Quanto Options

A quanto option, short for "quantity adjusting option", gives exposure to a foreign asset but pays out in a different currency at a fixed exchange rate. A US investor might buy a quanto call on Japan's Nikkei 225 index that pays in dollars as if one index point were worth a fixed $1, regardless of where the yen trades. The investor gets the index's performance without currency risk. Quanto features appear in options, futures and many structured products.

How a quanto works#

Compared with alternatives#

The correlation adjustment#

The seller of a quanto must hedge the foreign asset while the payout amount in the domestic currency is fixed. If the asset and the exchange rate tend to move together, that hedge gains or loses systematically. The result is a drift adjustment: in pricing, the foreign asset's growth rate is adjusted by the correlation between the asset and the exchange rate.

adjusted drift = r_foreign - q - ρ × σ_asset × σ_fx

• r_foreign: foreign interest rate
• q: dividend yield
• ρ: correlation between the asset (in its currency) and the exchange rate (domestic per foreign unit)
• σ_asset, σ_fx: volatilities of the asset and the exchange rate

If ρ is positive (the asset tends to rise when the foreign currency strengthens), the adjustment lowers the asset's expected growth in pricing, making quanto calls cheaper. If ρ is negative, quanto calls become more expensive. See Covariance and Correlation and Currency Correlations.

Where quantos appear#

• Quanto index futures: CME lists Nikkei 225 futures in dollars as well as yen; the dollar contract is a quanto. See How Futures Contracts Work.
• Structured products: notes linked to foreign indices often pay in the investor's home currency with quanto features.
• Crypto derivatives: some perpetual and futures contracts are quanto, for example contracts on an altcoin that are margined and settled in Bitcoin or a stablecoin at a fixed multiplier. Their profit and loss depends on the correlation between the two assets, which can surprise traders. See Perpetual Futures.

Risks and considerations#

• Correlation risk: the seller's hedge depends on correlation, which changes, especially in stress.
• Model sensitivity: quanto prices depend on estimates of correlation and FX volatility.
• Hidden cost: the correlation adjustment can make quantos more expensive than they appear.
• Crypto quanto contracts can have very different risk from ordinary linear contracts when both assets move sharply together.

Frequently asked questions#

What is a quanto option?#

An option on a foreign asset that pays out in another currency at a fixed exchange rate, removing currency risk for the holder.

Why does correlation matter for quanto options?#

Because the seller's hedge of the foreign asset gains or loses depending on how the asset and the exchange rate move together, which changes the fair price.

What is a quanto futures contract?#

A futures contract on a foreign asset, such as the Nikkei, that is quoted and settled in another currency at a fixed rate, like the dollar denominated Nikkei futures.

You have finished the Options track. Continue with the Volatility lessons, starting with Implied Volatility (IV).