A currency risk that is embedded in an option contract whose underlying is denominated in a currency other than that of the payoff currency. This type of risk (a quanto risk) arises when the two parties to an option contract agree to record/ report the transaction in a different currency (the reference currency against the base currency). Therefore, it is associated with changes in exchange rates that impact the reported value of the transaction over the term of the option.
In a corresponding context, quanto risk refers to the currency risk that relate to the need to translate the value of a currency option position in a currency other than the original currency (the base currency).
Yet in another different context, quanto risk is also known as a currency correlation risk– that is, the risk inherent in cross-currency investments/ positions where the correlation between investment/ position returns and exchange rates impact the performance and outcomes of the entire investment/ position. A correlation coefficient is established an a key input in valuation of such investments/ positions.
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