The variance swap is a way to position long or short exposure to market volatility - therefore creating a directional view of volatility. Whilst it is called a swap contract, its characteristics have more in common with an option-based product.
Variance swaps are used for volatility trading. It acts as an alternative for traders who otherwise use a delta-neutral option strategy to take a position on volatility, as the variance swap can offer a more precise way of taking a view on future volatility.
The need for a product like this stems from the losses that traders and hedge funds have experienced as a component of volatility trading linked to running an options portfolio.
An equity variance swap's has advantages over using options in taking a directional view of volatility, says Nicolas Cohen-Addad, director at Barclays' equity derivatives desk in Hong Kong. "When trading a variance swap you are quite insensitive to the level of the market," he explains. "Your gamma will stay identical across the life of the product, whereas with options and fixed strikes the 'Greeks' move a lot. With variance swaps you don't need to rebalance your portfolio to keep the same exposure."
Buying optionality also entails a premium. Cohen-Addad comments: "Thanks to increasing liquidity in variance swaps in the IDB market, it is now much more interesting to trade these rather than vanilla, over-the-counter options or listed options. There are better cost efficiencies."
Barx is the first global electronic trading system that can provide online trading of equity variance swaps. Products are added to this platform after they attain a degree of maturity and liquidity. Equity variance swaps, which are fairly innovative, have now reached that level of market acceptance.
"Pricing has to be continuous, and so the product has to be at a sufficient level of use before it is suitable for electronic trading," says Gyan Newman, regional head of e-commerce at Barclays Capital in Singapore.
The Barx system introduced the first electronic single-dealer trading platform for interest rate swaps in 2003 and added cross-currency swaps in October 2005. It has five asset classes and nearly half of Barclays clients have migrated to the Barx platform trading approximately $5.3 trillion per year across it.
It is a globally available system, but an important feature for Asian users is what a system can deliver in the Asia time zone. For example, this was the first electronic trading system for LME base metals available in the Asian trading hours. In addition it was also the first non-Japanese institution to secure access to the Tokyo Commodities Exchange.
Future plans for Barx include the market's first direct exchange-to-client DMA connectivity. The full roll-out will take place in early 2006. DMA is Direct Market Access, electronic access to an exchange such as the LSE or the Hang Seng without having to go through a middleman.
Barclays Capital has also been testing a Barx strategy server service with select clients in 2005, providing the ability to execute algorithmic strategies - mathematical models for making transaction decisions - through Barx for futures trading applications.
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