What is it?
A quanto (or cross-currency derivative) is a cash settled derivative (such as a future or option) that has an underlier denominated in one (“foreign”) currency, but settles in another (“domestic”) currency at a fixed exchange rate.
How is it constructed?
- Constructed the same as a regular option/future, the only difference is it is purchased in its own domestic currency, although denominated in a foreign currency.
- At initiation, the investor fixes an exchange rate, which is then kept for the duration of contract.
What is the payoff?
At maturity of a quanto call option in domestic currency
Payout = X * MAX [ (St,foreign – Kforeign), 0 ]
Where:
X = exchange rate fixed at initiation,
ST,foreign= price of asset in foreign currency
K= strike price in foreign currency
T= expiration date
When is it used?
- To get exposure to foreign assets without experiencing the added risk of interest rates.
- Were historically created to increase liquidity in global markets as it enticed investors to explore overseas possibilities without the incorporated risk of currency fluctuations especially of those which are volatile.
- Are widely used today by numerous hedge funds and investment banks to minimizerisks due to changing currencies when choosing to implement option trades in possibly more profitable foreign markets.
What are the benefits?
- Shields the purchaser from exchange rate fluctuations whilst allowing exposure to the underlying asset.
- High leverage means the percentage returns can be significant.
- Can limit risk but can also limit profit potential.
- Possibility to gain a position that will mimic the stock almost identically.
The Financial Engineer 
For example, an option on the Nikkei stock index held by an investor in the USA. The underlying index and strike would be in JPY but the investor would receive USD based on the fixed exchange rate should the option be in-the-money at expiry.