What Is a Quantity-Adjusting Option (Quanto Option)
A quantity-adjusting option, also known as a Quanto option, is a cash-settled, cross-currency derivative, where the underlying asset is denominated in a currency other than the currency in which the option is settled.
Understanding Quantity-Adjusting Option (Quanto Option)
Investors use Quantos when they believe a particular asset will do well in a country but fear that country's currency will not perform as well. Thus, the investor will buy an option in the foreign asset while keeping the payout in their home currency.
How Quanto Options Work
World markets are volatile entities. Fluctuations may cause one currency to trade higher or lower than another at any given time. If a U.S.-based investor were to invest directly in a foreign stock index, they would expose themselves to risks in that foreign index as well as risks due to the fluctuations in the currency exchange rate.
A side benefit of a Quanto option is to create greater liquidity in smaller or riskier markets by removing currency risk for overseas investors. Reduction of risk encourages participation in these markets.
Quantos are settled at a fixed rate of exchange, providing investors shelter 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.
Both the strike price and 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 Quantity-Adjusting Options
Quantos are built the same way as traditional equity options. The critical difference is that it is purchased in the investor's domestic currency, while 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 additional types of quantity-adjusting options an investor may purchase. One kind of Quanto futures contract 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, as opposed to in Japanese yen.