What characterizes variance swaps?

Variance swaps are derivative instruments that allow investors to trade future realized volatility against current implied volatility. The primary characteristic of variance swaps is that payments are tied directly to the realized variance of an asset's returns over a specified time period. This means that the payment calculation is based on how much the asset's returns fluctuate, rather than on fixed interest rates or historical performance alone.

In a variance swap, one party pays the other based on the difference between the realized variance (calculated from the actual asset price movements) and a pre-agreed fixed variance strike. This allows traders to take positions on future volatility without being directly exposed to the underlying asset.

The other options do not accurately capture the essential nature of variance swaps. Payments based on fixed interest rates, historical performance, or rights to purchase an asset do not reflect the key feature of variance swaps that specifically relates to actual market volatility. Therefore, the correct answer emphasizes the connection between payments and the realized variance of the asset, underscoring the product’s purpose in trading volatility.