Why can a variance swap be perfectly statically hedged whereas a volatility swap requires dynamic hedging?
Possible reference request to the corresponding literature.
Quantitative Finance Stack Exchange is a question and answer site for finance professionals and academics. It only takes a minute to sign up.Sign up to join this community
There has been a lot of work in recent years on the pricing and hedging of volatility derivatives, leading to some non-obvious, even startling results. It is summarized in Mark Joshi's book More Mathematical Finance among other places.
It all started with the work of Anthony Neuberger on the Log Contract in 1994, which seemed to be a theoretical result about a non-existent contract. It led to a solution for Var swaps, the famous Derman paper More Than You Ever Wanted To Know About Volatility Swaps 1999 1; see also Bossu's Just What you Need to Know about Variance Swaps 2 for a simpler treatment. Then Peter Carr and Roger Lee wrote Robust Replication of Volatility Derivatives 3in 2009 which addressed Vol Swaps.
A Variance swap can be replicated by a static position in options plus a dynamic position in the underlying. This is a beautiful and very practical result. You have to hold options of all strikes at the given maturity, with holdings inversely proportional to the square of the strike.
A Volatility swap can be replicated with a dynamic position in options. This is not very practical as the transaction costs for continuously buying and selling a large number of options will eat you alive. As a result Vol Swaps are not much traded and Var Swaps are preferred.
Finally, the new method for pricing variance swaps was adopted by the CBOE in 2004 as a way of calculating VIX values. Essentially they compute VIX^2 by this method and then publish the square root of this at frequent intraday intervals. So whenever people look at the VIX they are implicitly relying in this method.
Not sure if still relevant for the OP, but as I lack modesty I'd like to say that it is possible, to a good approximation, to hedge varswaps dynamically using 3 delta-hedged options only. This is something I found out relatively recently, and explained in the following note:
The static portfolio of a continuum of options (and a dynamic position in the underlying) for varswaps replication is beautiful theoretically, but not feasible in practice.
Volswaps is a different matter, the square root really messes things up, and I am not sure there can be an 'easy' hedge for the volswap. As the volswap can be regarded as derivative on the terminal value of a varswap, it can be written as a static strip of options on realized variance (a la Carr-Madan), but not as a static strip of options on the underlying asset.