Yes, I was thinking this earlier. One way to start in valuing a variance swap would be to ask why do people buy them? What benefit do they provide? Then value that benefit. What I'm getting at is a more holistic valuation of an asset. That may not gel with you but I think discounted cash flows is too narrow.
I have no issues with a non traditional valuation approach but we need to define it as such. For example, if you were a wealth manager selling this product to a client, how you would you frame it? As you said, you would talk about the benefit it can provide in certain situations but what about the losses? If the client asked you long term, what impact on their portfolio will this product have, how would you answer that? How would you go about solving the equation? There is a lot of unknowns. I absolutely agree with you there is a benefit or at least a potential benefit. But I'm open as to how one would derive a long term value of owning such an asset if it will be perpetually owned or if it will be actively traded, how you do model that? At some point you are really pitching a "strategy" not a product.
The value of a varswap is no different than the value of art or gold. You cannot use a DCF calculation it's just supply and demand. If you consider volatility an asset because a varswap contract exists, then you should consider sports betting an asset class. You should also consider economic data as an asset class as Goldman Sachs will make you direct markets on economic data. You should consider weather as an asset class as there are weather derivatives that are tradable (and easier to value than art).
It only really matters to those selling volatility products, volatility funds, or volatility research. To them, everyone should have 5% of their account allocated to volatility!
Valuing an asset along the lines of benefits becomes highly context dependent. You'd have to look at how that product performs on its own and relative to other assets. Say for variance swaps, you could pitch them as a type of crash insurance with "purer" exposure than options. Well how much do I want to pay for that insurance? Well that's entirely up to my risk tolerance. So while for an individual it is possible to price that product we can never know the full benefit that that product has to the economy. Thus we can never know with certainty its true "fair value." To get an estimate of that value requires that the product be traded on the market among speculators and end users of that product. This may seem like a cop-out, "well you pay what you want to pay." But look at the market we have to deal with in reality. When does anything ever trade at a true "discounted cash flow fair value?" It's all based on what one wants to pay based on how they feel about potential benefits. "Buy when there's blood in the streets." As traders and investors we are really just dealing with the flaws in human emotion while riding an uptrend in global economic growth. Edited to clarify a bit.
I'll push back a little bit on this but I understand the spirit of your argument. I should be more clear, that in finance when we use DCF, we are not trying to come up with a "real" value per se of a given product but rather the value of the cash flows that come from that product. We "Should" be able to value those cash flows very accurately. So there is some relative certainty there. That certainty does not exist with swaps, even if we value the trader in isolation, there is little certainty. I think that is my main disagreement here. I'm not saying that allocating a percentage of your portfolio to long vol or short vol is bad, I just don't consider vol by itself an asset that produces measurable cash flows.
Great discussion! Thanks to everyone for the amazing feedback and insights. I think a few of you touched on the exact same concerns that I have which are the substantial flaws in the current products that we have to express a long term short or long vol position. I agree that short vol is highly correlated with long equity but it is not 100% correlated which is why I am interested in devoting some of my long equity exposure to short vol exposure. With the VIX gaining more and more popularity every day, maybe someday shorting VIX will be as common, easy and transparent as buying SPX.
If you want to short VIX or express your long term view then head right to the futures. You might not find the most liquidity far off in the back months but you'll be able to construct your own "products."