Explanation:
Quanto options are a type of derivative that allows an investor to hedge currency risk without having to deal with the foreign exchange risk. The investor can receive the payoff in their domestic currency, regardless of the performance of the foreign asset or the foreign exchange rate. The financial institutions that sell these options, however, do not know two key pieces of information. First, they do not know the amount of foreign currency that will need to be converted into the domestic currency. This is because the payoff of the option is dependent on the performance of the underlying asset, which is uncertain at the time the option is sold. Second, they do not know the exchange rate at the time of the option's maturity. The exchange rate is a variable factor that can fluctuate based on a variety of economic factors. Therefore, the financial institutions are taking on a certain level of risk when they sell these options, as they are uncertain about the exact amount of currency they will need to convert and the rate at which they will need to convert it.
Choice B is incorrect. The statement is incorrect because it reverses the direction of conversion. In a quanto option, the foreign currency amount (not the domestic currency amount) is converted into the domestic currency at a predetermined exchange rate. Therefore, financial
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Q.1546 A quanto option is another correlation option that authorizes a domestic investor to interchange his potential option payoff (which is in foreign currency) back into its domestic currency at a fixed exchange rate. This option helps the investor get protected against currency risk. From a risk management standpoint, the financial institutions which are selling these correlation options do not have information about two things. These are:
A
the foreign currency amount to be converted into the domestic currency, and secondly, the exchange rate at option maturity at which the foreign currency payoff will be converted into the domestic currency.
B
the domestic currency amount to be converted into the foreign currency, and secondly, the exchange rate at option maturity at which the domestic currency payoff will be converted into the foreign currency.
C
the foreign currency that’s correlated with the domestic currency, and secondly, the impact of the correlation on the buying and selling of quanto options.
D
the domestic currency amount to be converted into the foreign currency, and secondly, the impact of the correlation on the buying and selling of quanto options.