An option (particularly a currency-protected option) whose underlying asset is measured in one currency and the payoff is quoted in another currency. For example, a quanto call holder would have the right to buy a foreign stock and convert its payoff into local currency at a predetermined exchange rate. In pricing this type of options, in addition to the main factors used as inputs in option pricing models, the exchange rate should be determined in the contract and taken into account in price computation.
Furthermore, and in addition to the volatility of the underlying asset price, another type of volatility should be considered, literally: that of the exchange rate. Also, an important input in the quanto option pricing is the extent of correlation between the underling asset price and the exchange price. In fact, this kind of options is usually used when investors are certain of the underlying asset’s performance, but are skeptic or unsure about the performance of the currency in which the underlying asset is denominated.
“Quanto” is an Italian word for quantum or amount.
Quanto options, also known as quantoed options or guaranteed exchange rate options, are basically classified as quanto calls and quanto puts.
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