what is a quanto swap 
a quanto swap is a cash settled cross currency interest rate swap where one of the counterparties pays a foreign interest rate to the other the notional amount is denominated in the domestic currency interest rates may be fixed or floating because they depend on the currency exchange rate and differences in interest rates in those currencies they are also known as differential rate differential or just diff swaps another name for these swaps could also be guaranteed exchange rate swap because they naturally embed a fixed currency exchange rate in the swap contract understanding a quanto swapthough quanto swaps deal with two different currencies payments are settled in just one for example a possible quanto swap would involve a u s investor paying six month libor in u s dollars for a us 1 million loan and receive in return payments in u s dollars at the six month euribor 75 basis points fixed for floating quanto swaps allow an investor to minimize foreign exchange risk this avoidance of risk is achieved by fixing both the exchange rate and interest rate at the same time floating for floating swaps have a slightly higher risk in this cross currency swap exposure of each party to the spread of each country s currency interest rate happens quanto swaps and options are useful for investors who want exposure to a foreign market but not foreign exchange risk benefits of quanto swapsinvestors will use quanto swaps when they believe that a particular asset will do well in a country but at the same time fear that the country s currency will not perform as well thus the investor will swap the interest rates with another investor while keeping the payout in their home currency in this way they can separate interest rate risk from exchange rate risk in a typical interest rate swap two agreeable counterparties exchange one stream of future interest payments for another with a basis of a specific principal amount these swaps require the exchange of a fixed interest rate value for a floating rate value the swap may be in either direction but is built to reduce or to increase exposure to the changes in interest rates an interest rate swap may also help obtain a marginally lower interest rate than would have been possible without the swap however for an investor in a different country wishing to engage in a swap in the u s market they first would have to exchange their asset from their home currency into u s dollars each payment is made in u s dollars which the foreign investor must then transfer back into their home currency this strategy will involve potential interest rate risk depending on whether the foreign investor receives floating rate payments it also creates a foreign exchange or currency risk a quanto swap solves this problem because all future exchange rates are fixed at the time of the swap contract writing quanto swaps can exchange a fixed interest rate for a floating interest rate or they can swap between two floating rates this is slightly riskier than a fixed for floating swap requirements for a quanto swapthere are four important considerations when trading a quanto swap the first is the notional value of the underlying asset usually a loan this value is priced in the asset s home currency the second two figures are the index rates of the two currencies which can be fixed or floating one rate represents the interest rate of the home currency the other represents the international currency that is used to settle the transaction the last consideration is the date of maturity when the underlying loan or obligation comes due a quanto is any type of derivative instrument that is settled in a different currency than the underlying asset in addition to quanto swaps there are also quanto options quanto futures and quanto cdss example of a quanto swapas a demonstrative example of a quanto swap imagine a european company that borrows 1 million to fund operations in the united states to be repaid over five years with interest based on the 3 month sofr rate in this example the current sofr is 5 but the euribor is only 1 suppose further that the company expects u s rates to increase relative to european interest rates in that case they would be better off exchanging the sofr based interest payments for a euribor based rate the company would try to execute a quanto swap to replace their sofr based payments for an interest rate based on euribor 4 although they will continue to pay in dollars if the company s predictions about interest rates are correct they will end up saving money in the long run 