A quanto is an option or derivative where the asset is valued in a different currency than the one in which it is paid, providing protection against currency risk for international investors. They come in various forms, including swaps, and allow investors to gain exposure to foreign securities while avoiding exchange rate losses.
In investing, an option or derivative is a contract between two parties for the option to sell or buy an underlying asset at a predetermined price within a specified period. A quantity adjustment option, or quanto, is an option in which the asset is valued using a different currency than the one in which it is paid. Although the value of the strike prices and the intrinsic values of the quanta are denominated in one form of currency, the payments, if the options are exercised, are converted to a preferred form of currency at a predetermined exchange rate. Quantos attracts international investors because they provide protection against currency risk. They allow investors to gain exposure to foreign securities while avoiding exchange rate related losses.
For example, an investor from the United States (US) can buy a quanto futures contract on the European stock market. This contract obliges the holder to buy or sell an asset at a fixed price on a future settlement date. Since the quantos are settled in cash, the trader who suffered a loss transfers money to the investor. If the US investor has the gain, the counterparty converts the cash to the US dollar (USD) from the euro (EUR) at the exchange rate established by the contract. This agreement protects the American investor from an adverse exchange rate.
Quantums come in a variety of forms, including quanto swapping or differential swapping. Swaps consist of a series of cash exchanges, in which cash inflows are paid at a fixed interest rate and cash outflows are paid at a variable interest rate. In quanto swaps, investors change interest rates, with the floating leg pegged to a foreign index and the reward denominated in a different currency than the index. Each party to the swap is betting that the interest it will receive on its investment will exceed the interest it pays on money coming in from its counterparty.
For example, a US trader enters into a quanto swap agreement with a counterparty in Europe, with each party investing the same amount of money. The denomination of the reward, called notional, is the EUR. Periodically, the US investor pays fixed amounts to the EUR counterparty, while periodically receiving various amounts determined by a foreign index from its EUR counterparty, which are converted to USD at the London Interbank Offered Rate (USD LIBOR). The American investor hopes that the US fixed interest rate, at which he will pay interest to his counterparty, will be lower than the floating rate in Europe, allowing him to collect more interest on his investment than he pays. Quantos can also be structured with index-linked floating interest rates on both sides.
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