Volatility swaps are derivatives whose payoff is based on the difference between the realized volatility of an underlying asset and a predetermined volatility strike. A volatility swap is a forward contract which requires one party to pay a predetermined notional value multiplied by this difference between the realized volatility and the predefined volatility strike. The underlying asset can be any type of asset, such as a commodity, stock, bond, index, or aggregate market.

For example, a party might enter into a volatility swap where the underlying asset is the S&P 500 stock index, with a notional value of $10 million and a volatility strike of 20%. If the realized volatility at the end of the period is 25%, then the payoff for the contract is $10 million multiplied by the difference between 25% and 20%, or $500,000.

Volatility swaps offer investors the ability to trade volatility in a liquid and transparent manner, without taking on directional risk. This makes it a popular tool for hedging purposes and for capturing movements in market volatility.

Volatility swaps are also useful for speculative purposes, allowing investors to express views on a markets volatility without taking a directional risk on the underlying asset. This makes them attractive to investors looking to capture economies of scale and diversify risk.

Unlike traditional swaps, a volatility swap does not involve an exchange of cash flows, but rather a payoff based on the difference between realized volatility and the volatility strike. As such, volatility swaps are simpler to understand and have become increasingly popular for investors looking to take advantage of movements in volatility.

Overall, volatility swaps provide investors with an interesting and potentially profitable way to take advantage of movements in market volatility without taking on directional risk. Volatility swap contracts can be tailored to the individual needs of investors and offer the opportunity for efficient hedging and diversification of risk.