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 adjusting option, or quanto, is an option in which the asset is valued using a currency different from the one in which it is paid. While the value of the strike prices and the intrinsic values of quantos are denominated in one form of currency, the payouts, if the options are exercised, are converted to a preferred form of currency at a predetermined exchange rate. Quantos attract international investors because they provide protection from foreign exchange risk. They allow investors to gain exposure to foreign securities while avoiding losses related to currency exchange rates.
For example, a United States (US) investor may purchase a quanto futures contract on the European stock market. This contract obligates the holder to buy or sell an asset at a fixed price on a future settlement date. Because quantos are cash-settled, the trader who took a loss transfers money to the investor. If the US investor has the gain, the counterpart converts the cash to the US Dollar (USD) from the Euro (EUR) at the exchange rate established by the contract. This arrangement shields the American investor from an adverse exchange rate.
Quantos occur in a variety of forms, including the quanto swap or differential swap. Swaps consist of series of cash exchanges, in which cash inflows are paid a fixed interest rate and cash flows out are paid a floating interest rate. In quanto swaps, investors swap interest rates, with the variable leg fixed to a foreign index and the payoff denominated in a different currency than the index. Each party to the swap bets that the interest he will receive from his investment will surpass the interest that he pays for the money coming in from his counterpart.
For example, a US trader engages in a quanto swap agreement with a counterpart in Europe, with each side investing the same amount of money. The denomination of the payoff, called the notional, is the EUR. Periodically, the US investor pays fixed amounts to the counterpart in EUR, while he periodically receives various amounts determined by a foreign index from his counterpart in EUR, which are converted to USD at the USD London Interbank Offered Rate (USD LIBOR). The US investor hopes that the fixed US interest rate, at which he will pay interest to his counterpart, will be lower than the floating rate in Europe, allowing him to collect more interest from his investment than what he pays. Quantos may also be structured with floating, index-linked interest rates on both sides.