What it means
In an ordinary interest rate swap, two parties swap a fixed rate for a floating rate, both in the same currency. A quanto swap changes one detail: the floating rate comes from a foreign market, but the cash is paid in the home currency.
The notional (the reference amount on which interest is calculated) is never exchanged, only the interest difference is. This is useful when an investor believes foreign rates will move differently from domestic rates but does not want currency exposure.
Without the quanto feature, the investor would receive interest in a foreign currency and would have to convert it at an unknown future rate. With it, the conversion is already locked.
Quanto swaps are sometimes called differential swaps, or diff swaps, because the cash flows depend on the difference between two floating rates. One leg might pay a domestic floating rate while the other leg pays a foreign floating rate, with both applied to the same domestic notional.
The net payment is then the rate gap multiplied by the notional and the time period. Pricing needs care because the fixed exchange rate is not the same as the market forward rate.
The dealer adjusts the foreign rate to reflect the correlation between that rate and the exchange rate, along with volatility in both. This adjustment is often called a quanto adjustment, and it can be material for long-dated swaps.
The risks are different from those of a plain swap. The holder avoids exchange rate movement on the payout but still faces interest rate risk, credit risk on the other party, and the chance that the pricing adjustment moves against them.
These swaps are traded over the counter, so terms vary and documentation should be read closely.
In practice
Real-world examples.
Example
A US insurance company expects interest rates in another economy to stay higher than its own for several years. It enters a quanto swap that pays a dollar fixed rate and receives the foreign floating rate on a dollar notional. Its net cash flow arrives in dollars each period, which suits its reporting.
Example
A technology exporter with a floating-rate dollar loan wants some benefit if foreign rates fall faster than domestic ones. A bank structures a quanto swap that adjusts its payments based on the gap between the two rates. The company's treasury team gets monthly statements showing the net amount in dollars.
Example
A multi-currency fund uses a quanto swap to express a view on the direction of foreign short-term rates without a currency hedge. The fund's risk manager sets a limit on the notional so one wrong view cannot damage the fund. The position is reviewed whenever correlations between rates and currencies change.
Formula
Calculation
Net payment per period = domestic notional x (foreign floating rate - domestic rate) x fraction of the year
Suppose a company has a domestic notional of $10,000,000 and enters a quanto swap, receiving a foreign floating rate and paying a fixed domestic rate of 2.5%. For a six-month period the foreign floating rate is reset at 3.0%.
Step 1: rate gap = 3.0% - 2.5% = 0.5%.
Step 2: fraction of the year = 6 / 12 = 0.5.
Step 3: net payment = $10,000,000 x 0.005 x 0.5 = $25,000.
The $25,000 is paid in dollars with no currency conversion at the time, because the exchange rate was fixed in the contract.Case study
Seen in the real world.
Meridian Freight is a fictional shipping group that borrowed in dollars but earned part of its revenue in another currency. Its illustrative treasurer was convinced that foreign short-term rates would fall faster than dollar rates and wanted to benefit without taking currency risk on the proceeds. A bank offered a quanto swap on a $20,000,000 notional.
Over the first year the foreign rate did fall, and the swap paid a small net amount in dollars each period. The treasurer noticed, however, that the dealer's pricing included a quanto adjustment that reduced the benefit compared with an unadjusted forward rate. The board concluded that the swap had worked as intended, but that the adjustment should have been explained at the start.
Watch out
Common mistakes.
- Believing a quanto swap has no currency risk at all. The payout currency is fixed, but the pricing still depends on the relationship between interest rates and the exchange rate.
- Assuming the notional is exchanged. In a quanto swap only the net interest difference is paid, so the notional is just a reference amount.
- Ignoring the quanto adjustment when comparing quotes. Two dealers can quote different effective rates, so the adjustment must be asked about directly.
Questions
People also ask.
What is another name for a quanto swap?
It is often called a differential swap or diff swap, because payments depend on the difference between two floating rates.
Is a quanto swap the same as a cross-currency swap?
No, a cross-currency swap exchanges principal and interest in two currencies, while a quanto swap pays only in one currency.
Who uses quanto swaps?
Banks, funds, insurers and corporate treasurers who want exposure to foreign interest rates paid in their home currency.
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