Quanto Swap

Definition

A quanto swap is a cash‑settled, cross‑currency interest rate swap in which one counterparty pays an interest rate indexed to a foreign currency while all payments are settled in a single (domestic) currency. The notional principal is denominated in the domestic currency, and interest legs can be fixed or floating. Because the contract effectively fixes an exchange rate for settlement, quanto swaps are sometimes called guaranteed exchange rate swaps or rate‑differential (diff) swaps.

How it works

• Two parties agree to exchange interest payments referencing two different currency interest rates, but settlement is made in the same currency for both legs.
• One party pays interest based on a domestic rate; the other pays based on a foreign rate (which may include a spread).
• The notional remains in the domestic currency, so there is no physical exchange of principal in foreign currency at settlement.

Example structure:
– Party A pays 6‑month LIBOR (USD) on a USD notional.
– Party B pays 6‑month EURIBOR + 75 bps, but payments are made in USD on the same USD notional.

Types

• Fixed‑for‑floating: One leg is a fixed rate, the other floating. This structure reduces foreign exchange exposure more than floating‑for‑floating.
• Floating‑for‑floating: Both legs reference floating rates. This exposes counterparties to changes in the interest‑rate spread between the two currencies.

Benefits

• Separates interest‑rate exposure from currency exposure: investors can gain exposure to a foreign interest rate or asset performance without taking on currency risk.
• Useful when an investor expects an asset in another country to perform well but expects that country’s currency to underperform.
• Can potentially achieve more favorable interest economics than direct borrowing in the foreign currency while avoiding FX conversion and translation risk.

Key requirements

When structuring a quanto swap, the main elements to specify are:
– Notional amount (priced in the domestic/home currency).
– The two index rates (fixed or floating) that determine each leg’s payments.
– The currencies being referenced (home and foreign) for interest indices.
– Maturity date (when the underlying obligation or loan is due).

Example

A European firm borrows USD 1 million for five years, with interest tied to 3‑month SOFR (currently 5%). EURIBOR sits at 1%. The firm expects U.S. rates to rise relative to European rates, so it arranges a quanto swap to replace its SOFR payments with EURIBOR + 4%, while continuing to pay in USD. If U.S. rates rise as expected relative to EUR rates, the swap reduces the firm’s interest expense while eliminating currency‑exchange exposure.

Related instruments

• Quanto option: An option on an underlying denominated in one currency but settled in another at a fixed exchange rate, eliminating FX payoff risk.
• Quanto CDS: A credit default swap where premiums or cashflows are paid in a different currency than the reference asset.

Quanto swap vs. cross‑currency swap

• Cross‑currency swap: Principal and cash flows are exchanged in two different currencies; parties make and receive payments in their respective currencies.
• Quanto swap: Payments reference a foreign rate but are settled in a single (domestic) currency; there is no exchange of principal in the foreign currency at settlement.

Risks

• Quanto risk: Adverse changes in the underlying asset prices or the exchange rates referenced in the contract can affect economic outcomes relative to expectations.
• Interest‑spread risk: Especially in floating‑for‑floating structures, exposure to movements in the spread between the two countries’ interest rates.
• Counterparty risk: As with other OTC derivatives, the risk that the other party may default on its obligations.

Key takeaways

• A quanto swap lets parties exchange interest‑rate exposures across currencies while settling in one currency, isolating interest‑rate risk from currency risk.
• It is useful for investors seeking foreign market or rate exposure without taking on FX risk.
• Careful attention to notional, index rates, currencies, and maturity — and to quanto and counterparty risks — is essential when using these contracts.