Quantity-Adjusting Option (Quanto Option)

What is a Quanto Option?

A quantity-adjusting option, commonly called a quanto option, is a cross-currency derivative in which the underlying asset is denominated in one currency but settlement is made in another at a predetermined (fixed) exchange rate. Quantos exist as calls or puts and are typically traded over the counter as exotic, customizable instruments.

Key points
* Removes exchange-rate risk by fixing the conversion rate between the asset currency and the settlement (investor’s) currency.
* Underlying asset and strike are valued in the foreign currency; payoff is converted into the domestic currency at the fixed rate.
* Commonly used to facilitate international investment in markets with volatile currencies.
* Found in a range of derivatives: futures, forwards, vanilla options with quanto features, swaps, and structured notes.

How a Quanto Option Works

At inception the contract specifies:
* the foreign-denominated underlying asset (e.g., a foreign equity index),
* the strike price (denominated in the foreign currency),
* the settlement currency (the investor’s domestic currency), and
* a fixed exchange rate to be used at settlement.

At expiration the option’s intrinsic value is calculated in the foreign currency and then converted into the domestic currency using the predetermined exchange rate. This mechanism isolates the investor’s exposure to the asset’s performance while eliminating direct exposure to currency fluctuation between the two currencies.

Benefits

• Eliminates exchange-rate risk for investors who want exposure to foreign assets without FX volatility.
• Encourages international investment, including in smaller or more volatile currency markets.
• Provides a straightforward domestic-currency payoff even when the underlying asset is foreign-denominated.

Types and Variations

• Exchange-traded examples: Some quanto-style contracts are listed—an example is a Nikkei 225 product on the CME that settles in U.S. dollars rather than Japanese yen.
• Quanto swaps: One counterparty pays an interest rate tied to one currency while the notional or settlement is in another currency. These are also called guaranteed-exchange-rate swaps or rate-differential (diff) swaps.
• Quanto features can be embedded into a variety of derivatives, including futures, forwards, vanilla options, and exotic structured notes.

Quanto Contract vs. Quanto Swap

• Quanto contract: A standard options agreement where settlement currency differs from the underlying asset’s currency and the conversion rate is fixed in the contract.
• Quanto swap: A swap in which interest-rate payments or differentials are exchanged across currencies with a guaranteed or fixed exchange-rate element.

Compo Option (Contrast)

A compo option (or “comp” option) is a related variation in which the settlement currency can be chosen at or before exercise—often with a fee charged to the party electing to change the settlement currency. This flexibility distinguishes it from a standard quanto, which fixes the settlement currency and exchange rate at inception.

Bottom Line

Quantos allow investors to gain exposure to foreign assets while removing currency risk by fixing the exchange rate used for settlement. They are useful tools for international investing and can be structured across various derivative products, but they are typically exotic, customizable contracts handled OTC rather than through standard exchange-listed options.