quantos

Quantos are a class of derivative contracts whose payoff is linked to the performance of a foreign-quoted asset but settled in the investor’s domestic currency using a fixed, pre-agreed exchange rate. The term quanto comes from “quantity-adjusted,” reflecting the aim of removing currency translation risk from the payoff. A common example is a quanto option on a foreign stock or index, where the payoff is paid in domestic currency while the underlying asset is priced in its home currency.

Mechanics: If the foreign asset price at maturity is S_T (in foreign currency) and the contract specifies a fixed exchange rate X for settlement, a quanto call with domestic strike K pays max(X S_T − K, 0) in domestic currency. Because X is fixed, fluctuations in the FX market do not directly affect the payoff. Pricing quantos requires considering the volatility of the foreign asset, the volatility of the exchange rate, and the correlation between them, since this correlation influences the effective drift and risk to the option.

Valuation: In extensions of Black-Scholes, the domestic value depends on the volatilities of both the underlying and the FX rate, as well as their correlation. The so-called quanto drift reflects how these factors interact. The result is typically different from a standard foreign-currency-denominated option due to the fixed FX conversion.

Applications: Quantos are used by investors who want exposure to foreign assets while avoiding currency risk, such as international equity options, cross-border index options, or structured notes. Variants include quanto futures and quanto warrants, which apply the fixed FX settlement principle to different payoff structures.