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