Swaps often contain caps or floors. In this problem, you are to construct an oil contract that has the following characteristics: The initial cost is zero. Then in each period, the buyer pays the market price of oil if it is between K1 and K2; otherwise, if S K2, the buyer pays K2 (there is a floor and a cap). Assume that K2 − K1= $2 and that oil volatility is 15%.
a. If there is a single settlement date in 1 year, what are K1 and K2?
b. If the swap settles quarterly for eight quarters, what are K1 and K2?