An interest rate swap with an additional feature of a knock-out (KO) barrier. In other words, a knock-out swap terminates periodically or permanently if a designated interest rate breaks out above or below a preset benchmark for a given floating reference rate. A knock-out swap has an embedded option to terminate the underlying transaction when it is favorable for a respective party to do so. In return, the other party has the advantage of paying a lower fixed rate on that swap.
For example, when a bond issuer transacts a knock-out swap with a swap dealer, the former would have the right to enter into the swap as a fixed rate payer at a lower rate. However, the bond issuer is exposed to the risk of the hedge being cancelled when the floating rate overtakes a predetermined barrier level.
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