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Time Decay in Monthly Variance Swap Hedging

Article Quant Q&A · Author: Clayton Estey
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Summary

The document raises a practical question about maintaining a long volatility hedge by rolling spot variance swaps monthly. It describes replicating spot VIX with a portfolio of out-of-the-money calls and puts, weighted by the inverse square of each strike, and asks how time decay affects the realized payout relative to the swap’s theoretical payout.

The text provides no answer, empirical results, or cited research. It flags transaction costs and draws a comparison with long strangles, but does not quantify the effects or explain how they differ across instruments. The central lesson is that implementation drag from time decay is a concern to investigate when constructing a rolling variance exposure; the document alone does not establish its size or whether it reduces payout in a particular way.

Key ideas

  • A monthly long volatility hedge can be implemented by rolling spot variance swaps.
  • The proposed VIX replication uses out-of-the-money calls and puts weighted by inverse squared strikes.
  • The author asks how time decay changes realized payout relative to the theoretical swap payout.
  • The document raises the issue but provides no evidence or quantitative estimate.

Tags

VolatilityOptionsDerivatives pricingRisk management
Full text
# Practical Effect of Time-Decay on Variance Swaps?


# Practical Effect of Time-Decay on Variance Swaps?












I want to implement a long vol hedging strategy by rolling spot variance swaps every month. This would be done through replicating spot VIX using the definition of VIX as a portfolio of OTM one-month calls/puts weighted by the inverse square of their strikes. In addition to transaction costs, I've read that time decay can be a problem for similar strategies (e.g. long strangles).

Does anyone have an intuition (either through experience or academic research) as to what extent time decay should lower the payout compared to the theoretical payout for the swap?

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.