what is a volatility swap 
a volatility swap is a forward contract with a payoff based on the realized volatility of the underlying asset they settle in cash based on the difference between the realized volatility and the volatility strike or pre determined fixed volatility level volatility swaps allow participants to trade an asset s volatility without directly trading the underlying asset volatility swaps are not swaps in the traditional sense with an exchange of cash flows between counterparties they are also similar to variance swaps where the payoff is based on realized variance understanding volatility swapsvolatility swaps are pure volatility instruments allowing investors to speculate solely upon the movement of an underlying asset s volatility without the influence of its price thus just like investors speculate on the prices of assets by using this instrument investors are able to speculate on how volatile the asset will be the name swap in this case is a misnomer because swaps are structured contracts consisting of cash flow exchanges typically matching a fixed rate with a variable rate volatility swaps and variance swaps are actually forward contracts with payoffs based on the observed or realized variance of the underlying asset at settlement the payoff is at inception the notional amount is not exchanged the volatility strike is a fixed number that reflects the market s expectation of volatility at the time the swap begins in a sense the volatility strike represents implied volatility although it is not the same as traditional implied volatility in options the strike itself is typically set at the beginning of the swap to make the net present value npv of the payoff zero what volatility actually ends up being at the end of the contract determines the payoff assuming it is different than the implied volatility volatility strike using volatility swapsa volatility swap is a pure play on an underlying asset s volatility options also give an investor the possibility to speculate on an asset s volatility however options carry directional risk and their prices depend on many factors including time expiration and implied volatility therefore the equivalent options strategy requires additional risk hedging to complete volatility swaps don t require this they are simply based on volatility there are three main classes of users for volatility swaps variance swaps are far more common in equity markets than volatility swaps example of how to use a volatility swapassume that an institutional trader wants a volatility swap on the s p 500 index the contract will expire in twelve months and has a notional value of 1 million currently the implied volatility is 12 this is set as the strike for the contract in twelve month s time volatility is 16 this is the realized volatility there is a 4 difference or 40 000 1 million x 4 the seller of the volatility swap pays the swap buyer 40 000 assuming the seller is holding the fixed leg and the buyer the floating leg if volatility dropped to 10 the buyer would pay the seller 20 000 1 million x 2 this is a simplified example since volatility swaps are over the counter instruments otc they can be constructed in different ways some alternatives may be to annualize the rates or calculate the difference in volatility in terms of daily changes 