Forex Investment and Currency Trading

Description

A Periodic Knock Out Cap (also known as a Knock Out Cap or KO Cap) is an Interest Rate Cap that partially protects the buyer from rises in floating interest rates. It “deactivates”, or “knocks out” for each period when LIBOR (or the relevant floating interest rate index) fixes above a certain threshold – the KO strike or KO trigger. In effect, the buyer of the KO Cap is simultaneously buying a Cap and selling another option (the option of ending up NOT being hedged for every period that LIBOR fixes above the KO strike). As a result, a KO Cap has a lower premium than a vanilla Cap.

Application

The KO Cap can be a cost effective method of providing a range-bound hedge for interest rate risk. In the example below, it is used by a borrower who believes that interest rates might rise but probably not significantly:

• For each period where 6 month LIBOR fixes below the 5.30% strike, the KO Cap will not make a payment but the company will benefit from lower borrowing costs.
• When 6 month LIBOR fixes between 5.30% and 6.80%, the company receives a payout from the KO Cap such that their net borrowing cost will be 5.30%.
• However, if 6 month LIBOR fixes above 6.80%, the company will lose their hedge for that period and will be exposed to the higher LIBOR on its borrowings.
• The lower the KO strike, the less that the buyer’s interest rate risk is hedged. Hence, the lower the cost of the KO Cap compared to a vanilla Cap. Similarly, terms for the company are enhanced when (i) the yield curve is steep and (ii) the Cap volatility curves are positively skewed (i.e. the 6.80% strike volatility sold by the company is higher than the 5.30% strike volatility it bought).

In this example, the company pays a premium of 48bp, which is lower than the 62bp for a similar vanilla Interest Rate Cap.

Variations

• Usually the KO is “temporary”. This means that the KO event applies only to that particular interest period and not to the entire structure. This is known as a “periodic” knock out. A variation is that the KO can be “permanent”, where the entire Cap will terminate the first time the KO is triggered.
• The Cap strikes and/or KO strikes can be “stepped up” over future fixing dates to allow for expected increase in interest rates.
• The floating rate observed can be set in arrears or of a tenor the length of which differs from the payment frequency e.g. 3 month LIBOR paid monthly or 10 year CMS paid quarterly.
• The same KO concept is widely used under other Swap formats.
• The KO can be structured to be “partial”; instead of receiving zero, the company receives a fixed payment – say 0.50% p.a. – when the KO is triggered. This is known as a Shark Fin Cap.