A quanto basket is where one or more of the assets of the basket are traded in a currency different from that of the basket payout. This lets the option’s user gain protection (or speculate) against price movements in the underlying commodities without being exposed to exchange rate movements.
In order to understand this, it is necessary to understand what a regular basket is.
What is a regular basket?
Many risk management situations require an option that has as its underlying asset not a single commodity or equity, but a group of individual commodities or equities. For example, an oil refinery which produces unleaded gasoline and heating oil. Though these two refined products are very active and very liquid and the refinery can hedge these risk exposures separately, it may be more interesting for this refinery to adopt a portfolio approach. In this example, the basket would consist of unleaded gasoline and heating oil.
In this case you would buy a basket option. A basket option lets you buy a group of commodities or equities, as long as they all trade in the same currency. This group is called a basket, and one unit of the basket is made up of weighted amounts of the components (each asset is weighted according to the user’s exposure to it). The basket is then considered the underlying asset, and has its own forward rate and volatility. Each component in the basket would contribute to determining the ultimate payoff of the option. At expiry, the payout is in the same currency as the currency in which all the components are traded.
However there are situations where you need to buy or sell a “basket” of assets, but your needs do not meet the demands of a regular basket. For example:
Each of the individual commodities (or equities) that you want to combine into a basket trades in a different currency. Remember, in a basket all assets must trade in the same currency.
You do not want any FX exposure. In a basket, the payout currency must be the same as the trading currency. This is a problem if your reference (or accounting) currency is not the currency in which the basket components are traded. This is because on expiry, any payout will be in a foreign currency, and you will therefore have a FX exposure, between your home currency and the payout currency. For example, you are a GBP-based manufacturing company that is looking to hedge against price rises in Aluminium Alloy, Nickel and Tin. You could of course buy three separate call options to protect against individual rises in each commodity, but with a payout in dollars, you will be exposed to the risk of a weakening USD.
Although you could buy individual options for each individual asset, you want to take advantage of the correlation between the assets.
In these situations, the solution is to buy a quanto basket. This is because a quanto basket can be used in the following cases:
- Where one or more of the individual assets in the basket are traded in a different currency to the payout currency.
- This allows you to eliminate the foreign exchange exposure of the underlying assets.
- When hedging, a group of options may be cheaper than hedging each individual asset. This is because of the risk-minimizing that correlation may have. Continuing with the example of the GBP-based manufacturer above, even if you bought an individual quanto option for each asset with a payout in GBP, the quanto basket may still offer an advantage as you are only concerned with a combined rise or fall of all the prices together. As a purchaser, you are only really concerned with a combined rise in the three prices, as opposed to for example one rising and two falling.
- The quanto basket is likely to offer a cheaper insurance in this case than three separate call options. This is due to the fact that their prices are not perfectly correlated.