Division 3 List of examples of non-standard derivatives with the related commitment methodology being used:

Variance swaps: Variance swaps are contracts that allow investors to gain exposure to the variance (squared volatility) of an underlying asset and, in particular, to trade future realised (or historical) volatility against current implied volatility. According to market practice, the strike and the variance notional are expressed in terms of volatility. For the variance notional, this gives:

The vega notional provides a theoretical measure of the profit or loss resulting from a 1 % change in volatility.

As realised volatility cannot be less than zero, a long swap position has a known maximum loss. The maximum loss on a short swap is often limited by the inclusion of a cap on volatility. However without a cap, a short swap’s potential losses are unlimited.

The conversion methodology to be used for a given contract at time t is:

Variance notional * (current) variance_t (without volatility cap)

Variance notional * min [(current) variance_t volatility cap²] (with volatility cap)

whereby: (current) variance_t is a function of the squared realised and implied volatility, more precisely:

Volatility swaps

By analogy with the variance swaps, the following conversion formulae should be applied to volatility swaps:

• Vega notional * (current) volatility_t (without volatility cap)

• Vega notional * min [(current) volatility_t; volatility cap] (with volatility cap)

whereby the (current) volatility t is a function of the realised and implied volatility.