Backdated variance swap

What Is a Backdated Variance Swap?

A backdated variance swap is a hypothetical and illicit financial contract, belonging to the broader category of derivatives, where the effective start date of the swap is fraudulently set to a point in the past. In a legitimate variance swap, parties agree to exchange a fixed payment (the "strike variance") for a floating payment based on the realized variance of an underlying asset over a specified future period. The concept of backdating, when applied to a backdated variance swap, implies selecting a historical date where the market conditions, particularly the volatility of the underlying asset, would have been favorable to one party, thereby conferring an unfair advantage. This practice is inherently fraudulent and aims to manipulate the contract's value from its inception, undermining market integrity and transparency, a core tenet of sound financial market operations.

History and Origin

While variance swaps themselves are a product of modern financial engineering that emerged to allow direct trading of future volatility, the act of "backdating" has a well-documented history, predominantly associated with employee options grants. The practice gained notoriety in the early to mid-2000s when numerous public companies were found to have retroactively selected stock option grant dates to coincide with low points in their stock prices. This enabled executives and employees to receive "in-the-money" options, which were immediately profitable. One prominent case involved Comverse Technology, Inc., where its co-founder and former CEO, Jacob "Kobi" Alexander, was charged by the Securities and Exchange Commission (SEC) in 2006 for engaging in a decade-long scheme to backdate stock option grants. The SEC alleged that executives received millions of dollars in ill-gotten compensation through such actions¹². Alexander later agreed to a $53.6 million settlement with the SEC in 2010¹¹. While backdating gained infamy in the context of stock options, its conceptual application to other financial instruments, such as a backdated variance swap, highlights how manipulative practices can extend across different types of financial contracts.

Key Takeaways

• A backdated variance swap is a theoretical concept representing a fraudulent act where the effective date of a variance swap is set retrospectively.
• The purpose of backdating is to exploit historical market data, specifically the realized volatility of an underlying asset, to create an unfair financial advantage.
• Legitimate variance swaps are a form of risk management or speculation on future volatility, but backdating renders the contract illicit and invalidates its intended purpose.
• Such practices violate accounting standards and principles of fair dealing, potentially leading to significant legal and regulatory consequences.

Formula and Calculation

A legitimate variance swap is typically based on the realized variance of the underlying asset. The realized variance ($\sigma^2_{\text{realized}}$) over a period from $T_0$ to $T_1$ is often calculated as the sum of squared logarithmic returns:

$\sigma^2_{\text{realized}} = \frac{1}{N} \sum_{i=1}^{N} \left( \ln \frac{S_{i}}{S_{i-1}} \right)^2$

Where:

• $S_i$ = price of the underlying asset at the end of the $i$-th interval.
• $S_{i-1}$ = price of the underlying asset at the start of the $i$-th interval.
• $N$ = total number of observations (intervals) over the period.
• $\ln$ = natural logarithm.

In a variance swap, the payoff is calculated as:

$\text{Payoff} = \text{Notional} \times (\sigma^2_{\text{realized}} - K_{\text{variance}})$

Where:

• Notional = the notional principal amount of the swap, typically expressed in dollars per annualized variance point.
• $K_{\text{variance}}$ = the agreed-upon strike variance, which is a fixed rate agreed at the inception of the swap.

If a backdated variance swap were to be constructed, the fraudulent activity would occur in the selection of the "effective" $T_0$. Instead of setting $T_0$ to the actual trade date, it would be set to a historical date where the realized variance between the backdated $T_0$ and the legitimate $T_1$ (the true end date of the observation period) would already be known, allowing the selection of a $K_{\text{variance}}$ that ensures a profit for the backdating party. This retroactively chosen $T_0$ would fundamentally alter the intended fair value of the contract.

Interpreting the Backdated Variance Swap

Interpreting a legitimate variance swap involves analyzing the relationship between the agreed-upon strike variance and the expected future realized volatility of the underlying asset. If a party believes actual future volatility will exceed the strike, they would enter a swap to receive the floating variance payment. Conversely, if they expect lower volatility, they would pay the floating leg. The contract serves as a direct exposure to volatility, distinct from direct price exposure.

However, a backdated variance swap defies legitimate interpretation because its creation is based on concealed historical knowledge rather than forward-looking expectations. The "interpretation" in this illicit context would be to understand the degree of fraudulent gain achieved by the party who selected the advantageous historical start date. The selection of the backdated strike variance would not reflect a genuine market expectation of future volatility but rather a calculated value based on known past performance. This would directly influence the settlement price in an unfair manner.

Hypothetical Example

Consider a legitimate variance swap on the S&P 500 index, agreed upon on January 1, 2024, with a notional of $100,000 per variance point and a strike variance of 0.02 (representing 20% annualized volatility squared). The swap is set to expire on December 31, 2024. Throughout 2024, the S&P 500 experiences significant fluctuations, and its realized variance for the year turns out to be 0.03.

In this legitimate scenario, the party receiving the realized variance would receive:
Payoff = $100,000 \times (0.03 - 0.02) = $100,000 \times 0.01 = $1,000.

Now, imagine a backdated variance swap. On January 1, 2024, a party "creates" a backdated variance swap contract but falsely dates its inception to January 1, 2023. They do this knowing that the realized variance for the S&P 500 during 2023 was, for instance, a very low 0.015, and they want to benefit from paying out as little as possible. They then set a strike variance of 0.016, slightly above the known realized variance of 2023. By backdating, they can structure the terms to guarantee a profit by exploiting information that was not available on the purported contract inception date. This manipulation of the "start date" makes the contract fundamentally fraudulent, bypassing the genuine risk management or speculation intentions of a valid swap.

Practical Applications

In a legitimate context, variance swaps are valuable tools within derivatives markets for purposes such as hedging volatility exposure or taking a direct speculative position on future price movements. For example, a portfolio manager concerned about unpredictable market swings might use a variance swap to offset the impact of high or low volatility on their portfolio's returns. Similarly, a proprietary trading desk might use them for speculation on an asset's expected variance. The global over-the-counter (OTC) derivatives market, where many variance swaps are transacted, had a notional value of $667 trillion at the end of December 2023, according to the Bank for International Settlements (BIS)⁹, ¹⁰. These markets are subject to significant oversight, with various regulatory bodies, including the U.S. Department of the Treasury and the Commodity Futures Trading Commission (CFTC), working to ensure transparency and mitigate systemic risk⁷, ⁸.

However, the "backdated" element transforms a potentially useful financial instrument into a vehicle for illicit gain. A backdated variance swap has no legitimate practical application. Its existence would imply deliberate securities fraud and a breach of ethical conduct within finance. The U.S. Department of the Treasury collects data on cross-border derivative contracts to ensure market stability and transparency, highlighting the importance of accurate reporting and legitimate transactions⁶. The regulatory framework for derivatives, including efforts spurred by the Dodd-Frank Wall Street Reform and Consumer Protection Act, aims to bring transparency and reduce systemic risk in these markets⁴, ⁵.

Limitations and Criticisms

The primary limitation and criticism of a backdated variance swap are rooted in its fundamental illegality and unethical nature. The practice of backdating, irrespective of the financial instrument involved, is a form of financial crime. It undermines the integrity of financial reporting and misleads stakeholders by presenting a false economic reality. Such schemes constitute a deliberate manipulation of contract terms to benefit one party at the expense of another, or to misrepresent financial performance.

For instance, in the context of stock options, backdating leads to misstated earnings and a lack of proper disclosure regarding executive compensation, violating corporate governance principles. The SEC has actively pursued cases involving backdated options, leading to significant penalties and imprisonment for those involved¹, ², ³. If a backdated variance swap were discovered, it would similarly expose the perpetrators to severe legal consequences, including civil penalties, criminal charges, and reputational damage. The lack of transparency and the deceptive nature of backdating directly contradict the principles of a fair and orderly [financial market](https://diversification.com/term/financial market).

Backdated Variance Swap vs. Backdated Stock Options

While both a backdated variance swap and backdated stock options involve the fraudulent practice of retroactively setting a contract's effective date, they differ in the type of financial instrument being manipulated and their typical application.

The core commonality is the deceptive practice of using hindsight to manipulate the value of a financial instrument at its purported inception. In both cases, the backdating aims to create an artificial advantage, misrepresenting the true economic terms and the risk-reward profile of the agreement.

FAQs

What makes a backdated variance swap illegal?

A backdated variance swap is illegal because it involves fraudulent misrepresentation of a contract's inception date, allowing one party to gain an unfair advantage based on known historical data. This violates principles of fair dealing, transparency, and often securities fraud laws.

Are variance swaps inherently risky?

Legitimate variance swaps carry inherent risks, primarily related to the unpredictable nature of future volatility. Unexpected market events can cause realized volatility to differ significantly from the strike variance, leading to losses for one party. However, these are legitimate market risks, unlike the pre-determined outcome of a backdated contract.

How do regulators monitor for backdating?

Regulators like the SEC and CFTC use various methods to detect backdating, including reviewing public filings, whistle-blower tips, and data analysis to identify suspicious patterns in grant dates or contract initiations relative to market movements. Enhanced corporate governance and internal controls are also crucial in preventing such schemes.

Can individuals participate in variance swaps?

Variance swaps are typically complex derivatives traded in the over-the-counter (OTC) market, meaning they are privately negotiated between institutions, hedge funds, and sophisticated investors. Due to their complexity and bespoke nature, they are generally not accessible to retail investors.