What Is a Quantity-Adjusting Option (Quanto Option)?
A quantity-adjusting option, commonly called a Quanto option, is a cross-currency derivative in which the underlying asset is denominated in one currency but settlement is made in another currency at a predetermined exchange rate.
Another name for these options is a guaranteed exchange rate option. Quanto options come in both call and put varieties.
- The Quanto option is designed to remove currency rate risk as a factor in foreign options trading.
- The options contract specifies that the underlying asset is denominated in one currency while settlement is to be made in another currency.
- Quanto options have been a key factor in opening up international transactions in foreign markets whose currencies tend to be volatile.
- Quanto options are a type of exotic derivative and usually trade over the counter.
Understanding the Quanto Option
Quantity-adjusting options get their name from their potential currency forward nature, with a variable notional, or abstract, amount. Hence the term "quantity adjusted" or "Quanto," for short.
Investors use Quantos when they believe that a particular asset will do well in a country but fear that the country's currency will not perform as well. Thus, the investor will buy an option in the foreign asset while keeping the payout in the home currency.
The quanto option is a type of exotic option. These are customizable transactions and are normally traded over-the-counter rather than on an exchange.
Benefits of Quanto Options
All financial markets are volatile, and currency markets are not immune. A U.S.-based investor who invests directly in a foreign stock index, for example, is exposed to the risk that the foreign index will underperform, and the risk that the currency will fluctuate in the wrong direction. At worst, both could happen.
Quantos are settled at a fixed rate of exchange. That shelters the investor from exchange-rate risk. At the time of expiration, the option's value is calculated in the foreign currency and then converted at a fixed rate into the domestic currency.
The Quanto option removes currency risk for overseas investors. That increases investor confidence and encourages investment in smaller or riskier markets.
Both the strike price and the underlying asset are valued in the foreign currency. At the time of exercise, calculation of the option's intrinsic value is in the foreign currency. This foreign currency value is converted to the investor's domestic currency at the fixed exchange rate.
Types of Quanto Options
Quantos are in most ways identical to traditional equity options. The critical difference is that they are purchased in the investor's domestic currency but denominated in the asset's foreign currency. At inception, the Quanto contract fixes the exchange rate between the two currencies. This fixed exchange rate remains in force for the duration of the contract.
There are variations on quantity-adjusting options contracts. One is the Nikkei 225, which is traded on the Chicago Mercantile Exchange (CME Group). The underlying asset for the futures contract is the Nikkei 225 Stock Index. The contract is settled in U.S. dollars rather than in Japanese yen.
There are also Quanto swaps available. In a swap, one of the counterparties pays a foreign interest rate to the other party, while the notional amount is in the domestic currency.
The Quanto Feature
Derivatives with Quanto features are common, due to their ability to protect the international investor from currency price swings. They may be found in futures, forwards, vanilla options, and exotic notes.
What Is a Quanto Contract?
Like any options contract, a Quanto contract is an agreement between two parties to complete a transaction on a specific future date at a specific price.
The unusual aspect of a Quanto contract is its specification that the settlement will be made in a currency other than the one that the investment is valued in.
What Is a Quanto Swap?
A quanto swap is an options contract to exchange interest rates in two distinct currencies. The parties pay each other in one of the two currencies.
A quanto swap may also be called a guaranteed exchange rate swap or a rate differential swap (abbreviated "diff swap.")
What Is the Difference Between a Quanto and Compo Option?
A compo option, or "comp" option, is a variation on the quanto option. The foreign asset or the payoff price may be denominated in the domestic currency or in a foreign currency, with a final decision made at settlement. The party who elects to change the settlement currency pays a fee for making the switch.
The Bottom Line
The quanto option removes a source of risk from foreign investing.
That is, it protects the investor from a steep decline in the value of the foreign asset's home currency that could coincide with the contract settlement date. The contract establishes that the payout will be valued in the investor's currency rather than the foreign currency.