The accurate hedge tail risk assessment is extremely important for the successful business development and accurate forecasting of the future business development. In this regard, variance swaps is one of the method that allows assessing hedge tail risks. Today, this method is quite popular due to its relatively high reliability and overall effectiveness.
The essence of variance swaps is the variance of price changes of the underlying product (Breneman & Taylor, 1996). The variance swaps imply earnings of investors on changes in the price of the product (Kogut and Kulatilaka, 1994).
Variance swaps work when the price of the product changes. The underlying price of the product changes will be daily log returns, based upon most commonly used closing price (Chowdhry and Howe, 1999). The other leg of the swap will pay a fixed amount, the strike (Hebner, 2007). Hence, the net payoffs of the counterparties will be the difference between these two and will be settled in cash.
The process of variance swaps includes the variance strike, the fixed amount of money paid off on the ground of the fixed pay (Bodie and Merton, 1998). The variance swap includes the investment in a product, which price is changing. As the price changes, investors earn on swaps of the price and the higher is the daily log returns the higher are return on investments (Carter, 2003). As the difference between the strike and the underlying price is turned into cash, investors receive money.
Variance swaps are good because they allow earning money fast on the difference of the price of the product, while risks are relatively low because variance swaps are oriented on short-run operations (Bogle, 1994). The shot-run scope of variance swap allows investors to invest in reliable products and reap off stable profits.