Quanto Options (Quantitative Options) are financial tools which allow to hedge joint-risk of two underlyings. They were developed and are widely used in the FX market, and nowadays used also for hedging the joint price-volume risk in the wholesale energy market for electricity.
Specific weather conditions may lead to a double effect on utility companies’ margin: a direct effect due to a decrease/increase in consumption and an indirect one arising from the triggered change in the commodity price. For instance, a milder winter than expected would shift downward the demand curve for gas, leading to a decrease in gas prices. In this case, the utility company could not avoid selling exceeding gas at lower prices.
Quanto Options are tailor-made products and, as such, they can be structured in the best way to cover different portfolios’ risk management.
Different underlyings can be chosen for Quanto Options, depending on the to-be-hedged portfolio, as long as they are highly correlated indexes. For this reason, a pair of temperature index and energetic commodity index (i.e.: gas, power) is usually chosen.
The payoff of Quanto Options can be generalized as follows:
(Energetic commodity Index - Energetic commodity Strike) x (Temperature Index – Temperature Strike)
However, the payoff structure can be modified in different ways in order to improve product efficiency in hedging risks.
For instance, one could:
- Multiply it by a Notional Amount
- Choose a Call structure instead of a Swap
- Choose a Put structure instead of a Swap
The most common underlying selected as temperature index are:
- HDD - Heating Degree Day: calculated as the difference between average daily temperature and a threshold value, generally 18°C. This index is used to manage temperature exposure in the winter period.
- CDD - Cooling Degree Day: the equivalent of HDD for the summer period.
- CAT – Cumulative Average Temperature: the sum of the temperatures recorded over a period.