What Is a Quanto Swap?
A quanto swap is a cash-settled, cross-currency interest rate swap where one of the counterparties pays a foreign interest rate to the other. The notional amount is denominated in the domestic currency. Interest rates may be fixed or floating.
Because they depend on the currency exchange rate and differences in interest rates between those currencies, they are also known as differential, rate differential, or just “diff” swaps. Another name for these swaps could be guaranteed exchange rate swap because they embed a fixed currency exchange rate in the swap contract.
Key Takeaways
- A quanto swap is a derivative transaction where two parties exchange interest rates in different currencies.
- Quanto swaps are also known as guaranteed exchange rate swaps, differential, rate differential, or “diff” swaps.
- Although the payments reference exchange rates in two different currencies, the principal for both payments is in the same currency.
- Quanto swaps are useful to investors who believe a particular asset will perform well in a certain country, but the country’s currency will not.
- Quanto swaps can use fixed or floating interest rates. A fixed-for-floating swap has slightly higher risk but reduces foreign exchange risks.
Understanding a Quanto Swap
Though quanto swaps deal with two different currencies, payments are settled in just one. For example, a possible quanto swap would involve a U.S. investor paying six-month LIBOR in U.S. dollars for a $1 million loan, and receiving payments in U.S. dollars at the six-month EURIBOR + 75 basis points.
Fixed-for-floating quanto swaps allow an investor to minimize foreign exchange risk. This is achieved by fixing both the exchange rate and interest rate simultaneously.
Floating-for-floating swaps carry a slightly higher risk. In this cross-currency swap, each party is exposed to the interest rate spread of each country’s currency.
Benefits of Quanto Swaps
Investors use quanto swaps when they believe a particular asset will perform well in a specific country but fear the country’s currency performance. Thus, the investor swaps interest rates while keeping payouts in their home currency, separating interest rate risk from exchange rate risk.
In a typical interest rate swap, two counterparties exchange one stream of future interest payments for another, based on a specific principal amount. These swaps require exchanging a fixed interest rate for a floating rate value to adjust exposure to interest rate changes. They can also help obtain a slightly lower interest rate than would be possible without the swap.
For an investor in a different country wishing to engage in a swap in the U.S. market, they must exchange their asset from their home currency into U.S. dollars, making payments in U.S. dollars that must then be transferred back into their home currency. This strategy involves potential interest rate risk depending on whether the foreign investor receives floating-rate payments, creating foreign exchange risk. A quanto swap solves this problem by fixing all future exchange rates at the time of the swap contract.
Quanto swaps can exchange a fixed interest rate for a floating interest rate, or they can swap between two floating rates. This is riskier than a fixed-for-floating swap.
Requirements for a Quanto Swap
There are four essential considerations when trading a quanto swap:
- The notional value of the underlying asset, usually a loan, priced in the asset’s home currency.
- The index rates of the two currencies, which can be fixed or floating. One rate represents the home currency’s interest rate, the other represents the international currency used to settle the transaction.
- The date of maturity when the underlying loan or obligation comes due.
- The type of derivative instrument used (e.g., swaps, options, futures, CDS).
Example of a Quanto Swap
Imagine a European company borrows $1 million to fund operations in the United States, to be repaid over five years with interest based on the 3-month SOFR rate. Currently, SOFR is 5%, but EURIBOR is only 1%.
Suppose the company expects U.S. rates to increase relative to European interest rates. In that case, they would prefer exchanging the SOFR-based interest payments for a EURIBOR-based rate.
The company would try to execute a quanto swap to replace their SOFR-based payments with an interest rate based on EURIBOR+4%, but continue to pay in dollars.
If the company predicts interest rates correctly, they will save money in the long run.
What Is a Quanto Credit Default Swap?
A quanto credit default swap is a credit default swap where the swap premium or cashflows are paid in a different currency than the underlying asset. These are useful for international investors wanting exposure to a CDS in another country while reducing their exposure to exchange rate risk.
What Is a Quanto Option?
A quanto option is an options contract denominated in a different currency than the underlying asset. When the option matures, any payoff is received in foreign currency at a fixed exchange rate. This is useful for traders seeking exposure to foreign options markets without taking on exchange rate risk.
Is a Quanto Swap the Same as a Cross-Currency Swap?
A quanto swap is not the same as a cross-currency swap, although there are some similarities. A typical cross-currency swap involves two parties exchanging principal and cash flows in two different currencies, along with predetermined interest rates. In a quanto swap, one party pays another at a foreign interest rate, but using a local currency.
What Is Quanto Risk?
Quanto risk refers to the possibility of adverse changes in asset prices or exchange rates used in a quanto option or swap.
Related Terms: cross-currency swap, interest rate swap, credit default swap, quanto option.
References
- BookDown. “Quanto Options”.
- FINcyclopedia. “Quanto Risk”.
