A quanto cap/floor is similar to a Cap or Floor in that you have a series of options (caplets/floorlets) and the payout of each is based upon the underlying index exceeding (in a caplet) or falling below (in a floorlet) the strike.
The difference with a quanto cap/floor is that the underlying index is set by reference to an index which is different than the currency of the notional of the cap/floor. For example, the quanto underlying index can be taken from the 6-month EURIBOR but payout can be made according to a different currency, e.g., the USD dollar.
|
|
The payout itself is always denominated in the domestic currency. |
Advantages of a Quanto Cap/Floor
Quanto caps/floors are used when an investor/hedger wishes to express a view on or hedge against rising or falling foreign interest rates without taking any foreign exchange risk.
The dealer that sells the quanto cap/floor is also implicitly selling a series of variable notional FX forwards which are used to convert the foreign currency payoff into the payment currency.
The advantage of using a quanto cap/floor rather than simply buying a cap/floor in the foreign currency is the complete insulation against changes in the FX rate.
Pricing a Quanto Cap/Floor in SDX Interest Rates
Pricing a quanto cap/floor in SDX Interest Rates is the same as pricing a cap/floor except for the following:
The indexes available for selection for the quanto leg are based on currencies other than the currency of the cap/floor.
Because there are two currencies involved, the pricing must take account of both of the following:
The ATM (at the money) volatilities between the underlying currency pair. You can see the ATM volatilities for the currency pair in the instrument’s Volatility window (accessed by clicking the FX Volatility Curve button). For more information see Working With the Volatility Window.
The correlation between the IR forward rate (i.e., the forward rate of the quanto swap’s currency) and the FX forward rate (i.e., the forward rate of the currency pair that consists of the quanto cap/floor’s currency and the currency of the foreign index). You can see the correlation data in the instrument’s Correlation window (accessed by clicking the Correlation Curve button). For more information see Working with the Correlation Window.
The premium, which is expressed as a percentage of the notional, is usually paid upfront. However, it can also be paid in installments over the life of the quanto cap/floor.
The upfront payment to be made for a quanto cap/floor is shown in the Market Price result. The Amortize premium result shows the annual periodic payment that would be paid if the quanto cap/floor was bought in installments.
By default the Amortize premium result is not displayed. You can choose to display it in the Settings window. For more information see Displaying the Cap/Floor Premium as an Amortized Value .