An extended barrier option in which the barrier depends on whether the price of another underlying trades through a preset barrier or not. More specifically, the option deactivates or knocks out if the underlying reaches the barrier, with the payoff being the difference between the terminal price of the other asset and the strike level. For example, a firm may use a rainbow barrier option to secure its requirements of foreign exchange. Suppose a Japanese auto maker is intending to extend production into Australia, and it is concerned about its exposure to the rise of the Australian dollar against the yen.

To hedge this risk, the car maker can either purchase Australian dollars forward or buy a call option on Australian dollars, procuring it the right to buyer a fixed amount of dollars at a fixed exchange rate. Since the auto maker is not yet sure that it will expand operations overseas, it views the flexibility of the option outweighing its typically high upfront premium. However, keen to make this premium as low as possible, the car maker might find it more worthwhile to buy a rainbow barrier option, which would knock out if auto prices rise. A rise in auto prices will enhance the auto marker’s revenues, more than offsetting the cost (premium) of the unexercised option.