Gated knock out
How is the notional determined? On the trade date the total potential notional is set; subsequently over the option's lifecycle, for each day that the spot rate does not trade at a predefined trigger the amount of notional fades in (or increases) by a set amount.
If the trigger is hit the notional amount stops fading in. However, any amount already accumulated is not at risk. It is this amount that serves as the underlying vanilla’s notional.
Why buy a gated knock out option?
You would use a gated knock out option because of the following reasons combined:
- It is inevitably cheaper than its equivalent vanilla counterparty. This is because it has a risk of the total potential notional not being faded in if the knock out barrier is hit.
- You have a particular take on the spot's movement that makes the risk of the added barrier worthwhile.
- It provides better protection than a regular knock out barrier option because its notional fades in, and whatever notional has faded in before the knock out trigger is hit is safe.
- You can structure it so that the notional accumulates as long as the protection is needed. Once the spot hits the knock out trigger the assumption is that the protection is no longer needed.
Example of a gated knock out option:
A corporation is short Euro/USD for a horizon of 3 month. It can hedge itself in a variety of ways including, for example, any of the following:
- Buy a 3m forward – 1.2925
- Buy a vanilla call Euro with a strike of 1.2800 and pay 2.12%
- Buy a knock out barrier option call Euro with a knock out barrier at 1.2500 and pay 1.94%
- Buy a gated knock out option with a knock out barrier at 1.25000 and pay 1.95%
If you buy the knock out and the spot rate hits the barrier, you are left completely unprotected, even if the market then proves volatile and moves sharply against you. If you buy the gated knock out option and the spot rate hits the barrier, you still have a hedge on the notional accumulated up until that date.