Hedging FX Exposure

The main theme of a quanto option is the difference in forward compared to a regular option. 

 

Hedging FX exposure on the quanto option might not be very intuitive but is very simple in practice. 

 

This is because the FX hedge is captured by the delta hedge, which in turn is because the option notional in the local currency keeps changing with the changing FX. 

Namely, the notional of the quanto option is agreed in the quanto currency. Therefore the notional in the local currency changes whenever the FX changes. 

 

This implies that if the quanto currency halves in value w.r.t the local currency, the notional of the quanto option in the local currency halves, and therefore the trader needs to halve his delta hedge even though the stock price might not have moved. 

 

Example: 

Trader sells an ATM quanto call on BP: 

- strike = 5£

- Notional = $10M

- Delta ~ 0.5 

- FX rate = 2 USD/GBP

 

Delta hedge: trader would need to buy £2.5M worth of BP stock. 

 

Suppose that USD halves w.r.t GBP --> FX rate = 4 USD/GBP. 

 

Even though the stock price did not change, the trader would need to change his delta hedge to be long £1.25M of BP stock. 

 

There is no need for a trader to put on FX hedge in place for a quanto option. 

This is because the equation prescribes financing in the local currency. 

 

If the trader buys a quanto option, he effectively ensures financing in the local currency because he would first need to sell the local currency to buy the quanto currency in order to pay for the quanto option. 

 

Therefore the trader will only need to do an FX hedge if he sells a quanto option, which is selling the quanto currency and buying the local currency on the premium amount. This ensures financing in the local currency. 

 

Add a comment