Quanto

A quanto is a type of derivative, typically an option, whose payoff is tied to the value of an asset that is priced in a foreign currency but paid in the investor’s domestic currency using a fixed exchange rate. The term is used in quantitative finance to describe instruments designed to remove or reduce currency risk for an investor who wants exposure to a foreign asset without bearing FX fluctuations.

In a typical quanto call on a foreign- priced asset with price S_T in its native currency and a fixed domestic per foreign exchange rate F, the payoff at maturity is max(F·S_T − K, 0), where K is the strike expressed in domestic currency. A quanto put would have payoff max(K − F·S_T, 0). The fixed rate F ensures that the domestic payoff is not directly affected by exchange-rate movements at maturity, distinguishing quanto options from standard currency-cross options.

Pricing a quanto option involves evaluating the value of the foreign-asset option under a risk-neutral framework while accounting for the interaction between the asset and the exchange rate. The so-called quanto adjustment captures how the correlation between the asset’s price and the exchange rate, as well as differences in domestic and foreign interest rates, influence the effective drift and volatility of the domestic payoff. If the fixed rate were not used, FX risk would be incorporated, and pricing would resemble a cross-currency option.

Uses of quanto instruments include hedging foreign exposure for domestic investors, creating pure plays on foreign assets without FX risk, and enabling cross-border investment strategies. Common underlying assets include stock indices, equities, and commodities denominated in foreign currencies.