A binary option that constitutes a cap combined with a European upper barrier. More specifically, it is an option whose payoff is binary, nil or fixed, with respect to an upper barrier on an underlying reference rate/price. If the reference is above the barrier, on each caplet date (caplet fixing date), in which case the cap is in the money, the payment of the fixed amount is activated. However, if the reference is below the barrier, that is, the cap is out of the money, no payout is made. Binary caps are mainly used by investors who want to hedge against unfavorable upward movements in a specific underlying.
For example, if the annual payout for a binary cap is set at 1.5% of the notional amount, then the holder will receive, for each fixing date at which the cap is in the money:
Notional x 1.5% x applicable day count fraction
Binary caps are also known as digital caps.
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