Quanto
Encyclopedia
A quanto is a type of derivative
in which the underlying
is denominated in one currency
,
but the instrument itself is settled in another currency at some fixed rate. Such products are attractive for speculators and investors who wish to have exposure to a foreign asset, but without the corresponding exchange rate
risk.
Quantos are attractive because they shield the purchaser from exchange rate fluctuations. If a US investor were to invest directly in the Japanese stocks that comprise the Nikkei, he would be exposed to both fluctuations in the Nikkei index and fluctuations in the USD/JPY exchange rate. Essentially, a quanto has an embedded currency forward with a variable notional amount. It is that variable notional amount that give quantos their name—"quanto" is short for "quantity adjusting option."
Quanto options have both the strike price and underlier denominated in the foreign currency. At exercise, the value of the option is calculated as the option's intrinsic value in the foreign currency, which is then converted to the domestic currency at the fixed exchange rate.
Another type of structure is called Quanto in the weather/energy markets. In these markets, a Quanto is a weather-contingent energy (or commodity) derivative. Weather contingent means that a payoff is triggered if some weather variable (typically temperature, but also precipitation or any other weather variable) crosses (from above or from below) a specified strike value. For the structure to be called Quanto, the payoff must depend on the market price of a publicly traded commodity. A typical example of a buyer of a Quanto is a retailer in a liberalized electricity market, with a customer base to which they deliver to a fixed contracted price. The retailers do buy most of their electricity forward, but have to go and purchase from the expensive spot market whenever they need to deliver more than what they've planned to. This situation typically occurs if the weather is hotter (colder) than expected and a substantial number of households turn on the airconditioning (heating). As electricity demand rises sharply in such a situation, spot prices spike while the revenue from the sales side remains constant. Buying a quanto allows the retailer to hedge against that risk.
Common types of quanto include :
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1895474
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
in which the underlying
Underlying
In finance, the underlying of a derivative is an asset, basket of assets, index, or even another derivative, such that the cash flows of the derivative depend on the value of this underlying...
is denominated in one currency
Currency
In economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...
,
but the instrument itself is settled in another currency at some fixed rate. Such products are attractive for speculators and investors who wish to have exposure to a foreign asset, but without the corresponding exchange rate
Exchange rate
In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...
risk.
Quantos are attractive because they shield the purchaser from exchange rate fluctuations. If a US investor were to invest directly in the Japanese stocks that comprise the Nikkei, he would be exposed to both fluctuations in the Nikkei index and fluctuations in the USD/JPY exchange rate. Essentially, a quanto has an embedded currency forward with a variable notional amount. It is that variable notional amount that give quantos their name—"quanto" is short for "quantity adjusting option."
Quanto options have both the strike price and underlier denominated in the foreign currency. At exercise, the value of the option is calculated as the option's intrinsic value in the foreign currency, which is then converted to the domestic currency at the fixed exchange rate.
Another type of structure is called Quanto in the weather/energy markets. In these markets, a Quanto is a weather-contingent energy (or commodity) derivative. Weather contingent means that a payoff is triggered if some weather variable (typically temperature, but also precipitation or any other weather variable) crosses (from above or from below) a specified strike value. For the structure to be called Quanto, the payoff must depend on the market price of a publicly traded commodity. A typical example of a buyer of a Quanto is a retailer in a liberalized electricity market, with a customer base to which they deliver to a fixed contracted price. The retailers do buy most of their electricity forward, but have to go and purchase from the expensive spot market whenever they need to deliver more than what they've planned to. This situation typically occurs if the weather is hotter (colder) than expected and a substantial number of households turn on the airconditioning (heating). As electricity demand rises sharply in such a situation, spot prices spike while the revenue from the sales side remains constant. Buying a quanto allows the retailer to hedge against that risk.
Common types of quanto include :
- Quanto futures contractFutures contractIn finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...
s, such as a futures contract on a European stock market indexStock market indexA stock market index is a method of measuring a section of the stock market. Many indices are cited by news or financial services firms and are used as benchmarks, to measure the performance of portfolios such as mutual funds....
which is settled in US dollars. - Quanto optionsOption (finance)In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
, in which the difference between the underlying and a fixed strike price is paid out in another currency. - Quanto swapSwap- Finance :* Swap , a derivative in which two parties agree to exchange one stream of cash flows against another* Barter- Technology :* Swap space, related to a computer's virtual memory subsystem...
s, in which one counterpartyCounterpartyA counterparty is a legal and financial term. It means a party to a contract. A counterparty is usually the entity with whom one negotiates on a given agreement, and the term can refer to either party or both, depending on context....
pays a non-local interest rateInterest rateAn interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
to the other, but the notional amountNotional amountThe notional amount on a financial instrument is the nominal or face amount that is used to calculate payments made on that instrument...
is in local currency. The second party may be paying a fixed or floating rate. For example, a swapSwap (finance)In finance, a swap is a derivative in which counterparties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved...
in which the notional amount is denominated in Canadian dollarCanadian dollarThe Canadian dollar is the currency of Canada. As of 2007, the Canadian dollar is the 7th most traded currency in the world. It is abbreviated with the dollar sign $, or C$ to distinguish it from other dollar-denominated currencies...
s, but where the floating rate is set as USD LIBOR, would be considered a quanto swap.
External links
Pantz, Julien 2011 Quantos and FX Skewhttp://papers.ssrn.com/sol3/papers.cfm?abstract_id=1895474