Quantitative Finance > Pricing of Securities
5 stars based on
A quanto is a type of derivative in which the underlying is denominated in one currencybut the instrument itself is settled in another currency at some 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. 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" quanto option payoff formula 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. 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 quanto option payoff formula 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, quanto option payoff formula prices spike while the revenue from the sales side remains constant. Buying a quanto allows the retailer to hedge against that risk.
Pricing quanto derivatives involves modeling financial variables stocks, interest rates etc. In order to write the dynamics of the modeled financial variables under foreign currency pricing measure one has to apply Girsanov theorem leading to a drift term which depends on its volatility, the FX rate volatility FX rate between the pricing currency and the modeled variable currency and correlation between both.
This drift term leads to an adjustment in the pricing that is referred quanto option payoff formula as "quanto adjustment" and falls into the more general category of what is called in mathematical finance convexity adjustments. From Wikipedia, the free encyclopedia. Common types of quanto include: Quanto futures contractssuch as a futures contract on a European stock market index which is settled in US dollars.
Quanto optionsin which the difference between the underlying and a fixed strike price is quanto option payoff formula out in another currency. Quanto swapsquanto option payoff formula which one counterparty pays a non-local interest rate to the other, quanto option payoff formula the notional amount quanto option payoff formula in local currency.
The second party may be paying a fixed or floating rate. For example, a swap in which the notional amount is denominated in Canadian dollarsbut where the floating rate is set as USD LIBORwould be considered a quanto swap.