A Volatility Swap is a type of financial derivative that allows investors to trade an agreed-upon level of volatility, rather than trading the underlying asset directly. It is a contract in which one party pays a fixed rate based on the realized volatility of an underlying asset, while the other party pays a floating rate based on the same underlying asset's actual volatility.For example, one party may agree to pay a fixed rate of 10% per year in exchange for receiving the floating rate of the underlying asset's realized volatility. If the underlying asset's actual volatility is higher than 10%, the second party will pay the first party the difference; if the actual volatility is lower, the first party will pay the second party.Volatility swaps are used to hedge or speculate on the level of volatility in an underlying asset, as well as to transfer volatility risk between parties. They are typically traded over-the-counter and can involve a variety of underlying assets, including stocks, bonds, commodities, and currencies.A volatility swap is a forward contract with a payoff based on the difference between realized volatility and a volatility strike. The key feature of a volatility swap is that it provides exposure to changes in realized market volatilty, without the need to take an explicit position in the underlying asset. This makes it an ideal tool for hedging or speculation on future changes in market conditions.The most common type of volatility swap is based on equity index options, where the underlying asset is typically an index such as the S&P 500. The notional value of the contract is usually $10 million, and contracts are typically traded over-the-counter between two financial institutions. Volatility swaps can also be used to trade other types of assets, including currencies, interest rates, and commodities.
