A knock-in floor is a floor 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 floorlet and which must be set lower than the floorlet’s strike. It can only be triggered on the underlying floorlet’s expiry date, i.e., it only matters where the floating rate is in relation to the barrier on the floorlet’s expiry dates.
This provides the buyer with protection for each payment period, as long as on its expiry date the index is below the barrier.
If the barrier is hit on a floorlet’s expiry date the underlying floorlet is knocked-in (the payout is that of the underlying floorlet and is made on the relevant floorlet payment date). If the barrier is not hit on a floorlet’s expiry date, the underlying floorlet 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 Floor
When specifying a knock-in floor you have to specify:
The knock-in trigger.
The strike of the underlying floor.
In addition you must define whether the fixing date of the floor is to be set in advance or in arrears.
Advantages of a Knock-In Floor
This option is useful when you need protection against a drop in the interest rate index but can tolerate a drop down to a certain level. Because the underlying floor is only knocked-in when the interest rate index is below a certain level (the knock in barrier), the premium is less than that of the equivalent floor with the same strike.