Quanto: Returns Without Currency Risk

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  Christian Ingerl
  Redaktor

The returns on most structured investment products depend on several variables. However, two factors are generally the most significant: firstly, the performance of the underlying and, secondly – provided the underlying is denominated in a foreign currency – the movement in the exchange rate between the currency of the underlying and the currency of the product. The fact is that many investors underestimate exchange rate risk, including where the Swiss franc is concerned.

In recent years, it has tended to be in a strong position against most major currencies, such as the US dollar or the euro. This means that the Swiss franc has appreciated against the euro or the US dollar. Or to put it another way: today, you have to pay significantly fewer francs for one euro or one US dollar than you did five years ago. Yet it is precisely this appreciation of the domestic currency against foreign currencies that is risky – it erodes returns.

Example of currency risk

Suppose that, at the start of 2025, a Barrier Reverse Convertible linked to the US tech giant Apple was issued for Swiss investors with a term of 18 months. This hypothetical product was due for redemption in June. Let us also assume that the nominal value was USD 1,000, the coupon was fixed at 8.00% p.a. and no barrier event occurred. Now looking at the exchange rate: at the time of the issue of the BRC, the USD/CHF exchange rate stood at approximately CHF 0.91. At the time of redemption, the USD/CHF exchange rate was ten 10 Swiss cents (Rappen) lower. What does this mean for the investor?

A sobering outcome

During the subscription phase, the nominal value of the product (USD 1,000) linked to Apple shares was priced at around CHF 910. The coupon, worth 80 US dollars, had a value equivalent to CHF 72.80 at the time. Due to the unfavourable exchange rate movements, the investor receives only CHF 810 for the nominal value plus CHF 64.80 from the coupon payment at maturity. Whereas the value of the product at issue was the equivalent of CHF 972.80 (CHF 910 face value + CHF 72.80 coupon), one year later at maturity the investor will receive only CHF 874.80 (CHF 810 face value + CHF 64.80 coupon). In this example, therefore, the appreciation of the Swiss franc has not only eroded the entire return on the Barrier Reverse Convertible but has also led to a loss of capital (in CHF).

Return boost through foreign currencies

The second problem for Swiss investors is the current low interest rate environment. The yield on 10-year Swiss Confederation bonds currently stands at 0.43% per annum. The money market rate, as measured by SARON (Swiss Average Rate Overnight), is even slightly negative at minus 0.04%. To achieve higher returns in a portfolio, yields in foreign currencies are needed.

For example, the yield of 10-year US Treasury bonds currently stands at 4.66% p.a., which is significantly higher than in Switzerland. As many Structured Products – such as Barrier Reverse Convertibles – incorporate a zero-coupon bond, the higher the interest rates, the more attractive the product terms can be. Due to the higher interest rate levels in the US, “Structured Products” such as Barrier Reverse Convertibles based on US underlying offer, ceteris paribus (assuming that all other basic conditions remain the same), an opportunity to boost returns. However, on the other hand – as noted previously – this is accompanied by a currency risk that should not be underestimated.

Products with currency hedging (Quanto)

On the one hand, there are attractive foreign-currency returns; on the other, there is exchange-rate risk. One solution may be products with exchange-rate hedging, which can be identified by the suffix “Quanto”. With a Quanto hedge, a foreign underlying is paid out on a one-to-one basis in the investor’s home currency by fixing the initial exchange rate. This completely eliminates both currency losses (and potential currency gains). However, a Quanto hedge also means that part of the interest rate advantage is lost, as the following practical example illustrates. Leonteq has recently issued two Barrier Reverse Convertibles linked to the US oil company Valero Energy: one product denominated in US dollars without currency hedging (symbol: LTAEGQ), the other in Swiss francs with a USD/CHF quanto mechanism (symbol: LTAEGO). Whilst the other features were identical (such as the same barrier and the same maturity), the difference lay in the coupon rate. For the unhedged product, it amounts to 14.00% p.a., whilst for the quanto product it is 10.00% p.a. This difference of four percentage points stems primarily from the interest rate differential between Switzerland and the US, but may also include a cost component for the quanto hedge.

The costs of hedging

Quanto hedging incurs costs, as the issuer must enter into corresponding offsetting transactions to hedge their own position. Generally speaking, these costs are in the basis point range, so they are manageable. Their level is determined in particular by the volatility of the underlying (the higher the volatility, the more expensive the hedge), the volatility of the exchange rate (the higher the volatility, the more expensive the hedge) and the correlation between the underlying and the exchange rate (put simply: the lower the correlation, the cheaper the hedge). These costs can be passed on not only via the coupon but also via the fair value of the product, or a combination of both.

By the way: if a barrier event occurs in the case of a Barrier Reverse Convertible linked to shares, the repayment is, as is well known, made by delivering shares of the underlying in accordance with the conversion ratio. However, in the case of shares denominated in foreign currencies, the investor once again holds a position with currency risk in their portfolio.

One final point: hedging only makes sense if the investor wants to completely rule out exchange rate losses. On the other hand, investors who expect their home currency to depreciate against the currency of the underlying asset may be able to do without a “Quanto”. This is because if the expected exchange rate scenario materializes, the potential return of the product will be further increased by exchange rate gains.