional upon the underlying being
within a certain range.
An approximate mark-to-market valuation (“MTM_Value”),
similar to the expiry settlement calculation, can be used that
involves so-called blended variance:
2 2
NRealisedIn Range
= +
Blended Realised
NRealisedIn Range + NImpliedInR ange
N RealisedIn Range + N ImpliedInR ange
PO =
N Expected
MTM_Value ≈ Multiplier x (BlendedVar – Strike) x PO
Blended Var and PO are modified formulae that combine
the realized variance at mid-life with the model derived
remaining implied variance, as per the formulae:
The modification in the formulae includes a new
variable/model output required for the calculation,
“NImpliedInRange”, that is the estimated number of observations
until maturity expected to count toward the final realized variance.
This figure will depend mostly on the so-called moneyness of the
trigger level, but also to some extent on the volatility skew. In a
binomial tree context, this figure can be derived from the number
of nodes of the binomial tree that will satisfy the trigger condition.
The graph below illustrates this concept, as well as the implied
quote’s contribution to “blended variance”. For simplicity, we have
assumed that: (i) valuation date is half way through the trade, (ii)
50% of realized observations satisfy the trigger condition, (iii)
realized volatility and implied volatility quotes are equal, (iv) spot
level is equal to forward level and (v) no volatility skew.
Valuation equally implied and realized
4800
Already realized (N InRange ~50%)
4400
4000
3600
3200
2800
7-Apr
24-Mar
31-Mar
14-Apr
21-Apr
28-Apr
By looking at the cone of potential future stock paths derived
from a binomial tree, it can intuitively be seen that about 50% of
remaining observations should satisfy the trigger conditions, and
blended variance will be a mix of 50% implied and 50% realized.
As for the variance multiplier, it will be scaled back by PO,
estimated at 50% around the valuation date.
Trading Strategies
Various trading strategies using conditional variance swaps can
be implemented.
www.derivativesweek.com Derivatives Week
Isolating skew: skew trading is very dynamic and requires
active management. Conditional variance swaps transfer the
risk of this position management to dealers with competitive
advantage. Skew can, however, be a poor predictor of volatility
for structural and fundamental reasons.
Carry trades: Conditional variance swaps can be used by
investors that have views on volatility and market trends. For
2
NImpliedInR ange instance, up-variance swaps can cut out some of the lower
Implied
NRealisedIn Range + NImpliedInR ange strike exposure that produces a higher normal variance strike.
Therefore, those with a bullish view on the market can
consider a carry trade that buys up-variance (13%) and sells
normal variance (15%). While the index remains above the
up-variance trigger, this accrues the strike spread of the two
swaps as P&L (2%). If the market moves below the trigger, the
position is short realized volatility however. A similar trade can
be implemented to capture more of the volatility skew in
range-bound markets. For example, given a normal skew, by
buying an up-variance swap with 95% trigger at strike 12%
and selling a down-variance swap with 105% trigger at strike
15%, a 3% volatility profit will be achieved if the index
remains between the triggers.
Portfolio protection: empirical evidence shows that volatility
usually increases as the market decreases. This is priced into
volatility skews somewhat but for structural (structured products
issuance) or fundamental reasons (market trend changes), the
skew may not accurately reflect volatility risks. Long-biased
portfolio managers could utilize conditional variance swaps by
buying down-variance with a trigger below current market
levels. If the market still rallies, no payment will ever need to be
made. If the market reverses, the manager will have long
volatility exposure in a declining market that could offset losses
in their equity portfolio if the skew under priced the risk.
Still implied (N InRange ~50%)
Hedging Risks And Construction
A conditional variance swap is hedged in much the same way
as a normal variance swap—through the daily delta hedging of
Half way through trade and
PO = 50% = (50%+50%)/2
a portfolio of options weighted by the inverse of the option
strike squared. Because variance exposure is only required at
5-May
12-May
19-May
Source: Citigroup
certain underlying levels, however, the portfolio of options is
truncated at the trigger level. Thus, whereas for a standard
variance swap, the 1/K2 weighting of the options in the hedge
produces constant variance exposure, for a conditional variance
swap the variance exposure is not constant at the trigger level.
At this point, the required gamma step-change is impossible to
fully replicate with listed options. This imperfection is the risk
of the dealer.
This week’s Learning Curve was written by Gerry Fowler and Alexis
Collomb, equity derivatives strategists at Citigroup in London.
Copying prohibited without the permission of the publisher. 11