In essence it belongs to the class of barrier options. Thanks to the knock-out mechanism, this swaption has the potential to reduce the premium of a standard interest rate swaption on either leg. The swaption is, therefore, contingent upon a barrier being broken through by a reference rate on a rollover date, in which case it automatically knocks out (gets deactivated). This mechanism can be fixed on both legs of a swaption (i.e., receiver and payer). There is a wide range of reference rates that can underlie this type of options including LIBOR, exchange rates, equity prices, commodity prices, etc.

For example, a Japanese exporter expects the exchange rate USD/JPY to appreciate in the future to USD/JPY 100 from its current level of USD/JPY 90. Of course, with the higher rate, the exporter will make higher profits, and by which it can easily get by. However, in the short run, the exporter might not be able, due to liquidity problems, to finance its working capital by what is generates of revenues at the current exchange rate of USD/JPY90. To sort things out, the exporter decides to buy a payer swaption with a knock-out feature that allows it to opt out when the exchange rate hits USD/JPY 100. When the exchange rate actually trades through that level, the exporter would be financially able to bear higher financing costs thanks to its increasing revenues.

This type of swaptions particularly suits borrowers or investors whose need of interest rate protection is contingent upon developments in an economic variable such as exchange rates, equity prices, and so on.