Quanto-Protected Structured Products on the Rise in Europe, Guarding Investors from FX Risks

As global financial markets continue to evolve, investors are constantly searching for new opportunities to diversify their portfolios and optimize returns. One such opportunity is investing in structured products, which are highly customizable and can offer a wide range of risk-return profiles.

Many structured products, such as warrants, certificates, and other derivatives, have underlying securities denominated in foreign currencies on their home exchanges. For instance, American shares are often priced in US dollars (USD).

Consequently, investors who buy such products are exposed to additional foreign exchange (FX) risks, as the value of these products at maturity is calculated based on a foreign currency. To mitigate these risks, issuers of structured products have introduced the “quanto” feature, which offers investors built-in currency hedges that protect them from FX fluctuations. There is a growing popularity of quanto-protected structured products in Europe and how they can safeguard investors’ base currencies while providing a marketing edge for issuers.

The Foreign Exchange Risk in Structured Products.

Structured products are complex financial instruments that are often created to meet specific investor needs. These products are built around underlying assets, such as stocks, bonds, or commodities, and can offer exposure to various markets and asset classes. However, when the underlying security of a structured product is denominated in a foreign currency, the investor takes on additional FX risk.

FX risk arises from changes in exchange rates, which can have a significant impact on an investment’s value. For example, if an investor in Europe buys a structured product with an underlying American share priced in USD, their return on investment will be affected by fluctuations in the EUR/USD exchange rate. If the value of the EUR decreases relative to the USD, the investor’s returns will be negatively affected, even if the underlying American share performs well.

The Quanto: A Solution to FX Risk.

To address the FX risk associated with structured products, issuers have developed the “quanto” feature. The term “quanto” is derived from the words “quantity adjusting option.” Essentially, a quanto is an embedded currency hedge that protects investors from exchange rate fluctuations between their base currency and the currency of the underlying asset.

When a structured product includes a quanto, the investment’s payout is adjusted based on the prevailing exchange rate, ensuring that the investor’s returns are not adversely affected by currency movements.

For instance, a European investor who purchases a quanto-protected structured product linked to an American share would receive returns in euros, regardless of how the EUR/USD exchange rate changes during the investment period. The quanto essentially neutralizes the FX risk, allowing the investor to focus solely on the performance of the underlying asset.

The Growing Popularity of Quanto-Protected Structured Products in Europe.

In recent years, quanto-protected structured products have gained significant traction in Europe, driven by several factors:

1. Increased awareness of FX risk: As more investors recognize the potential impact of currency fluctuations on their investments, they are actively seeking strategies to mitigate FX risk. Quanto-protected structured products offer an attractive solution, as they provide exposure to foreign assets without the additional currency risk.
2. Enhanced diversification: European investors are increasingly looking for opportunities to diversify their portfolios beyond their home markets. By investing in quanto-protected structured products, they can access foreign markets.

When investors participate in foreign markets, they are exposed to a significant amount of currency risk. Currency risk, or exchange rate risk, refers to the potential for losses or gains due to changes in exchange rates between currencies. This risk can be significant, particularly when investing in markets with volatile currencies. One way to manage this risk is through the use of a financial instrument known as a Quanto.

What is Quanto?

A Quanto is a structured product that is designed to protect investors against exchange rate risk. The word “Quanto” is short for “Quantitative Analysis And Optimization.” This financial instrument is a type of derivative that is linked to an underlying asset, such as a stock, index, or commodity, but is denominated in a different currency than that of the underlying asset.

The Quanto structure is achieved through the use of a currency hedge. A currency hedge is a financial transaction that offsets the risk of currency fluctuations. In the case of a Quanto, the currency hedge is used to neutralize the effect of exchange rate fluctuations between the currency in which the underlying asset is denominated and the currency in which the Quanto is denominated.

How Does Quanto Work?

To understand how Quanto works, consider an example. Let’s say that an investor in the United States wants to invest in a European stock. The investor is concerned about the risk of currency fluctuations between the US dollar and the Euro, which could result in a loss of value for the investment.

To address this risk, the investor decides to invest in a Quanto product. The Quanto is linked to the value of the European stock, but is denominated in US dollars. This means that the investor’s investment is protected against fluctuations in the Euro/US dollar exchange rate.

To achieve this protection, the Quanto provider will enter into a currency hedge. The currency hedge will involve a financial transaction in which the Quanto provider buys or sells currencies in order to offset the risk of exchange rate fluctuations between the US dollar and the Euro. The Quanto provider will then use the proceeds of the currency hedge to pay out the returns on the Quanto investment.

Benefits of Quanto :

The use of Quanto has several benefits for investors. The most significant benefit is the protection it provides against exchange rate risk. By investing in a Quanto, investors can participate in foreign markets without having to worry about fluctuations in exchange rates.

Another benefit of Quanto is that it provides investors with a way to access investments denominated in foreign currencies. This can be particularly advantageous for investors who are looking for opportunities in emerging markets, where currency risk can be significant.

Finally, Quanto products are relatively easy to understand and trade. They are typically offered through structured products and can be purchased through a broker or online trading platform.