Gamma Swaps And Corridor Variance Swaps
Two variations on the plain variance swap that reweight or restrict which price moves count, letting a desk fine-tune exactly what kind of realized volatility exposure it wants to trade.
Prerequisites: Variance Swaps
A plain variance swap pays out based on the realized variance of an asset's returns over the life of the contract, weighting every day's squared return equally regardless of the price level at the time. That equal weighting has an awkward side effect: if the underlying falls a long way, the notional exposure of the position, measured in dollar terms, effectively grows, since a given percentage swing represents a bigger dollar move at a lower price with an unchanged weighting scheme.
A gamma swap fixes this by weighting each day's squared return by the underlying's price level on that day, so a large percentage move when the price is low contributes proportionally less to the payout than the same percentage move at a higher price — this keeps the position's dollar sensitivity roughly constant as the underlying drifts, which matters to a hedger comparing it directly against an equity position. A corridor variance swap takes a different cut: it only accumulates variance on days when the underlying's price sits inside a specified range, ignoring squared returns from days when the price is trading outside that corridor entirely.
A gamma swap reweights variance by price level to keep dollar exposure stable as the underlying drifts, while a corridor variance swap restricts which days count at all, only capturing variance while the price stays inside a chosen range — both are ways to shape exactly what part of realized volatility a trade is exposed to.
Corridor variance swaps are priced cheaper than a full-range variance swap precisely because the seller is taking on less risk, only paying out on volatility realized inside the agreed band.
Related concepts
Further reading
- Bossu, 'Introduction to Variance Swaps'