Variance Swaps as a Hedge for Insurers

Abstract

This thesis addresses whether variance swaps should be part of an insurer's hedge strategy, and the replicating portfolio of a variance swap is derived and analysed to see if it creates a payout similar to the variance swap under more realistic assumptions than the theoretical ones.

The return of investing in an insurer's equity is studied numerically for three investment strategies with and without a variance swap overlay. For two of the strategies the overlay improves the distribution of the value of the owners' equity at the horizon of the analysis.

A cost effective implementation of an insurer's investment strategy can increase the return of the owners' equity. Before a derivative transaction (such as a variance swap) is entered, it should be reviewed if entering the derivative through a market-maker is advantageous, or if the transaction's replicating portfolio should be used to reduce the cost of intermediaries. As the replicating portfolio often is purely theoretical, such a decision can only be made by a thorough understanding of the replicating portfolio's constituents. Also, causes for a mismatch between a variance swap and its replicating portfolio entered in practice are discussed.