Quanto Swap
Candlefocus EditorThe main feature of a quanto swap is that, although the payments reference exchange rates in two different currencies, the principal for both payments is in the same currency. In other words, one counterparty will pay an amount denominated in the domestic currency, and the other counterparty will receive that same amount denominated in the foreign currency. This allows the parties to manage their foreign exchange risk without having to actually trade the currency itself.
One of the most common types of quanto swaps is a fixed-for-floating swap. Here, one side agrees to pay a fixed rate of interest while the other agrees to pay a floating rate of interest. While these swaps tend to be slightly more risky than regular derivatives, the currency exchange risks are completely eliminated, making them attractive to those who believe an asset will do well in a certain country but that country's currency is weak.
Quanto swaps are generally used by large investors such as hedge funds, pension funds, and other institutional investors, although retail traders can also take advantage of quanot swaps to protect their portfolios from foreign-exchange fluctuations. Quanto swaps are becoming increasingly popular as a way to reduce risk and speculate on the currency markets. In general, quanot swaps can be used as a form of hedging, as a means of speculation, or as a way to arbitrage the interest rate differentials between currencies.