A knock-out floor is a floor 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 which 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 date.
This provides the buyer with protection for each payment period, as long as on its expiry date the index is lower than the strike and higher than the barrier.
If the barrier is hit on a floorlet’s expiry date that underlying floorlet only is immediately knocked-out (or terminated). If there is a payout, it is that of the underlying floorlet and is made on that floorlet’s payment date.
Pricing a Knock-out Floor
When specifying a knock-out floor option you have to specify:
The knock-out 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.
The premium, which is expressed as a percentage of the notional, is usually paid upfront.
Advantages of a Knock-out Floor
This option is useful when you need limited protection against a drop in the interest rate index because you think rates will only drop to a certain level. Because you have no protection under a certain level (the knock out barrier), the premium is less than that of the equivalent vanilla floor with the same strike.