This guide introduces quanto options, and provides a pricing spreadsheet. Quantos are options that hedge against exchange rate risk. Typical examples are Nikkei index warrants.
Quanto options are priced in one currency but pay out in another. They are used when an investor is confident that trading a derivative in another country will be profitable, but want to be shielded from exchange rate volatility.
The exchange rate protection is provided by an exchange rate forward with a variable notional amount within their structure. The exchange rate is fixed at the start of the contract. The holder pays a premium for this protection.
The name “quanto” is, in fact, derived from the variable notional amount, and is short for “quantity adjusting option”.
Quantos have their underlying asset and strike price denominated in a foreign currency. Pricing quanto options requires that the underlying asset, the exchange rate, and the correlation between the two, is modeled.
Pricing Quantos in Excel
This Excel spreadsheet prices fixed exchange rate quanto options.
The analytical equations were taken from this reference: Derman, Karasinski & Wecker (1990), “Understanding Guaranteed Exchange-Rate Contracts in Foreign Stock Investments”, Goldman Sachs.