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Non-Tech : Derivatives: Darth Vader's Revenge -- Ignore unavailable to you. Want to Upgrade?

To: Knighty Tin who wrote (272)	9/30/1998 10:55:00 AM
From: Henry Volquardsen	Read Replies (1) \| Respond to of 2794

I was wondering if someone was going to bite on those <g>. Both are real. A digital has a defined payout and does not put you into a position. As an example lets say you have a dollar call against the deutschmark at 1.7000. An ordinary call would give you the right to buy a predefined number of dollars at that price and you would now have a position. Your gain or loss would depend on how much further the market moved. With a digital you get a defined payout. In the above example instead of being able to buy dollars you get a fixed payout but have no additional position and no ongoing exposure to the underlying market. How about a real world example. With gold at $290 you could ask a derivatives desk to price a one year call with a digital payout at $350. Let's say they come back with 4%. So if you pay $40,000 and at any point in the yeas gold hits $350 you get $1,000,000. $349.90 you get nothing. $500 you still get only $1,000,000. Very similar to lottery tickets. Quantos are a bit more intellectually complex. Basically a quanto is when your risk is influence by another price dyanamic. A classic quanto is what is referred to as dif risk. In a dif you price the differential between two instruments. Lets say the difference between US and German 10 year interest rates. A typical structure would be defining a US dollar notional and a US dollar payout based on the difference between 10 year rates in both currencies. Now at first blush the risk looks obvious, you have long risk in one intstrument and short risk in the other. The quanto risk comes in when you try to define your notional risk in deutshmarks. How much deutschmark risk do you have? At the current exchange rate you have a certain amount but if exchange rates move you have a different amount. So if you hedge the deutschmark 10 year risk based on the current notional and the fixed income market moves your okay. But if at some point later the exchange rate moves your notional changes and you may be over or underhedged in the fixed income market. That is quanto risk. You can complicate the above picture even further by defining the payout in a third currency to suit a particular client. Lets say the above transaction was designed for a UK portfolio manger so you define the payout in sterling, more quanto risk. A quanto that is actually pretty common is a put on the Nikkei in which the payout is a fixed number of dollars per Nikkei point. There are lots of quanto risks embedded in transactions that people don't realize they have. Also I think there are guys at brokerage firms who do nothing but sit around and think up way to separate the unwary from their commission dollars. <G> Since the dawn of mankind :) Henry