Quanto

<body onLoad="MM_checkPlugin('Shockwave Flash','','http://www.riskglossary.com/default_nofl.htm',false);return document.MM_returnValue" stylesrc="../_private/template.htm" bgcolor="#FFFFFF" link="#669933" vlink="#000000" alink="#000000"> <div align="left"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table1"> <tr> <td width="740"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" height="37" id="table2"> <tr> <td height="35" width="100%"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" id="table3"> <tr> <td width="100%" align="left" valign="top"> <p class="header_gold">Quanto</td> <td width="45" align="right" valign="bottom"> <map name="FPMap6"> <area href="http://www.contingencyanalysis.com" shape="rect" coords="1, 0, 44, 11" target="_top"> </map> <img border="0" src="../images/home.gif" usemap="#FPMap6" width="45" height="12"></td> </tr> </table> </td> </tr> <tr> <td width="100%" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td width="0%" valign="top" bgcolor="#FFFFCC"> <table border="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" cellspacing="1" id="table4"> <tr> <td width="0%" align="left" valign="top"> <p class="header2_black">Explained:<br> <img border="0" src="../images/blank_1x100.gif" width="100" height="1"></td> <td width="100%" align="left" valign="top"> <p class="word_list"><a href="#cross-currency derivative"> cross-currency derivative</a><p class="word_list"> <a href="#diff swap">diff swap</a><p class="word_list"> <a href="#differential swap">differential swap</a><p class="word_list"> <a href="#quanto">quanto</a><p class="word_list"> <a href="#quanto swap">quanto swap</a><br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="0" style="border-collapse: collapse" bordercolor="#111111" width="310" align="right" id="table5"> <tr> <td align="right" width="9" height="14"></td> <td width="300" height="14"> <font size="2"> </font><font size="4"> </font></td> </tr> <tr> <td align="right" width="9"> </td> <td width="300"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table> <p class="body"><strong style="font-weight: 400">A </strong><strong> <a name="quanto">quanto</a></strong><strong style="font-weight: 400"> (or </strong><strong> <a name="cross-currency derivative">cross-currency derivative</a></strong><strong style="font-weight: 400">) is a <a href="../articles/physical%20settlement.htm">cash settled</a> <a href="../articles/derivative_instrument.htm">derivative</a> (such as a <a href="../articles/future.htm">future</a> or <a href="../articles/option.htm">option</a>) that has an </strong> <a href="../articles/derivative_instrument.htm" target="_self"> <strong style="font-weight: 400">underlier</strong></a><strong style="font-weight: 400"> denominated in one ("foreign") currency, but settles in another ("domestic") currency at a fixed exchange rate. For example, the Chicago Mercantile Exchange (CME) trades futures on Japan's Nikkei 225 stock index that settles for <a href="../articles/currency_codes.htm">USD</a> 5.00 for each <a href="../articles/currency_codes.htm">JPY</a> .01 of value in the Nikkei index. If you hold a future, and the Nikkei rises JPY 12 (or 12 points), you earn USD 6000.</strong></p> <p class="body"><strong style="font-weight: 400">Quantos are attractive because they shield the purchaser from exchange rate fluctuations. If a US investor were to invest directly in the Japanese <a href="../articles/common_stock.htm">stocks</a> that comprise the Nikkei, he would be exposed to both fluctuations in the Nikkei index and fluctuations in the USD/JPY exchange rate. Essentially, a quanto has an embedded currency <a href="../articles/forward.htm">forward</a> with a variable <a href="../articles/notional_amount.htm">notional amount</a>. It is that variable notional amount that give quantos their name—"quanto" is short for "quantity adjusting option."</strong></p> <p class="body">Quanto options have both the <a href="../articles/option.htm">strike price</a> and <a href="../articles/derivative_instrument.htm">underlier</a> denominated in the foreign currency. At exercise, the value of the option is calculated as the option's <a href="../articles/time_value_and_intrinsic_value.htm">intrinsic value</a> in the foreign currency, which is then converted to the domestic currency at the fixed exchange rate.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="345" align="left" id="table6"> <tr> <td width="336" height="10"><font size="2"> </font></td> <td width="9" height="10"></td> </tr> <tr> <td width="336"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> <td width="9"> </td> </tr> </table> <p class="body">A <b><a name="quanto swap">quanto swap</a></b> (<b><a name="differential swap">differential swap</a></b> or <b><a name="diff swap">diff swap</a></b>) is a fixed-floating or floating-floating <a href="../articles/swap.htm">interest rate swap</a>. One of the floating rates is a foreign interest rate, but it is applied to a notional amount in the domestic currency. For example, a US investor might make USD payments at 3-month USD <a href="../articles/libor.htm">Libor</a> and receive USD payments at 3-month GBP Libor – 85, with both payments calculated by applying the respective interest rates to a USD 100<a href="../articles/mm.htm">MM</a> notional amount. Floating-floating diff swaps are a vehicle for directly betting on <a href="../articles/spreads.htm">spreads</a> between different currency's interest rates.</p> <p class="body"><strong style="font-weight: 400">Pricing a quanto option entails modeling both the underlier and the exchange rate, as well as the <a href="../articles/correlation.htm">correlation</a> between them. See Reiner (<a href="#Reiner">1992</a>) and Dravid, Richardson and Sun (<a href="#Dravid">1993</a>).</strong></p> <p>Diff swaps are generally valued by devising an (imperfect) static <a href="../articles/hedging_and_diversification.htm">hedge</a>, pricing the components of that hedge, and adding a suitable spread for warehoused risk. See Walmsley (<a target="_blank" href="http://www.riskbook.com/link/walmsley_j_(2000).htm">2000</a>).</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table7"> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Internal Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table8"> <tr> <td width="100%"> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/derivative_instrument.htm"><strong style="font-weight: 400">derivative instrument</strong></a><strong style="font-weight: 400"> An instrument which derives its value from the value of other financial instruments. 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