Quanto Options
Quantity-Adjusting options (also called Quanto options) are cross-currency derivatives instruments in which the underlying is denominated in a foreign currency, not in its domestic one. For example, a SX5E/SPX quanto option that will be settled in USD (instead of EUR for the SX5E leg).
Quanto options are particularly interesting for traders seeking to guarantee a specific exchange rate and by the way, to avoid exchange rate risk.
Quantity-adjusting options get their name from its potential FX forward nature, with a variable notional. Hence the term « quantity adjusted » or « Quanto, » for short.
Investors use Quantos when they believe a particular asset will do well in a country but fear that country’s domestic currency will not perform as well. Then, the investor will buy an option (either call or put) in the foreign asset while keeping the payout in their home currency.
For example, a US investor were to invest directly in the Japanese stocks that comprise the Nikkei, he would be exposed to both fluctuations in the Nikkei index and fluctuations in the USD/JPY exchange rate. Essentially, a quanto has an embedded currency forward with a variable notional amount. Then, the US investor will benefit from the settlement in its domestic currency, here the US Dollar.
