Quanto Swap

A quanto swap refers to a cash-settled swap where two parties holding non-identical currencies swap interest rates. This derivative is useful for traders who think that a specific asset will perform well in a country, but the nation’s currency will not fail to do well.

Since these financial contracts depend on the difference in the parties’ interest rates and the currencies’ exchange rates, one can also call them differential swaps. Moreover, they are also called guaranteed exchange rate swaps since they have a fixed exchange rate embedded in them. These derivatives are of three types — quanto credit default swap, quanto option, and quanto futures contract.

• Quanto swap meaning refers to an interest rate swap that is transacted in a notional currency yet is settled in some other currency. It can help investors mitigate the risk related to purchasing assets that are attached to different currencies.
• The three types of quanto swaps are quanto option, quanto CDS, and quanto futures contract.  
• A benefit of this type of derivative is that it can reduce the risk of a certain currency’s value rising or dropping aggressively.
• There are multiple quanto swap parameters. For example, the maturity date and the underlying asset’s notional value.

Quanto swap refers to a cross-currency, cash-settled interest-rate swap in which a counterparty pays a foreign rate of interest to the other, but the denomination of the notional amount is in the local or domestic currency. It is an enticing product for traders and speculators as it exposes them to a foreign currency without an equivalent exchange rate-related risk. Also, one must note that the interest rate, in this case, can be floating or fixed.  

Quanto swap purpose is to help traders minimize financial risk when they expect their assets in a nation will increase in value. Still, at the same time, they anticipate the nation’s currency value to decrease. If this kind of situation materializes, a trader enters into an agreement with another person to exchange interest rates while not altering currency. This enables a trader to differentiate between interest rate and exchange rate risk to minimize the effects of either exposure.

One must note that traders can avoid the risk by fixing the interest and exchange rates simultaneously. Also, individuals must remember that floating-for-floating swaps carry a marginally higher risk than fixed-for-floating swaps, as the two parties involved are exposed to the spread of each nation’s currency interest rate.

Let us look at the different kinds of differential swaps.

• Quanto Futures Contracts: These are cash-settled derivatives involving a futures contract with an underlying asset belonging to the domestic stock market. However, their settlement occurs at a fixed exchange rate in a foreign currency.
• Quanto Credit Default Swap: Individuals can enter a CDS or credit default swap by purchasing a default protection worth a certain amount in a different currency. However, they purchase the regular protection in another currency.
• Quanto Options: Such contracts include the options contract that has a strike price in one currency and a payout in a different currency. For instance, suppose Sam, an American investor, holds an option on the TSX or Toronto Stock Exchange. The strike price of the derivative is in CAD. That said, he will obtain U.S. dollars on the basis of the fixed exchange rate.

There are certain quanto swap parameters. They are as follows:

• The first consideration when trading quanto swaps is the underlying asset’s notional value. The pricing of the value is in that asset’s domestic currency. Usually, the underlying asset is a loan.
• The second and third considerations are the two currencies’ interest rates, which can be floating or fixed. While one of the rates is the home currency’s interest rate, the other one represents the foreign currency utilized for the settlement of the transaction.   
• The last quanto swap parameter is the date of maturity. It is the date on which the underlying obligation or loan comes due.

Let us look at a few quanto swap examples to understand the concept better.

Example #1

Suppose David, an Irish investor, pays a six-month LIBOR or London Interbank Offered Rate in U.S. dollars for a loan worth $1 million. In exchange, he received payments in the same currency at the seven-month EURIBOR or Euro Interbank Offered Rate 50 base points.

Example #2

Suppose a European organization, ABC, borrows funds worth $2 million to fund the expansion of its operations in the U.S. The company must repay the amount over three years in addition to the interest based on the three-month SOFR (Secured Overnight Financing Rate). Let us say that the SOFR rate, in this case, is 4% while the EURIBOR is 2%.

ABC anticipates that the U.S. rates will rise relative to the European interest rates. In such a case, the organization will be in a better position if they exchange the interest payments based on SOFR for a rate based on EURIBOR. Therefore, ABC would aim to implement a quanto swap for the replacement of the SOFR-based payments for a rate of interest that is based on EURIBOR+2%. However, they will keep paying in dollars. If it turns out that the organization’s predictions regarding interest rates are accurate, it will be able to save money over the long term.

The benefits and limitations of such financial contracts are as follows:

#1 - Advantages

• Such derivatives act as a hedge against currency pairs aggressively rising or falling in value.
• This type of financial contract can minimize the risk of a particular currency’s value aggressively moving in a specific direction.  
• There are multiple ways to execute such contracts.

#2 - Disadvantages

A key drawback of this derivative is that the floating interest rate might become a higher cost during maturity than the swap’s whole purpose.  

Although both quanto and cross-currency swaps are swap contracts, they have certain differences. Not knowing such differences can often lead to confusion, specifically for one unfamiliar with the concepts. So, here are their key differences:

This has been a guide to what is Quanto Swap. We explain its examples, comparison with cross-currency swap, types, requirements, advantages, & disadvantages. You can learn more about it from the following articles –

• Swap Curve
• Bermuda Swaption
• Atomic Swaps