A quanto swap is similar to a Vanilla Swap whereby each party exchanges payments based on a predetermined payment schedule on a predefined notional amount in a single currency. The difference is that the quanto leg must be based on a floating rate, and this floating rate is set by reference to an index which is NOT based on the currency of the swap. For example, the quanto floating rate can be taken from the 6-month USD LIBOR and applied to a CHF notional.
It is important to note though that both legs of the swap are paid in the same currency. The foreign index is simply used to compute the coupon.
In agreeing to an exchange of interest payments you must define which rate each party will be paying on the notional. The following options are available:
One party pays a fixed rate and one pays a floating rate.
This is known as a fixed to floating quanto swap. Both the fixed and floating rates are paid in the same currency.
Both parties pay a floating rate, each taken from a different interest rate index, such as LIBOR and EURIBOR.
This is known as a floating to floating quanto swap, or a differential swap. Both floating rates are payable in the same currency.
Advantages of a Quanto Swap
The advantages of a quanto swap are as follows:
It lets you take a view on an interest rate index’s floating rates, without exposing yourself to any foreign exchange rate risk. For example, it enables an investor who trades in USD to take a view on the path of EURIBOR, without having to convert currency between USD and EURO, and thereby prevents any foreign exchange risk.
It lets you transfer liquidity in one currency into another currency.
Pricing a Quanto Swap in SDX Interest Rates
Pricing a quanto swap in SDX Interest Rates is the same as pricing a vanilla swap except for the following:
The indexes available for selection for the quanto leg include indexes based on currencies other than the currency of the swap.
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 swap’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.