Quanto Swap or Diff Swap is a swap that comes with various swap features of equity, currency and interest rate. In case of the quanto swap the payments are based on the interest rate movements of two different countries.
Diff swap is also called as differential swap. The classical definition of differential swap goes like this – differential swap is an interest rate swap where the floating interest rate of one participant currency is exchanged for the floating interest rate of another. Both the rates of interest of the currencies are on the same notional value that is measured in terms of one of those currencies.
The quanto swap or diff swap deals with two different currencies. But the payments made in this swap are settled in a single currency. For example, if a quanto swap requires a US investor to pay six-month LIBOR (London Interbank Offered Rate) in terms of U.S. dollar then he will receive a sum in U.S. dollar calculated on the basis of the six-month EURIBOR + 75 basis points.
There are two types of quanto swaps – fixed-for-floating quanto swaps and floating-for-floating quanto swaps. The quanto swaps that are fixed-for-floating quanto swaps save the investors from foreign exchange risks. This is done by fixing both the interest rates and exchange rates at the same time. The floating-for-floating quanto swaps, on the other hand, have slightly higher risk than the previous one. This happens because both the parties are open to the spread lying between the currency interest rates of the countries that are involved in trading.
A quanto swap actually illustrates the combination of standard derivative instruments. It can also be said that a quanto swap is a combination of the interest rate swap and foreign currency swap. The currency swap generally involves the exchange of interest payments and principal of a local firm for a foreign entity while in case of the interest rate swap, both the firms included are local and only the interest payments and not the capital are exchanged. When the concepts currency and interest rate swap intersect, we get the quanto swap. The quanto swap contract thus takes into consideration the exchange of interest payments of a local firm for the foreign entity. In this case, the local firm pays interest at the foreign interest rate while its notional being held in the local currency.
Last Updated on : 1st July 2013