A knock-in cap is a cap that is only knocked in under the condition specified in its contract.
The condition takes the form of a European knock-in barrier that is defined for each underlying caplet and which must be set higher than the caplet’s strike. It can only be triggered on the underlying caplet’s expiry date, i.e., it only matters where the floating rate is in relation to the barrier on the caplet’s expiry dates.
This provides the buyer with protection for each payment period, as long as on its expiry date the index is higher than the barrier.
If the barrier is hit on a caplet’s expiry date the underlying caplet is knocked-in (the payout is that of the underlying caplet and is made on the relevant caplet payment date). If the barrier is not hit on a caplet’s expiry date, the underlying caplet is not activated and there is no payout for that period.
The premium, which is expressed as a percentage of the notional, is usually paid upfront.
Pricing a Knock-in Cap
When specifying a knock-in cap you have to specify:
The knock-in trigger
The strike of the underlying cap.
In addition you must define whether the fixing date of the cap is to be set in advance or in arrears.
Advantages of a Knock-in Cap
This option is useful when you need protection against a rise in the interest rate index but can tolerate a rise up to a certain level. Because the cap is only knocked-in when the interest rate index is above a certain level (the knock in barrier), the premium is less than that of the equivalent cap with the same strike.