A knock-out CMS cap is similar to a Knock-out Cap. The only difference is that instead of the floating rate being based on a reference rate (such as LIBOR), it is based on a long-term swap rate, i.e., the CMS index).
As in the knock-out cap, the knock-out barrier must be set higher than the strike. This means that each underlying caplet is only deactivated (or knocked-out) for a payment period if the swap rate is above the specified barrier.
This provides the buyer with protection for each payment period, as long as on its fixing date the swap rate is greater than the strike and lower than the barrier. If the barrier is hit in a payment period the underlying caplet is immediately knocked-out (or terminated) for that period only.
A knock-out CMS cap is useful when you need limited protection against a rise in the swap rate but you think that rates will only rise to a certain level. Because you have no protection over a certain level (the barrier), the premium is less than that of the equivalent CMS cap with the same strike.