Quanto Options

Uwe Wystup MathFinance AG Waldems, Germany www.mathfinance.com 19 September 2008

.1 FX Quanto Drift Adjustment . . . . . . . we let EUR be the numeraire or domestic or base currency and consider a Black-Scholes model (3) (3) (3) (3) XAU-EUR: dSt = (rEU R − rXAU )St dt + σ3 St dWt . which is EUR in this case. . . . . . . . .Contents 1 Quanto Options 1. The actual underlying is then (3) St (1) XAU-USD: St = (2) . . . . . . . . . . where we use a minus sign in front of the correlation. . . . .1. . . . . . . . . Since the payoff is in EUR. . . . . . . . . . . . . . . 1. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1. Foreign exchange market terminology. . . . . . (2) rU SD )St (1) (2) (3) (2) USD-EUR: dSt (3) (2) dWt dWt dt + (2) σ2 St (2) dWt . . .6. . . (4) St Using Itˆ’s formula. . . . . 1. . . . .5 Hedging of Quanto Options . 2 2 4 5 5 6 6 7 8 9 1 Quanto Options A quanto option can be any cash-settled option. . . . . . . . . There can be quanto plain vanilla. .5. allow the computation of option values. . . etc. . . . . . we first obtain o . . . whose payoff is converted into a third currency at maturity at a pre-specified rate. .4 Quanto Digital . . . . Option pricing: general principles. . . . . .1 Extensions to other Models . . . .2 Quanto Vanilla . . . . . . called the quanto factor. . . . . . The Arbitrage pricing theory and the Fundamental theorem of asset pricing. . . . . . . . . . . . 1. . . . . . . . . . . .1 Performance Linked Deposits . . . . . . . also covered for example in [3] and [2]. . . . . quanto barriers. . . . . .3 Quanto Forward . . . . . . . . . quanto corridors. . . . . . . . . . . 1. . The scenario is displayed in Figure 1. . . . . . . 1. . . . . . . . . . . . Other references: Options: basic definitions. . . . . . . . .1 FX Quanto Drift Adjustment We take the example of a Gold contract with underlying XAU/USD in XAU-USD quotation that is quantoed into EUR. . = (rEU R − = −ρ23 dt. .6 Applications .1 Vega Positions of Quanto Plain Vanilla Options 1. . . quanto forward starts. because both S (3) and S (2) have the same base currency (DOM). . . . . 1. . . . . . . 1. . .

d 1 (2) St = − 1 1 (2) · 2 · (2) (dSt )2 2 (St )3 1 1 (2) 2 = (rU SD − rEU R + σ2 ) (2) dt − σ2 (2) dWt .Quanto Options 3 XAU σ3 ϕ 23 π − ϕ 23 EUR σ1 ϕ12 π − ϕ12 σ2 USD Figure 1: XAU-USD-EUR FX Quanto Triangle. The arrows point in the direction of the respective base currencies. St St (2) (St )2 1 dSt + (2) (5) . if the base currency (DOM) of S (i) is the underlying currency (FOR) of S (j) . The cosine of the angles cos φij = ρij represents the correlation of the currency pairs S (i) and S (j) . The length of the edges represents the volatility. then the correlation is denoted by −ρij = cos(π − φij ). If both S (i) and S (j) have the same base currency (DOM).

1. However. accounting for smile effects is important in real market scenarios. 1 Since St is a geometric Brownian motion with volatility σ1 . one could. (1) (1) (1) (10) This is the Risk Neutral Pricing process that can be used for the valuation of any derivative (1) depending on St which is quantoed into EUR. we obtain the usual formula for the drift adjustment dSt (1) = (rU SD − rXAU − ρσ1 σ2 )St dt + σ1 St dWt . in [1]. (9) As explained in the currency triangle in Figure 1. ρ12 is the correlation between XAU-USD and ∆ USD-EUR. This would still allow to use the previous result. Inserting this into Equation (6). 2 2 2 σ1 = σ2 + σ3 + 2ρ23 σ2 σ3 . Nevertheless. . (7) (8) which yields 2 σ2 + ρ23 σ2 σ3 = ρ12 σ1 σ2 . To do this. 1. (1) (1) (1) (6) Now Figure 1 and the law of cosine imply 2 2 2 σ3 = σ1 + σ2 − 2ρ12 σ1 σ2 . capture the smile for a multi-currency model with a weighted Monte Carlo technique as described by Avellaneda et al.4 and hence dSt (1) Wystup = = = (1) 1 1 (3) (3) (3) dSt + St d (2) + dSt d (2) (2) St St St (3) (3) S St (3) (r − rXAU ) dt + t(2) σ3 dWt (2) EU R St St (3) (3) (3) S S S (2) 2 + t(2) (rU SD − rEU R + σ2 ) dt − t(2) σ2 dWt + t(2) ρ23 σ2 σ3 dt St St St (1) (1) (3) (2) 2 (rU SD − rXAU + σ2 + ρ23 σ2 σ3 )St dt + St (σ3 dWt − σ2 dWt ). See Foreign exchange smile: conventions and empirical facts and Foreign exchange smile modeling for details.1 Extensions to other Models The previous derivation can be extended to the case of term-structure of volatility and correlation. whence ρ = −ρ12 is the correlation between XAU-USD and EUR-USD. we introduce a new Brownian (1) motion Wt and find dSt (1) 2 = (rU SD − rXAU + σ2 + ρ23 σ2 σ3 )St dt + σ1 St dWt . introduction of volatility smile would distort the relationships. for example.

˜ σ ∆ (12) be the adjusted drift. T the expiration time.Quanto Options 5 1. (17) This follows from the vanilla quanto value formula by taking both the normal probabilities to be one. φ the usual long-short indicator. σ = σ1 the volatility of this currency pair. Since a forward contract is always exercised. Furthermore we let rQ be the risk free rate of the quanto currency. (16) where K denotes the strike.2 Quanto Vanilla Common among Foreign exchange options is a quanto plain vanilla paying Q[φ(ST − K)]+ .3 Quanto Forward Similarly. we can easily determine the value of a quanto forward paying Q[φ(ST − K)]. . With the same principles as in Pricing formulae for foreign exchange options we can derive the formula for the value as ρ= ˜ v = Qe−rQ T φ[S0 eµT N (φd+ ) − KN (φd− )]. (14) S0 1 2 ln K + µ ± 2 σ T ˜ √ . T the expiration time. both these probabilities must be equal to one. Then the formula for the value can be written as ˜ v = Qe−rQ T φ[S0 eµT − K]. S the underlying in FOR-DOM quotation and Q the quanto factor from the domestic currency into the quanto currency. φ the usual put-call indicator taking the value +1 for a call and −1 for a put. 1. (15) d± = σ T where N denotes the cumulative standard normal distribution function and n its density. where rd and rf denote the risk free rates of the domestic and foreign underlying currency pair respectively. S the underlying in FOR-DOM quotation and Q the quanto factor from the domestic currency into the quanto currency. σ = σ2 the ˜ volatility of the currency pair DOM-QUANTO and 2 σ3 − σ 2 − σ 2 ˜ (13) 2σ˜ σ the correlation between the currency pairs FOR-DOM and DOM-QUANTO in this quotation. We let µ = rd − rf − ρσ˜ . These normal probabilities are exercise probabilities under some measure. (11) where K denotes the strike.

55%. USD rate 2.000 EUR if at maturity. JPY rate 0. The valuation of European style quanto digitals follows the same principle as in the quanto vanilla option case. 1.5 Hedging of Quanto Options Hedging of quanto options can be done by running a multi-currency options book.65 USD-JPY 71. Notional Maturity European style Barrier Theoretical value Fixing source 100. EUR rate 4%. An exception is the correlation risk. USD-JPY ATM vol 8.1%. In FX the correlation risk can be translated into a vega position as shown in [4] or in the section on Foreign exchange basket options. The buyer receives 100. . EUR-JPY ATM vol 6.60. The value is v = Qe−rQ T N (φd− ). φ takes the values +1 for a digital call and −1 for a digital put. the ECB fixing for USD-JPY (computed via EUR-JPY and EUR-USD) is below 108.555 EUR ECB Table 1: Example of a quanto digital put. We illustrate this approach for quanto plain vanilla options now. which can only be hedged with other derivatives depending on the same correlation. This is normally not possible. All the usual Greeks can be hedged.5%.6 Wystup 1.99% (corresponding to a correlation of -27. (19) We provide an example of European style digital put in USD/JPY quanto into EUR in Table 1. Delta hedging is done by trading in the underlying spot market.89% for USD-JPY against JPY-EUR).000 EUR 3 months (92days) 108. and Q is the pre-specified conversion rate from the domestic to the quanto currency.4 Quanto Digital A European style quanto digital pays QI {φST ≥φK} . Terms were created on Jan 12 2004 with the following market data: USD-JPY spot ref 106.65. EUR-USD ATM vol 10.69%. ST the spot of the currency pair FOR-DOM at maturity T . I (18) where K denotes the strike.

The FOR-DOM vega is smaller than the corresponding vanilla vega in case of a call and positive correlation or put and negative correlation. that dominating vega risk comes from the FOR-DOM pair. Therefore. independent of ˜ each other. Similar statements would apply for quantoed stocks or stock indices. σ µ = −QS0 e(˜−rQ )T φN (φd+ )ρσT. whence most of the risk can be hedged.1 Vega Positions of Quanto Plain Vanilla Options 7 Starting from Equation (14). there is no liquid vanilla market in XAU-EUR. depending on what is more likely to be known. σ = ∂v ∂ρ ∂ρ ∂σ3 ∂v σ3 = ∂ρ σ˜ σ µ = −QS0 e(˜−rQ )T φN (φd+ )σ˜ T σ µ = −QS0 e(˜−rQ )T φN (φd+ )σ3 T µ = −QS0 e(˜−rQ )T φN (φd+ ) σ 2 + σ 2 + 2ρσ˜ T. This shows exactly how the three vega positions can be hedged with plain vanilla options in all three legs. The third independent risk is either σ3 or ρ. µ = −QS0 e(˜−rQ )T φN (φd+ )σ˜ T. larger in case of a put and positive correlation or call and negative correlation. (20) The understanding of these Greeks is that σ and σ are both risky parameters. we obtain the sensitivities ∂v ∂σ ∂v ∂σ ˜ ∂v ∂ρ ∂v ∂σ3 √ µ = QS0 e(˜−rQ )T n(d+ ) T − φN (φd+ )ρ˜ T . However. in FX. however. where we notice. ˜ σ σ3 σ˜ σ Note that the computation is standard calculus and repeatedly using the identity ˜ S0 eµT n(φd+ ) = Kn(φd− ). provided there is a liquid vanilla options market in all three legs. The signs of the vega positions are not uniquely determined in all legs. the correlation risk remains unhedgeable.Quanto Options 1. there are situations with all legs being hedgeable. The DOM-Q vega takes the sign of the correlation in case of a call and its opposite sign in case of a put.5. In the example with XAU-USD-EUR the currency pairs XAU-USD and EUR-USD are traded. for instance EUR-USD-JPY. We provide an example of pricing and vega hedging scenario in Table 2. The FOR-Q vega takes the opposite sign of the put-call indicator φ. .

00% 12.00% 25.6994 800.8 data set 1 FX pair spot strike quanto volatility quanto volatility correlation domestic interest rate foreign interest rate quanto currency rate time in years 1=call -1=put quanto vanilla option quanto vanilla option quanto vanilla option quanto vanilla option quanto vanilla option quanto vanilla option vanilla option vanilla option FOR-DOM FOR-DOM FOR-DOM DOM-Q FOR-DOM DOM-Q FOR-DOM – DOM-Q DOM FOR Q T FOR value vega FOR-DOM vega DOM-Q vega FOR-Q correlation risk vol FOR-Q value vega data set 2 Wystup data set 3 XAU-USD XAU-USD XAU-USD 800.0000% 0.00% 2.34207 8. . we need a quanto product.81329 298. Naturally.50661 17. and the exchange rate risk is with the seller.00% -75.0000 10.0000% 32.6657 316.47953 4.0000 10.5000% 4.00% 25.0000% 1 1 30.00 1.6994 Table 2: Example of a quanto plain vanilla.0000 10. Any time the performance of an underlying asset needs to be converted into the notional currency invested.4356% 30.5000% 4.14188 -10.83387 17.38797 -35.00% 12.00 810. 1.4356% 32.6657 316.07056 -70.0000% 1 1 35.6994 800.7635 316.28625 321.90062 350.00 810.38877 65.0000% 0.14600 33.00% 2.23447 -4.00 810.61383 -5.00% 2.0000% 1 -1 31.49308 9.00 1.5000% 4.6 Applications The standard application are performance linked deposit or performance notes as in [5].0000% 0.00% 12.00 1.

in addition to the minimum coupon. the investor buys a EUR call GBP put with strike K = S0 and notional N = pA GBP or N = pA/S0 EUR. 1.a. ˆ The investor buys a EUR call GBP put with strike 0. ˆ The investor receives a minimum payment of 24.Quanto Options 9 an underlying like gold. such as 50% or 25%.5 Million GBP.275% p.677. strike K and notional N in EUR.863.6.1 Performance Linked Deposits A performance linked deposit is a deposit with a participation in an underlying market. where the investor is protected against negative returns. For a weakly bullish view an alternative would be to buy an up-and-out call with barrier at 0.11 GBP.0% and a EUR rate of 2.01 GBP at the maturity date. We consider the example shown in Table 3.7200. The notional is often a percentage p of the deposit amount A. the investor gets a coupon of p · 10% p. so this product is advisable for a very strong EUR bullish view.a. when the investment is in a currency other than USD.a. 0] .275% p..51 GBP. would be a default candidate for a quanto product. The strike is often chosen to be the current spot.931. ˆ The offer price of the call is 26. . The break-even point is at 0.7000 and with notional 1. (21) p· S0 which is the return of the exchange rate viewed as an asset.a.7467. These parameters have to be chosen in such a way that the offer price of the EUR call equals the money market interest rate plus the sales margin.8571% p.7400 and 75% participation. which would lead to a total coupon of 6. Thus. The annual coupon paid to the investor is then a pre-defined minimum coupon plus the participation max[ST − S0 . the additional coupon would be 0. The standard is that a GBP investor waives her coupon that the money market would pay and instead buys a EUR-GBP call with the same maturity date as the coupon. assuming a volatility of 8. In this case. if the EUR-GBP spot fixing is 0. which is quoted in USD. Example.7399 with an additional coupon of 4. obviously.73 GBP. where we would find the best case to be 0. So. ˆ The deferred premium is 24. if the EUR goes up by 10% against the GBP.220. Composition ˆ From the money market we get 49.50%.

Of course. however. Note that in GBP the daycount convention in the money market is act/365 rather than act/360. which is quoted in FOR-DOM (foreign-domestic).10 Notional Start date Maturity Number of days Money market reference rate EUR-GBP spot reference Minimum rate Additional coupon ST Fixing source 5. But here.00% act/365 30% · 100 max[ST −0.0] 0.7000. ˆ Note that the option the investor is buying must be cash-settled. Variations. For a participation in a downward trend. this payoff can be converted into the foreign currency (EUR) at maturity.40 GBP (awfully poor I admit). one can think of European style knock-out calls or window-barrier calls. but at what rate? If we convert at rate ST . where the investor is paid 30% of the EUR-GBP return. ˆ Subtracting the deferred premium and the minimum payment from the money market leaves a sales margin of 254. Of course. then the investor buys a vanilla EUR call. which is what we could do in the spot market at no cost.7000 Wystup act/365 EUR-GBP fixing on 31 August 2005 (88 days) ECB Table 3: Example of a performance linked deposit.7000 2. is the deposit currency being different from the domestic currency of the exchange rate. What is the problem? The payoff of the EUR call USD put [ST − K]+ (22) is in domestic currency (USD). There are many variations of the performance linked notes. the investor can buy puts. the investor receives a coupon given by .000. So if we have a EUR investor who wishes to participate in a EUR-USD movement.000 GBP 3 June 2005 2 September 2005 (91 days) 91 4.00% act/365 0. One of the frequent issues in Foreign Exchange. we have a problem. meaning how many units of domestic currency are required to buy one unit of foreign currency. the usual quanto confusion that can drive anybody up the wall in FX at various occasions.

C. a EUR call USD put. Buff. ST (23) If the investor wishes to have performance of Equation (21) rather than Equation (23). who wishes to participate in the gold price.. International Journal of Theoretical and Applied Finance. pp. (2001). 91-119. Stochastic Calculus for Finance I+II. Kruk. so the investor needs to buy a XAU call USD put quantoed into EUR. this implicitly means that we must use a quanto plain vanilla with a quanto factor of 1.0000. 1. August 2001. . R. M. This self quanto vanilla can be valued by inverting the exchange rate. London 2002. then the payoff at maturity is converted at a rate of 1. This way the valuation can incorporate the smile of EUR-USD. where the coupon is paid in EUR. London. Risk Publications. i. where the payoff in USD is converted into EUR at a rate of 1. i. cash-settled in EUR. and Wystup. S. L. (2006). vol 4. Grandechamp. j. Risk Publications. Wilmott Research Report. So the investor is promised a coupon as in Equation (21) for a XAU-USD underlying. Foreign Exchange Risk. [2] Hakala. 0] .0000.e..e. and the vanilla is actually a self-quanto vanilla. U. J. and Newman. A typical situation is a EUR investor. (2002).Quanto Options 11 p· max[ST − S0 . Also in Foreign Exchange Risk. FX Options and Structured Products.0000 into EUR. [3] Shreve.. looking at USD-EUR. Friedman. This is the quanto factor. No. (2004). (2001). References [1] Avellaneda. Weighted Monte Carlo: A new Technique for Calibrating AssetPricing Models. [4] Wystup.E. U. [5] Wystup. which is measured in USD. Wiley Finance Series. Similar considerations need to be taken into account if the currency pair to participate in does not contain the deposit currency at all. and this rate is set at the beginning of the trade. N. Springer... U.. How the Greeks would have hedged Correlation Risk of Foreign Exchange Options.

10 vega. 5 options. 8 quanto quanto quanto quanto quanto quanto quanto digital. quanto plain vanilla. 2 plain vanilla. 5 currency triangle. 4 self-quanto. 8 vanilla.Index correlation. 6 12 . FX. 4 law of cosine. 2 factor. 6 drift adjustment. 4 performance linked deposit. 2 forward.