A knock-out cap is a cap that can be terminated (or knocked out) under the condition specified in its contract.
The condition takes the form of a European knock-out 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 greater than the strike and lower than the barrier.
If the barrier is hit on a caplet’s expiry date that underlying caplet only is immediately knocked-out (or terminated). If there is a payout, it is that of the underlying caplet and is made on the relevant caplet payment date.
The premium, which is expressed as a percentage of the notional, is usually paid upfront.
Pricing a Knock-out Cap
When specifying a knock-out cap you have to specify:
The knock-out trigger
The strike for 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-Out Cap
This option is useful when you need limited protection against a rise in the interest rate index because you think that rates will only rise to a certain level. Because you have no protection over a certain level (the knock in barrier), the premium is less than that of the equivalent vanilla cap with the same strike.