0
$\begingroup$

Client A comes to dealer to trade variance notional $1m at T=0. The trade is executed with dealer short volatility with strike of 20.

term Payoff of dealer = notional*( Stike^2 - realized vol^2 )

now at t=T1 the client , comes back with the order to reduce the notional of variance swap by half.

How can the dealer hedge the remaining portfolio ?

$\endgroup$
1
$\begingroup$

Since variance is additive, your var swap at $t=t_1$ is the same as the realized cash pnl plus a new var swap traded on $t=t_1$ with strike being $K_1$ rather than $K_0$, with a variance amount being $\frac{T - t_1}{T}$ times the original variance amount, where $K_1$ is the fair strike on $t=t_1$ and $K_0$ is your old strike traded on $t=0$.

If you would like to unwind (part of) the var swap, what you are doing is just trading a new var swap with the same maturity as the old var swap. Therefore the dealer just hedge as how they normally hedge when trading var swaps.

$\endgroup$
3
  • $\begingroup$ Yes, it is included in the cash pnl needed to be settled when unwinding. $\endgroup$ – CABLE Jul 8 '20 at 2:41
  • $\begingroup$ Thanks for this. if I try to solve this by equation I can cancel by exposure to realised volatility and I am left with . Following term. $Notional*( K_{t,T}^2 - K_{0,T}^2)$. 1) Will the dealer charge this cost to exit the swap ? 2) People often quote this as vega cost /charge. what exactly is that ? How exactly the dealer estimate this vega cost to be charged to the client ? $\endgroup$ – user3426614 Jul 8 '20 at 16:30
  • $\begingroup$ 1. This is included in the cash to be settled when unwinding. Probably I should not use the term realized cash pnl, what I mean by this is actually the sum of the realized vol pnl + implied vol pnl. 2. I have not heard of this term. When unwinding, you usually quote different dealers rather than just the one with whom you trade the original swap to find the best $K_1$. The key point is that this so called "unwind" is essentially just short/long a new var swap to offset your original long/short var position. Therefore there is no "cost", you just trade as normal. $\endgroup$ – CABLE Jul 8 '20 at 17:24

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.