Commodity Variance Swap

ORE defines the product as follows:

A Commodity Variance or Volatility Swap has a payoff that depends on the volatility/variance of an underlying commodity instrument.

Source: ORE User Guide, Products catalogue, commodityvarianceswap.tex.

A commodity variance swap is a bet on movement, not direction. One side pays the realised variance of a commodity price over the life of the swap. The other side pays a fixed variance agreed at trade time. If the commodity moves more than expected, the variance buyer gains.

ORE states that the structure of the input is the same as that of the Equity Variance Swap. Only the underlying type changes, to a commodity instrument. The trade data carries the variance swap conventions, the observation period, and the commodity underlying.

The payoff is the difference between the realised variance and the variance strike, scaled by a notional that converts variance into money. The realised variance sums the squared daily returns over the observation period. A volatility swap variant exchanges the realised volatility instead.

• The implied volatility of the commodity. It prices the variance strike.
• The realised path of daily commodity returns. It settles the payoff.
• The variance notional. It scales the exposure.
• The observation schedule and the annualisation convention.
• The discount curve of the settlement currency.

A long variance position gains when realised movement exceeds the strike. It gains from jumps in either direction. Direction of the commodity price itself does not drive the payoff.

Each day adds one return to the realised variance. Early in life the realised part is small and the trade trades like a forward on implied variance. Late in life the realised variance dominates and the payoff locks in. At maturity the final variance settles and the swap stops.

A producer of a commodity is long the price but hedges its volatility. A trader takes a view that commodity volatility is cheap or rich. Variance swaps isolate that view from direction. In ORE Studio a customer books commodity variance swaps to value them and run sensitivities on the ORE engine.

ORE's catalogue does not show a worked commodity variance swap listing. The trade data follows the Equity Variance Swap structure, with the underlying type set to a commodity instrument. See the equity variance swap section of the catalogue for the node layout.