Quanto or Quantity Adjusting Option is a derivative instrument used by investors for hedging their exposure risk in foreign currencies. This article would help the reader get a systematic and precise idea on the topic.Quanto is the short form of “Quantity Adjusting Option”.
More precisely, quanto is a cross-currency derivative essentially cash-settled as in the case of futures and options and hence no physical delivery of the underlying asset takes place.
Quanto – Defined
In case of Cross-Currency Derivative or Quantity Adjusting Option (Quanto), the underlying asset bears a denomination of one currency, namely US Dollar.
But at the time of settlement, this asset is settled in a different currency, namely Indian Rupees.
Quanto – Example
Stock index future of Nikkei 225 (a stock market index of Japan) is traded in Chicago Mercantile Exchange (CME). Its settlement ratio is US $5 per 0.01 JP? value of the asset in Nikkei.
Quanto – Advantage
Quantos are settled at a fixed rate of exchange and thus protects its investors from probable fluctuations in the same. If an investor of one country invests in the assets traded in the exchange of another country then he/she is exposed to the risk of two types of fluctuations: –
- Asset price fluctuation in the foreign country
- Fluctuation in the exchange rate of the currencies of the two countries
Quantity Adjusting Option or Quanto help its investors by shielding them from the above-mentioned fluctuations because at the time of option exercising, its intrinsic value is converted from foreign currency to domestic one at a fixed rate.
Quanto Swap – A Related Variant Of Quanto
Quanto Swap is also known as Differential Swap. These are essentially of two types: –
1. Fixed Floating Type of Swaping Interest Rate
2. Floating-Floating Type of Swaping Interest Rate
Quanto – Basis of Pricing
Quanto is priced by making models on three aspects, namely
- Underlying Asset
- Exchange Rate
- Correlation between the underlying Asset and the Exchange Rate
Quanto or Quantity Adjusting Option is a risk management instrument used by the investors for hedging their risk. It shields them from exchange rate fluctuations as the intrinsic value of the currencies are converted from foreign to domestic at a fixed rate.
Last Updated on : 1st August 2013