Knock-Out Swap is a type of derivative contract that combines features of a traditional swap with an embedded option barrier. In this structure, the swap agreement automatically terminates if a specified underlying asset, such as an exchange rate, interest rate, or commodity price, reaches a predetermined level known as the knock-out barrier. This mechanism allows participants to hedge or speculate while limiting exposure to extreme market movements.

In a typical interest rate or currency knock-out swap, two parties agree to exchange cash flows based on variable and fixed rates. However, if the reference rate breaches the barrier during the contract term, the swap becomes void, and no further payments are exchanged. The presence of this knock-out feature usually makes the swap cheaper than a standard swap, as it reduces potential losses for one counterparty and limits upside potential for the other.

Investors and institutions use knock-out swaps to manage risk efficiently, particularly when they have a strong view that the underlying rate will remain within a certain range. For example, a corporate with foreign currency exposure may enter a knock-out currency swap to benefit from favorable rates while capping risk if the currency moves beyond expected limits. However, this also introduces barrier risk ó the risk that the swap will terminate prematurely, potentially disrupting hedging strategies.

From a regulatory standpoint, knock-out swaps are considered complex financial instruments and should only be used by investors who understand their structure, pricing, and potential outcomes. SEBI regulations in India emphasize transparency and investor awareness in derivative transactions, underscoring the need for adequate disclosure and risk assessment before entering such contracts.