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A quanto swap is a way for investors to reduce the risk associated with buying assets attached to different currencies. Rather than directly exchange the assets, two parties can insulate themselves from changes in the exchange rate by agreeing to transfer money according to a mutually agreeable framework. The parties may share the risk in various ways depending on the terms of the quanto swap.
A quanto is a specific type of financial derivative designed for international investors. It establishes a fixed exchange rate for a particular asset. A company might buy a quanto if they wanted to invest in an asset without gambling on the exchange rate of its country of origin. A quanto is likely to be slightly more expensive than the asset it underlies since, as in the case of an insurance policy, the buyer pays to diminish his risk. Quanto is short for "quantity adjusting."
A swap is a different type of relationship between two investors. A swap occurs when instead of trading assets, the two parties agree to simply give each other the cash that the assets generate. Swaps are one way for companies to profit their comparative advantage; a swap allows Company A to profit from a resource to which, for some structural reason, only Company B has access.
A quanto swap is a combination of these two financial instruments. It provides a way to perform a swap internationally without having to deal with fluctuations of the exchange rate. Company A and Company B have assets that yield value in the form of each of their local currencies. Rather than trade the assets and expose themselves to fluctuations in the exchange rate, they can simply agree to pay each other the value of the assets in a currency and rate they specify. This helps each company achieve the combination of risk and expected value that they desire.
Imagine a group of Chinese investors who want to make a credit default swap agreement with an American company, but they think the American economy is going to collapse. In an normal swap agreement, they would pay the American company some money and receive a payoff if a debtor defaults on a previously specified loan. However, because the Chinese investors believe that the economic collapse will weaken the American dollar and render their wise investment worthless, they may wish to make a quanto swap arrangement. If they do, the exchange rate is fixed and their payoff on the bad debt will be directly in yuan instead of dollars.