Digital Cap

A digital cap is a cap with a European barrier and a fixed payout, regardless of how far beyond the strike the reference rate fixes. That is, it only matters where the underlying asset is in relation to the barrier on each underlying caplet’s expiry date.

If on the caplet’s expiry date the interest rate is above the barrier (i.e., the option is in the money), the fixed payout is activated; if the interest rate is below the barrier (i.e., the option is out of the money), no payout is made.

The annual payout is defined as a specified percentage of the notional defined. Therefore for each fixing that the option is in the money the holder receives:

(notional * payout %) * relevant daycount fraction

Any payout is made on the caplet’s payment date; the premium is always paid upfront.

Advantages of a Digital Cap

A digital cap can be used for speculating if you have a view on the expected direction of the index rate movement.