In the Commodity market, a quanto version of an option is an option in which the underlying asset is traded in one currency (i.e., its base currency, but the payout is settled in another currency using a predefined FX exchange rate, typically set to 1.
This lets the investor take a view on the path of an asset without worrying about the translation of any future profits back into the domestic currency. It lets the investor have exposure to a foreign asset, but without the corresponding exchange rate risk.
For example, a speculator domiciled in the UK may believe there is big upside potential for Brent Crude Oil. If the speculator were to buy a vanilla option on that asset, the payout received would be in USD and the speculator would then have to convert the payout to GBP. The speculator is therefore exposed to the FX fluctuations–if the USD weakened against the GBP, the final amount in GBP would be lowered.
Using a quanto, the speculator can take a bullish position on Brent Crude Oil and quanto this into GBP. This fixes the USD/GBP exchange rate, thus isolating the exposure to the Brent Crude Oil asset only. Regardless of the USD/GBP exchange rate at the time of payout, the predefined exchange rate is used to determine the payout in GBP.
What quanto instruments are supported in SDX Commodities & Energy
In both pricing pages you can price a quanto version of the following instruments–vanilla, vanilla strip, Asian, Asian strip, swap and swap strip.
Pricing a quanto in SDX Commodities & Energy
Each commodity has a default base currency. This base currency is set according to the exchange it is traded on or, if it is traded OTC, according to market convention.
In the system, if you change an instrument's base currency, by default you enter into a composite version of the instrument. That is, changing the base currency affects the term structure used to price the instrument, and changes the payout currency, but because it does not fix the <base currency>/<payout currency> spot rate it still leaves you exposed to the FX risk–to any fluctuations in that spot rate between the trade date and the expiry date.
For supported instruments only, when you change an instrument's base currency, although you automatically enter into the composite version of the instrument, you can then instruct the system to instead use the quanto version instead.
You do this using the Compo <> Quanto button as seen in See "Pricing a Quanto in SDX Commodities & Energy" below.
Figure 1: Pricing a Quanto in SDX Commodities & Energy
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In the Single Option page, this button only appears for the supported instruments and only once you have changed the asset's base currency. In the Portfolio page, in order to use the quanto feature you must ensure that the portfolio only includes instruments that support the quanto functionality. |
How is the payout of a quanto version of an instrument calculated?
When pricing a quanto version of the instrument, the system sets the fixed exchange rate between the original and payout currencies to be 1.
So for example, at expiry, the payout of a vanilla call quanto option is calculated as follows:
Notional in payout currency * Max[(fwd price at expiry / Initial fwd price - Strike ), 0]
So if you are pricing a vanilla call quanto option in which the underlying is a stock traded in USD, the payout currency is GBP, the strike is 105% of the initial forward price, the initial fwd price is 96.656 GBP, the notional is 1,015 GBP, and at expiry the fwd price of the asset is 110 GBP, the payout would therefore be calculated as follows:
1,015 * (110/96.656 - 105%)
That is, 89.4 GBP.
To price a quanto version of a supported instrument in the Single Option page:
| 1. | In the Single Option page, from the Option Class dropdown list, select the relevant instrument. |
| 2. | From the Base Currency dropdown list, select the currency in which you want the payout to be received. The Compo <> Quanto toggle button is displayed, set to Compo. |
| 3. | Toggle the button to Quanto. This instructs the system that the instrument is a quanto version. |
To price a quanto version of a supported instrument in the Portfolio page:
| 1. | In the Portfolio page, use the Base Currency dropdown list to set the portfolio's base currency. |
| 2. | Define each relevant instrument. If the instrument's asset's base currency is different from the portfolio's base currency, the instrument is entered into as a composite version. |
| 3. | To set the relevant instruments (i.e., those whose asset's base currency is different from the portfolio's base currency) to quanto, toggle the Compo <> Quanto button to Quanto. |