ZHONG

Quanto Swap
Wei Zhong
I. I NTRODUCTION A quanto is a derivative security that involves two currencies. The payoff is dened in terms of a variable which is denominated in one currency and the actual delivery is made in another currency. For example, the CME futures contract on the Nikkei is dened in terms of Nikkei 255 index (which is measured in yen) and is settled in USD. A quanto swap is an interest rate swap with the oating leg xed to a foreign oating index. For example, a USD swap quanto EUR is a quanto swap agreement. The notional of this contract is in EUR. The xed payer pays periodically a xed amount in EUR to his counterparty. In return, the xed payer receives oating payments in EUR reset at the USD LIBOR rate. Hence, the xed leg of a quanto swap is nothing different from the xed leg of a vanilla interest rate swap; the oating leg of a quanto swap is different in the sense that its oating payoff is determined by a foreign index. Quanto swap allows investors to separate interest rate risk and foreign exchange risk. Let us suppose an investor in Europe speculates that USD LIBOR is going to move up faster and higher than the market implies. One thing he can do is to borrow cash in EUR, convert it into USD, and enter a vanilla swap denominated in USD as the receive-oating side. If the USD LIBOR rate behaves as he speculates, the investor will collect positive cash inows in USD. After the swap matures (and hopefully he has a lot of cash in USD now), the investor has to convert all his USD position into EUR because he is obliged to pay back his EUR loan. At that time, the investor has a full exposure to the FX risk because he has to take whatever spot FX rate is for the conversion. In this example, the investor incurs FX risk although he only wants to take positions in interest rate risk. Alternatively, the investor can enter a USD swap quanto EUR with borrowed EUR cash. The quanto swap contract settles in EUR and the payoff from his oating leg is linked to USD LIBOR. This way, the investor is immune from FX risk and only bears interest rate risk (which is exactly what he wants). In this article, we will show that if interest rate risk and FX risk are independent, the above two scenarios will cost the investor exactly the same. However, if the two risks are dependent on each other, it may cost the investor more or less for him to enter the quanto swap contract. The development of this article is as following. We explain the notations in Section II. We then show the valuation of a quanto swap with exactly one cashow exchange in Section III. II. N OTATIONS A quanto receive swap contract can be regarded as a portfolio of two securities: a short position in a xed leg and a long position in a quanto oating leg. Let K denote the xed rate, which is also dened as the quanto swap rate. Let Lf lt (s, T ) denote the foreign oating rate that applies to the period between s and T . Lf lt (s, T ) is usually xed on s1 . Let F (t, T ) be the forward rate of Lf lt (s, T ) observed at t. We use (s, T ) to denote day count fraction for the accrue period between s and T . We will simply write if it does not cause confusion in the context. We let DU SD (T ) denote the discount factor stripped from todays USD curve that applies to a receivable in USD at T valuated today. DU SD (T ) is determined by todays curve and not random. We should also write rU SD (t) as the short rate at t. We also denote the spot foreign exchange rate at T as S(T ) and the forward FX rate observed at t as S(t, T ). For the later development in this article, we always use t = 0 to denote the time for today. III. VALUATION A swap is a series of cashow exchange. Its value is the sum of all the discounted cashows. To valuate a quanto swap, it sufces to valuate one of the cashows and we can apply the same technique to other cashows. Consider a USD swap quanto EUR that only has one cashow. As the xed payer, the value of the outgoing cashow denominated in EUR is simply Vf ix = NEU R K(t0 , T ) At T , the xed payer receives a oating payment in EUR determined by the USD LIBOR rate Vf lt = NEU R L(t0 , T )(t0 , T ) (2) (1)

We use dynamic hedging technique to determine the pricing of the quanto swap. We show that it is possible to dynamically adjust a position in the vanilla interest rate swap in USD to perfectly hedge a short position of the quanto swap. The price of the quanto swap is thus simply the total hedging cost.
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precisely, n business days before s if the contract is using a T + n convention. n is typically 2 within the US.

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At T , the seller of the quanto swap, i.e. the xed receiver, is paying exactly NEU R L(t0 , T )(t0 , T ) and receiving NEU R K(t0 , T ). In order to replicate the payoff of his outgoing cashow, he enters a vanilla interest rate swap in USD on the receive-oating side with a notional of NU SD (0) = NEU R S(0, T ) This swap costs him zero to enter and will give him exactly NU SD (0)(L(t0 , T ) F (0, T ))(t0 , T ) at T . If S(t, T ) does not change over time t, i.e. it has a zero volatility, we do not need to adjust our position in the USD swap. At T , we will convert our receivable NU SD (0)(L(t0 , T ) F (0, T ))(t0 , T ) into EUR, which leads to NEU R (L(t0 , T ) F (0, T ))(t0 , T ). After paying NEU R L(t0 , T )(t0 , T ) to the xed payer in the quanto swap contract and receiving NEU R K(t0 , T ), we are left with exactly NEU R (K F (0, T ))(t0 , T ). In this case, K = F (0, T ) will make the original quanto swap worth zero to enter for either party because thus the quanto sellers short position will be perfectly hedged regardless the USD LIBOR rate; hence, the quanto swap rate (also the value of the quanto swap) is simply the forward rate F (0, T ). In reality, the forward exchange rate S(t, T ) is stochastic. We assume S(t, T ) and F (t, T ) follow geometric brownian motion with correlation (t) as follows. dS(t, T ) = s (t, T )S(t, T )dWs (t) dF (t, T ) = f (t, T )F (t, T )dWf (t) dWs (t)dWf (t) = (t)s (t, T )f (t, T )dt At any time t, we need to adjust our position in the USD vanilla swap with a new notional NU SD (t) = NEU R S(t, T ) The resulting position of the oating side at t has value (in USD) H(t) = NU SD (t)(t0 , T )F (t, T ) = NEU R (t0 , T )S(t, T )F (t, T ) (7) (6) (3) (4) (5)

At T , forward values in above equation S(t, T ) and F (t, T ) become spot values S(T ) and L(t0 , T ). Thus the payoff of H(T ) at T perfectly hedges the short position in the quanto swap oating leg as described above. Hence, H(t) can be thought of as the time-t price of the quanto oating leg. Note that H(t) is not necessarily a martingale due to the correlation between F (t, T ) and (S(t, T ). Hence we cannot simply use H(0) for todays price of the quanto oating leg. This dynamic adjustment requires us to continuously enter (or close) a new par USD swap with notional dNU SD (t) = NEU R dS(t, T ) The value change of H(t) is coming from two factors, dS (dNU SD ) and dF . dH(t) = = = = [(dNU SD (t) + NU SD (t))(F (t, T ) + dF (t, T )) NU SD (t)F (t, T )] NEU R [dS(t, T )F (t, T ) + S(t, T )dF (t, T ) + dS(t, T )dF (t, T )] NEU R F (t, T )S(t, T )[s (t)dWs (t) + f (t)dWf (t) + (t)s (t, T )f (t, T )dt] H(t)[s (t)dWs (t) + f (t)dWf (t) + (t)s (t, T )f (t, T )dt] (8)

(9)

From here on, we assume the volatilities and correlation are constants, i.e. s (t, T ) = s , f (t, T ) = f , and (t) = . The above equation reduces to dH(t) = H(t)[s dWs (t) + f dWf (t) + s f dt] (10)

Let G(t) = ln(H(t)). According to Itos Lemma, the SDE of G can be written as dG G 1 2G dH + dH 2 H 2 H 2 1 1 2 2 = H[s dWs (t) + f dWf (t) + s f dt] H 2 [s dt + f dt + 2s f dt] H 2H 2 1 2 2 = s dWs + f dWf (s + f )dt 2 =

(11)

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The terminal value G(T ) is stochastic and so is H(T ): G(T ) H(T ) = G(0) +
2 2 T (s + f + 2s f )X

T 2 2 ( + f ) 2 s

(12) T 2 2 2 2 = H(0)exp( T (s + f + 2s f )X (s + f )) (13) 2 where X is the standard normal variable with mean zero and unit variance. To receive H(T ) at T from the USD swap, we are obliged to pay back a xed amount for each dNU SD (t) USD swap we enter. The present value of our total payments at T as the xed-payer in all these swap contracts is EU SD [H(T )e 0 U SD ] in the risk-neutral world. This is also the present value of the hedging cost and we must be compensated this much in order to perfectly hedge our short quanto oating leg position. We can convert the above present value of total hedging cost into EUR denomination and get its present value in EUR as
0 EU SD [H(T )e S(0) T rU SD (t)dt

= exp(G(T ))

(t)dt

. Assuming H(T ) are independent of e P VU SD

T 0 T

rU SD (t)dt

, we have

= EU SD [H(T )]e 0 U SD = NEU R S(0, T )F (0, T )es f T DU SD (T ) P VU SD S0 = NEU R S(0, T )F (0, T )es f T DU SD (T )/S0 = NEU R F (0, T )es f T DEU R (T )

(t)dt

(14)

and P VEU R =

(15)

Hence, to valuate the quanto oating leg that pays EUR based on the USD LIBOR rate, we can use the forward USD LIBOR rate and apply a convexity correction term es f T . This term is sometimes referred to as quanto adjustment. The quanto swap rate K is simply the value that makes the quanto swap contract worth zero, which is K = F (0, T )es f T For the special case = 0, we have K = F (0, T ). Instead of entering the quanto swap, the invester may convert his EUR cash into USD, enter a vanilla USD swap with strike F (0, T ), and convert all his USD back into EUR after the swap matures. The present value for this alternative is exactly the same as the quanto swap. Note that in this section, we are valuating a quanto swap with only one cashow exchange. For multiple cashow exchanges, we need to apply quanto adjustment to each oating payment and the volatilities and correlation may not be the same across different payment dates, due to the term structure of volatilities and correlation.