An agreement to exchange the realized variance rate between the time of entering into the agreement and expiration date, based on a pre-determined variance rate. The variance rate is the square root of volatility. For example, if the realized, annualized standard deviation on the rate of return on an equity index is 35% and the contractual variance is 10%, then the counterparty receiving the realized variance on a notional amount of USD 100 million for six months would be required to pay: 100 million X (0.35² – 0.10) X 1/2= 1,125,000.

The variance swap can be viewed as a forward contract on annualized variance, and is used to trade forward volatility and correlation.