Abstract

Traditionally volatility is viewed as a measure of variability, or risk, of an underlying asset. However, recently investors began to look at volatility from a different angle. It happened due to emergence of a market for new derivative instruments - variance swaps. In this chapter, first we introduce the general idea of the volatility trading using variance swaps. Then we describe valuation and hedging methodology for vanilla variance swaps as well as for the third generation volatility derivatives: gamma swaps, corridor variance swaps, conditional variance swaps. Finally, we show the results of the performance investigation of one of the most popular volatility strategies - dispersion trading. The strategy was implemented using variance swaps on DAX and its constituents during the 5-year period from 2004 to 2008.

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