Dear All,I should price European quanto options with present of asset volatility smile but with flat FX volatility. (Here, quanto would mean an option on an asset denominated in a foreign currency with an associated predetermined exchange rate.)As far as I saw, the literature discusses the quanto pricing only for flat volatility surface. As it is written also in the Hull book, in this simple case one can still use the BS formula: one has to make just a forward adjustment and does not touch the volatility. However, the case of volatility smile is trickier.My approach is that there is a direct link between the volatility smile and the return distribution. Therefore, in case of quanto options when the numeraire has to be changed (which means to shift the return distribution according to the Girsanov theorem), we have to make sure that we shift not only the distribution mean (that we are doing with the forward adjustment), but we shift the volatility smile too (that defines the shape of the return distribution).Practically, it means that one can still use the common BS formula to price the quantos, but beside the forward adjustment one has to make an adjustment on the volatility as well. If in the vanilla case the implied volatility was looked at the strike, in the quanto case it has to be looked at the strike divided by the quanto factor. This ensures that beside the forward price the volatility smile will be shifted too.My problem is that I saw a quanto implementation where they did not make adjustment on the volatility even in case of volatility smile presence. They were arguing by hedging principles that my approach is wrong and there is no need to adjust the implied volatility comparing to the vanilla case.I need your help. Could you please confirm me if my approach is correct or explain me clearly why we do not need to adjust the volatility?Many thanks in advance.Peter

Hi, Did you read the recent paper in Risk (sep 2007) "calibrating and pricing with embedded local volatility models" by Ren, Madan and Qian? It gives the quanto correction in the presence of smile (local vol).