What Is a Quantity-Adjusting Option (Quanto Option)?
Let me explain what a quanto option is. It's a cross-currency derivative where the underlying asset is priced in one currency, but you settle it in another at a predetermined exchange rate. You might also hear it called a guaranteed exchange rate option, and it comes in both call and put varieties.
Key Takeaways
The main point of a quanto option is to remove currency rate risk from foreign options trading. In the contract, the underlying asset is in one currency, but settlement happens in another. These options have helped open up international transactions in markets with volatile currencies. Remember, quanto options are exotic derivatives and usually trade over the counter.
Understanding the Quanto Option
Quantity-adjusting options, or quantos, get their name from their currency forward nature with a variable notional amount. That's why they're called 'quantity adjusted' or 'quanto' for short. As an investor, you'd use them if you think a foreign asset will perform well, but you're worried about the country's currency tanking. So, you buy the option on the foreign asset but keep the payout in your home currency.
Just a fast fact: Quanto options are exotic options, meaning they're customizable and typically traded over-the-counter, not on exchanges.
Benefits of Quanto Options
All markets are volatile, and currency markets are no exception. If you're a U.S. investor putting money directly into a foreign stock index, you're exposed to the index underperforming and the currency moving against you—worst case, both happen at once.
With quantos, settlement is at a fixed exchange rate, shielding you from exchange-rate risk. At expiration, the option's value is calculated in the foreign currency and then converted to your domestic currency at that fixed rate. This removes currency risk for overseas investors, boosting confidence and encouraging investment in smaller or riskier markets.
Both the strike price and underlying asset are in the foreign currency. When exercised, the intrinsic value is calculated in foreign currency and converted to domestic at the fixed rate.
Types of Quanto Options
Quantos are mostly like traditional equity options, but they're bought in your domestic currency while denominated in the foreign one. The contract fixes the exchange rate between the two currencies at the start, and it stays that way throughout.
There are variations, like the Nikkei 225 traded on the Chicago Mercantile Exchange. Its underlying is the Nikkei 225 Stock Index, but it settles in U.S. dollars, not yen.
You also have quanto swaps, where one party pays a foreign interest rate to the other, but the notional amount is in the domestic currency. Derivatives with quanto features are common because they protect international investors from currency swings—you'll find them in futures, forwards, vanilla options, and exotic notes.
What Is a Quanto Contract?
A quanto contract is like any options contract: an agreement between two parties to transact on a future date at a set price. The twist is that settlement is in a currency different from the one the investment is valued in.
What Is a Quanto Swap?
A quanto swap is a contract to exchange interest rates in two different currencies, with parties paying each other in one of those currencies. It's also known as a guaranteed exchange rate swap or rate differential swap, or 'diff swap' for short.
What Is the Difference Between a Quanto and Compo Option?
A compo option, or 'comp' option, is similar to a quanto but with a twist. The foreign asset or payoff can be in domestic or foreign currency, decided at settlement. The party choosing to switch pays a fee for it.
The Bottom Line
In the end, the quanto option takes away a key risk in foreign investing. It protects you from a big drop in the foreign currency's value right when the contract settles, by ensuring the payout is in your own currency.
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