Quanto Options

Quanto options are cross-currency derivatives which allow investors to guard against exchange rate fluctuations while trading in a foreign market. Also known as quanto-adjusting options or guaranteed exchange rate options, these cash-settled options are denominated in a different currency to the underlying asset, allowing investors access to equity and other assets in foreign countries without exposing them to the risk of the foreign currency.

This guide will provide traders with a quanto options 101, including a simple definition of these exotic options, examples of how they are used, and information on crucial areas like pricing. We also explore popular trading strategies in 2023.

Below we list the top-rated brokers that offer retail options trading in 2023.

Quanto Options Explained

• Quanto options are used by investors who seek exposure in a foreign market but are worried about exchange rate risk
• The underlying asset trades in the foreign market’s currency, but the payout is made in the investor’s chosen currency
• They negate risks caused by exchange rate fluctuations by guaranteeing investors a fixed rate
• Types of quanto option include futures, swaps, basket options, and barriers

A standard, or “vanilla” option is a derivatives contract which gives the buyer the right, but not the obligation, to buy or sell an underlying asset at an agreed price during a specified time frame.

Since the investor will only lose the price paid for the contract if an option expires out of the money, they are a powerful tool for hedging as well as speculating.

However, it is not so simple for the investor with exposure to assets in a foreign market, as they must factor in not only fluctuations in the underlying asset’s price, but also volatility in the foreign currency’s exchange rate.Any profit that a U.S.-based investor’s option makes in, say, a European market could by diminished or entirely cancelled out by movements of the euro against the dollar.

Quanto options solve this problem by setting a fixed exchange rate to be used when the contract is settled.Units of the underlying asset are converted to the payoff currency at the agreed rate, meaning any exchange rate volatility that may have taken place over the contract’s life cycle is negated.

The quanto option’s full name – quantity adjusting option – comes from this feature of the contract, which effectively works as a built-in currency forward with a variable notional amount.As with standard option contracts, quanto options come in put and call products, allowing investors to take short and long positions respectively.

Types Of Quanto Option

One famous example of a quanto used to negate FX volatility risk is the Nikkei 225 Index Future on the Chicago Mercantile Exchange, which takes the Japanese stock index as its underlying asset and has a US dollar (USD) payout.

But quanto options come in a variety of forms not limited to future contracts:

Quanto Swaps

Quanto swaps work in a similar way to ordinary currency swaps, with both sides exchanging cash flows based on underlying assets in two different countries or currencies.

However, in a quanto swap, the payments are settled in just one currency.

Quanto Barrier Options

A standard barrier option is a type of exotic derivative whose payoff is determined by whether or not the price of the underlying asset reaches a predetermined price level. A quanto barrier shares the same feature, with a payout denominated in a different currency to the underlying asset.

Quanto Basket Option

As a risk mitigation strategy, some traders will use a “basket” of underlying assets in a derivative rather than a single asset. In a quanto basket option, one or more of the underlying assets in the basket are traded at a different currency to the payout.

Quanto vs Compo Options

Composite, or compo options are similar to quanto options in that they are also denominated in a foreign currency. But unlike quanto options, both the strike and payout are fixed in the compo’s currency, and the buyer will have exposure to exchange rate fluctuations.

Quanto Asian Options

This exotic derivative combines the features of a quanto and an Asian option, in which the payoff is dependent on the underlying asset’s average price over a set period. Both call and put options are available.

Quanto Energy Options

Quanto energy options are used as a risk management tool to protect against risk in energy markets. In this case, the risk in question may be linked to weather or temperature rather than exchange rate volatility, since energy demand is linked to these factors.

Pricing & Valuations

Given the variety of quanto options available, there is no single formula used to price put, call, and all the other iterations of quanto contracts, and different sellers may disagree on how to best price each variety.

Generally, the pricing depends on the correlation between the underlying asset and exchange rates.

Common methods for pricing quantos include the Monte Carlo model alongside options pricing calculators found online. Pricing and risk models can be built on programmes like excel or using powerful programming languages like Python.

Quanto Option Strategies

Traders will use quanto options as part of a broader strategy, or even build a system around quanto options, but this will largely depend on the type of option and the underlying asset being traded. For example, a common hedging strategy used with FX quanto options is to run a multi-currency options book. Delta hedging, in which the investor trades in the underlying spot market, is another method often used with quantos.

Quanto options offer excellent flexibility to investors since they enable access to foreign markets without the risks involved with currency volatility. Since quanto futures are available to individual investors on exchanges, they can make a lucrative part of a day trader’s portfolio.

Final Word On Trading Quanto Options

The key approach when investing in a quanto option is to carefully research the market you’re entering. Our website will give you plenty of information to get started, but you can also sharpen up your general knowledge through other tools, such as finance wikis or videos on YouTube.

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