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Conditional variance swap

    ==Introduction== A conditional variance swap is a type of swap derivative product that allow investors to take exposure to volatility in the price of an underlying security only while the underlying security is within a pre-specified price range This ability could be useful for hedging complex volatility exposures making a bet on the volatility levels contained in the skew of the underlying security's price or buying/selling variance at more attractive levels given a view on the underlying security Allen Peter; Einchcomb Stephen and Granger Nicolas Conditional Variance Swaps: Product Note JPMorgan 3 April 2006

    History

    Regular variance swaps were introduced first and became a popular instrument for hedging against the effect of volatility on option prices Thus the market for these securities became increasingly liquid and pricing for these swaps became more efficient However investors noticed that to a certain extent the price levels for these variance swaps still deviated from the theoretical price that would have resulted from replicating the portfolio of options underlying the swaps using options pricing formulas such as the Black-Scholes model This was partly because the construction of the replicating portfolio includes a relatively large contribution from out-of-the-money options which can often be illiquid and result in a pricing discrepancy in the overall swap Conditional swaps mitigate this problem by limiting the hedge to strikes within an upper and lower level of the underlying security Thus the volatility exposure is limited to when the underlying security lies within this corridor

    Notes