ERP Practice Exam3 7115

2015

ERP Practice Exam 3 PM Session Financial—25 Questions

ERP® Practice Exam 3

TABLE OF CONTENTS

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1

ERP Practice Exam 3 Candidate Answer Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3

ERP Practice Exam 3 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5

ERP Practice Exam 3 Answer Sheet/Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .15

ERP Practice Exam 3 Explanations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .17

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i

ERP® Practice Exam 3

Introduction

1. Plan a date and time to take the practice exam.

The ERP Exam is a practice-oriented examination. Its ques-

Set dates appropriately to give sufficient study/review

tions are derived from a combination of theory, as set forth

time for the practice exam prior to the actual exam.

in the core readings, and “real-world” work experience. Candidates are expected to understand energy risk man-

2. Simulate the test environment as closely as possible.

agement concepts and approaches and how they would

•

apply to an energy risk manager’s day-to-day activities.

•

erasers) available.

testing an energy risk professional on a number of risk man•

material before beginning the practice exam.

immediately be slotted into just one category. In the real •

Allocate two minutes per question for the practice exam and set an alarm to alert you when a total of

number of risk-related issues and be able to deal with them

50 minutes have passed Complete the entire exam but

effectively.

note the questions answered after the 50-minute mark.

The ERP Practice Exam 3 has been developed to aid candidates in their preparation for the ERP Exam. This

Minimize possible distractions from other people, cell phones, televisions, etc.; put away any study

energy risk manager will be faced with an issue that can world, an energy risk manager must be able to identify any

Have only the practice exam, candidate answer sheet, calculator, and writing instruments (pencils,

The ERP Exam is also a comprehensive examination, agement concepts and approaches. It is very rare that an

Take the practice exam in a quiet place.

•

Follow the ERP calculator policy. Candidates are only

practice exam is based on a sample of actual questions

allowed to bring certain types of calculators into the

from past ERP Exams and is suggestive of the questions

exam room. The only calculators authorized for use

that will be in the 2015 ERP Exam.

on the ERP Exam in 2015 are listed below, there will be no exceptions to this policy. You will not be allowed

The ERP Practice Exam 3 contains 25 multiple choice

into the exam room with a personal calculator other

questions. The 2015 ERP Exam will consist of a morning and afternoon session, each containing 70 multiple choice

than the following: Texas Instruments BA II Plus

questions. The practice exam is designed to be shorter to

(including the BA II Plus Professional), Hewlett Packard

allow candidates to calibrate their preparedness for the

12C (including the HP 12C Platinum and the Anniversary

exam without being overwhelming.

Edition), Hewlett Packard 10B II, Hewlett Packard 10B II+ and Hewlett Packard 20B.

The ERP Practice Exam 3 does not necessarily cover all topics to be tested in the 2015 ERP Exam. For a complete list of topics and core readings, candidates should refer to the 2015 ERP Exam Study Guide. Core readings

3. After completing The ERP Practice Exam 3 •

Calculate your score by comparing your answer

were selected in consultation with the Energy Oversight

sheet with the practice exam answer key. Only

Committee (EOC) to assist candidates in their review of the

include questions completed within the first 50 minutes in your score.

subjects covered by the exam. Questions for the ERP Exam are derived from these core readings in their entirety. As

•

such, it is strongly suggested that candidates review all core

Use the practice exam Answers and Explanations to better understand the correct and incorrect answers

readings listed in the 2015 ERP Study Guide in-depth prior

and to identify topics that require additional review.

to sitting for the exam.

Consult referenced core readings to prepare for the exam.

Suggested Use of Practice Exams To maximize the effectiveness of the practice exams, candidates are encouraged to follow these recommendations:

•

Remember: pass/fail status for the actual exam is based on the distribution of scores from all candidates, so use your scores only to gauge your own progress and level of preparedness.

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1

Energy Risk Professional ® (ERP ) Exam Practice Exam 3 Answer Sheet

ERP® Practice Exam 3

a.

b.

c.

d.

a.

1.

18.

2.

19.

3.

20.

4.

21.

5.

22.

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23.

7.

24.

8.

25.

b.

c.

d.





✓

✘

9. 10. 11. 12. 13. 14.

Correct way to complete

15.

1.

16.

Wrong way to complete

17.

1.



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3

Energy Risk Professional ® (ERP ) Exam Practice Exam 3 Questions

ERP® Practice Exam 3

1.

The middle office trade support group at a crude oil trading firm is evaluating the margin requirements for a long position in 400 April WTI futures contracts. The position includes the following terms: • • • •

Trade date: January 25 Purchase price: USD 107.81 Initial margin requirement: USD 3,900,000 Required maintenance threshold: USD 3,120,000

Below what price (in USD) will a margin call be triggered on the April WTI futures position, assuming the exchange requires the account balance for all futures positions to be “topped-up” to their initial required margin level in the event of a margin call? a. b. c. d.

2.

A refinery purchases NYMEX WTI futures contracts to hedge the purchase of 40,000 barrels of WTI crude oil in two months. The contracts are purchased at USD 97.00/bbl. Two months later, the refiner closes the futures position and purchases 40,000 barrels at spot. What is the effective price paid per barrel if the futures contract is now trading at USD 98.50/bbl and the spot price is USD 100.10/bbl? a. b. c. d.

3.

102.68 104.99 105.86 107.61

USD USD USD USD

98.50 98.60 100.10 100.40

Calculate the net profit on the following straddle position assuming the NYMEX ULSD closing futures price is USD 2.73/gallon at expiration? • •

2-month NYMEX USLD call option with a strike price of USD 2.91/gallon and premium of USD 0.05/gallon 2-month NYMEX USLD put option with a strike price of USD 2.91/gallon and premium of USD 0.09/gallon

a. b. c. d.

USD USD USD USD

1,680 per contract 2,100 per contract 3,780 per contract 5,400 per contract

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5

ERP® Practice Exam 3

4.

The market risk manager for a refinery plans to structure a collar for margin protection. She has the following price data available for options on NYMEX RBOB futures to assess the economics of the transaction: RBOB Strike Price (USD/gal) 3.21 3.29

Call Premium (USD) 0.156 0.129

Put Premium (USD) 0.137 0.146

Assuming the NYMEX RBOB futures contract is currently trading at USD 3.24/gal, how would the risk manager structure the transaction to best manage earnings volatility in the refinery’s operations? a. b. c. d.

5.

Buy put options @ USD 3.21 strike and sell call options @ USD 3.29 strike Sell put options @ USD 3.21 strike and buy call options @ USD 3.29 strike Buy put options @ USD 3.29 strike and sell call options @ USD 3.21 strike Sell put options @ USD 3.29 strike and buy call options @ USD 3.21 strike

A petroleum commodities trader observes the following NYMEX price quotes. He believes the spread is too wide and executes a ten-contract position to benefit from a narrowing of the spread: • •

August RBOB: USD 2.58/gal December RBOB: USD 2.74/gal

On June 30, the contracts close at the following prices: • •

August RBOB: USD 2.63/gal December RBOB: USD 2.68/gal

What is the trader’s profit (ignoring broker costs, margin requirements and other expenses) on the position based on the June 30 closing prices? a. b. c. d.

6

USD USD USD USD

5,040 29,400 46,200 67,200

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ERP® Practice Exam 3

Questions 6-7 use the information below: A risk manager at a large international bank, has compiled the following closing price data on the Brent Crude Oil futures contract for the past 31 trading days:

Futures Price (USD)

120 115 110 105 100 10/1/2013

6.

10/31/2013

Which quantitative approach will produce the most conservative (highest) 1-day, 95% VaR estimate for the bank’s Brent crude oil futures portfolio? a. b. c. d.

7.

10/16/2013 Time

Exponentially Weighted Moving Average with a lambda of 0.91 Exponentially Weighted Moving Average with a lambda of 0.99 Eigenvector Weighted Average with a lambda of 0.99 Simple Moving Average

While backtesting a 1-year, 99% VaR model, the risk manager finds six exceptions to the VaR model. How should he interpret this result relative to Basel requirements? a. b. c. d.

The model is in the “green zone” and is acceptable to use with no further revision The model is in the “yellow zone” and further adjustments must be made such as increasing the safety multiplier used with the model The model is in the “red zone” and must be dramatically revised before it can be used further The model is in the “red zone” and the model must be discarded

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7

ERP® Practice Exam 3

8.

The 10-day, 95% VaR for a USD 10,000,000 energy commodity portfolio is USD 2,000,000. Based on the VaR calculation, what is the correct interpretation of market risk for the portfolio? a. b. c. d.

9.

Portfolio losses over a ten day period are expected to exceed USD 2 million once in every five, ten-day periods Portfolio losses over a ten day period are expected to exceed USD 2 million once in every twenty, ten-day periods There is a 5% chance that portfolio losses will exceed USD 2 million during the next ten trading days There is a 95% chance that portfolio losses will exceed USD 2 million during the next ten trading days

A commercial airline structures a collar to manage price risk on 50,000 barrels of jet fuel. The collar includes the following terms: • • • •

Cap: USD 125/bbl Floor: USD 115/bbl Tenor: Six months (June to November) Valuation Index: Mean of Platts Singapore (MOPS)

The monthly MOPs Index per barrel are as follows: • • •

June: USD 132 July: USD 120 August: USD 111

• • •

September: USD 128 October: USD 122 November: USD 115

Calculate the net payment owed to/from the airline at settlement on November 30? a. b. c. d.

10.

The The The The

airline airline airline airline

receives USD 300,000 pays USD 300,000 receives USD 500,000 pays USD 500,000

A market risk analyst has applied a factor-push model to stress test the MtM value of several combinations of option positions on the April 2015 NYMEX WTI futures contract. The model applies a four standard deviation decrease in the price of the underlying futures contract. Each option has the same expiration date and the current settlement price for the April 2015 WTI contract is USD 105. What combination of options will be least impacted by the factor-push model? a. b. c. d.

8

A A A A

long 95 call and a long 115 call long 100 call and a short 110 call long 105 call and a long 105 put short 100 put and a long 100 call

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ERP® Practice Exam 3

Questions 11-12 use the information below: A credit analyst at a regional commercial bank has been asked to assess the credit fundamentals related to four different energy companies. To complete the analysis the analyst has assembled the following data from the most recently published balance sheet for each entity: Balance Sheet (in Millions USD) Cash Short-term investments Accounts receivable Inventory Total current assets

11.

Company A 1,675 1,767 888 4,467 8,797

Company B 5,643 8,259 1,337 21,785 37,024

Company C 7,610 5,659 4,296 2,145 19,710

Company D 15,376 5,297 6,489 45,832 72,994

Property, plant and equipment Total assets

13,370 22,167

17,812 54,836

3,899 23,609

27,432 100,426

Total current liabilities Long term debt Total liabilities Total shareholder equity

5,770 10,000 16,770 6,397

12,893 15,555 28,448 26,388

4,252 3,210 7,462 16,147

48,659 0 48,659 51,767

Which of the following relationships will provide the best measure of financial leverage used by each company? a. b c. d.

12.

(Total Liabilities) (Total Shareholder Equity) (Long Term Debt) (Total Current Assets) (Long Term Assets) (Total Current Liabilities) (Total Liabilities-Long Term Debt) (Total Assets)

Using the Quick Ratio as a guideline, which company has the highest relative short-term liquidity risk? a. b. c. d.

Company Company Company Company

A B C D

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9

ERP® Practice Exam 3

13.

The variance of historical weekly price returns on the SP-15 on-peak power futures contract is .0323 over a 5-year period. What is the best estimate of annual volatility on the SP15 contract. a. b. c. d.

14.

Which VaR methodology provides the greatest flexibility and best approximation for a portfolio of power generating assets? a. b. c. d.

15.

23.3% 40.2% 116.4% 129.5%

Delta Delta-Gamma Historical Simulation using information from the last 90 trading days Monte Carlo Simulation

A US based petroleum producer is building an LNG train on the coast of Australia which is scheduled to be completed in five years. To help mitigate foreign currency fluctuations the producer has structured a 5-year, fixed-for-floating swap on the Australian dollar (AUD) with an A rated counterparty. The producer is concerned about migration of the counterparty’s credit rating in the later years of the swap. Which of the following structures will help reduce the producer’s potential long-term counterparty exposure? a. b. c. d.

10

A A A A

CVA adjustment reset agreement take-or-pay provision netting agreement

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ERP® Practice Exam 3

Questions 16-17 use the information below: On September 1, 2014, a regional airline contracts to purchase 60,000 gallons of jet fuel from a local refinery for forward delivery in one-year at a fixed-price of USD 3.88/gallon. Terms of the purchase require the airline to take delivery of the jet fuel on September 1, 2015, after making payment in full. The continuously compounded risk-free interest rate is 4% per year.

16.

How will settlement risk on the transaction change if the closing price of jet fuel is USD 4.35/gallon on July 31? a. b. c. d.

17.

risk risk risk risk

increases. remains the same. decreases. cannot be determined from the information provided.

Assume that by the end of April 2015, the price for jet fuel has risen to USD 4.14/gallon. What is the refinery’s replacement risk on April 30, 2015 (four months from the delivery date)? a. b. c. d.

18.

Settlement Settlement Settlement Settlement

USD USD USD USD

7,407 9,309 11,684 15,393

Assume the daily change in Brent Crude Oil prices and Newcastle Coal prices are independent. What is the probability that the price of Brent Crude Oil and Newcastle Coal will both increase by more than 2% on a given day based on the following: • •

40% probability that Brent Crude Oil price will increase more than 2% 15% probability that Newcastle Coal price will increase more than 2%

a. b. c. d.

6% 9% 11% 55%

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11

ERP® Practice Exam 3

19.

Consider a USD 7,200,000 credit exposure related to a 10-year fixed-rate bond issued by a Baa3/BBB- rated midstream oil and gas company. Assuming a USD 8,000,000 par value and an estimated recovery rate of 43%, what is the bond’s implied default probability if the expected loss is USD 291,500? a. b. c. d.

20.

When executed, which of the following long option positions has the greatest potential for wrong-way risk with the referenced counterparty? a. b. c. d.

21.

A A A A

crude oil producer long a put option on WTI futures gas-fired electric power generator long a natural gas swap natural gas producer long a floor on natural gas refinery long a straddle on gasoline futures

Which statement best explains the difference between risk appetite and risk tolerance? a. b. c. d.

12

At-the-money call option on an oil future with a BBB rated oil producer At-the-money put option on an oil future with an AA rated shipping company Out-of-the-money put option on an oil future with a BBB rated shipping company Out-of-the-money put option on an oil future with an AA rated oil producer

What OTC derivative transaction provides the greatest economic benefit (to the counterparty identified) in a bilateral netting arrangement? a. b. c. d.

22.

6.19% 6.40% 6.83% 7.10%

Risk appetite is a measure of how much risk an organization is willing to take on, while risk tolerance is used to communicate a level of acceptable risk Risk appetite expresses a range of risk levels an organization is willing to endure, while risk tolerance is a single definitive figure Risk appetite is a willingness to embrace risk, while risk tolerance is an aversion to enduring risk Risk appetite cannot be derived empirically, while risk tolerance can

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ERP® Practice Exam 3

23.

A refined products trader has structured a 1-year fixed-for-floating swap on 150,000 barrels of gasoil with a Ba1/BB+ rated counterparty. The trader has been given the following information from various risk groups within the organization: • • • •

Expected exposure: 3.50% Loss given default: 70% Probability of default: 1-Year: 0.87% Annual continuously compounded risk-free rate: 1.50%

The best approximation of the CVA for the swap (assuming annual settlements) is: a. b. c. d.

24.

What best describes the approach senior management should take to develop an effective risk appetite statement for an energy company according to the COSO framework? a. b. c. d.

25.

0.009% 0.021% 0.599% 2.414%

Develop a consistent appetite across all risk classes to ensure the policy can be communicated clearly and powerfully across the company Focus on establishing a financial risk appetite benchmark that can ensure the profitability of each operating unit Delegate decisions on risk appetite to individual operational units to ensure fitness for purpose and ownership at the operating level Consider each major risk class separately and set independent risk appetites for each one

Risk managers at a nuclear power facility are working with plant engineers to develop an engineering-based model assessment of the potential for a catastrophic operational failure. What best describes the weakness in using this approach to forecast the probability of such an event? a. b. c. d.

It relies on reactive analyses when estimating projections It does not properly account for the interaction between parts of a complex mechanical system It tends to overweight the potential for a plant meltdown while underweighting the potential for less serious operational failures It fails to account for the reaction of plant managers to a crisis situation, likely underestimating the probability of an operational failure

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13

Energy Risk Professional ® (ERP ) Exam Practice Exam 3 Answers

ERP® Practice Exam 3

a.

b.

c.

d.



1.

18.



2.

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21. 22.







20.

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d.







c.

19.

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b.

  

23.

7.



24.



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25.



9.

 

10. 11.



12.



13.



14.



Correct way to complete

15.



1.

16.



Wrong way to complete

17.





1.

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✓

✘

15

Energy Risk Professional ® (ERP ) Exam Practice Exam 3 Explanations

ERP® Practice Exam 3

1.

The middle office trade support group at a crude oil trading firm is evaluating the margin requirements for a long position in 400 April WTI futures contracts. The position includes the following terms: • • • •

Trade date: January 25 Purchase price: USD 107.81 Initial margin requirement: USD 3,900,000 Required maintenance threshold: USD 3,120,000

Below what price (in USD) will a margin call be triggered on the April WTI futures position, assuming the exchange requires the account balance for all futures positions to be “topped-up” to their initial required margin level in the event of a margin call? a. b. c. d.

102.68 104.99 105.86 107.61

Answer: c Explanation: The correct answer is c. The trader can lose no more than (3,900,000-3,120,000), or 780,000, on this trade without receiving a call. In order to find the correct price, we must first find the gain or loss on the trade per dollar change in the WTI futures contracts, which is 400 contracts * 1,000 barrels per contract, or USD 400,000. Therefore, the contract can trade no lower than 107.81-(780,000/400,000), or 105.86, before the trader gets a call. Reading reference: IEA, “The Mechanics of the Derivatives Markets: What They Are and How They Function” (Special Supplement to the Oil Market Report, April 2011), Or Kaminski 4, 116-117.

2.

A refinery purchases NYMEX WTI futures contracts to hedge the purchase of 40,000 barrels of WTI crude oil in two months. The contracts are purchased at USD 97.00/bbl. Two months later, the refiner closes the futures position and purchases 40,000 barrels at spot. What is the effective price paid per barrel if the futures contract is now trading at USD 98.50/bbl and the spot price is USD 100.10/bbl? a. b. c. d.

USD USD USD USD

98.50 98.60 100.10 100.40

Answer: b Explanation: The effective price paid (in dollars per barrel) is the final spot price less the gain on the futures, or 100.10 – 1.50 = 98.60. This can also be calculated as the initial futures price plus the final basis, 97.00 + 1.60 = 98.60. Reading reference: Robert McDonald, Derivatives Markets, 3rd Edition, Chapter 6.

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17

ERP® Practice Exam 3

3.

Calculate the net profit on the following straddle position assuming the NYMEX ULSD closing futures price is USD 2.73/gallon at expiration? • •

2-month NYMEX USLD call option with a strike price of USD 2.91/gallon and premium of USD 0.05/gallon 2-month NYMEX USLD put option with a strike price of USD 2.91/gallon and premium of USD 0.09/gallon

a. b. c. d.

USD USD USD USD

1,680 per contract 2,100 per contract 3,780 per contract 5,400 per contract

Answer: a Explanation: Answer “a” is correct because at a closing price of 2.73, the profit is 2.91 - 2.73 - 0.05 - 0.09 = 0.04 multiplied by 42,000 gallons per contract. In this situation the “long put” provided the profit, while the premium payments reduced the profit. Reading reference: IEA, “The Mechanics of the Derivatives Markets: What They Are and How They Function.” (Special Supplement to the Oil Market Report, April 2011).

4.

The market risk manager for a refinery plans to structure a collar for margin protection. She has the following price data available for options on NYMEX RBOB futures to assess the economics of the transaction: RBOB Strike Price (USD/gal) 3.21 3.29

Call Premium (USD) 0.156 0.129

Put Premium (USD) 0.137 0.146

Assuming the NYMEX RBOB futures contract is currently trading at USD 3.24/gal, how would the risk manager structure the transaction to best manage earnings volatility in the refinery’s operations? a. b. c. d.

Buy put options @ USD 3.21 strike and sell call options @ USD 3.29 strike Sell put options @ USD 3.21 strike and buy call options @ USD 3.29 strike Buy put options @ USD 3.29 strike and sell call options @ USD 3.21 strike Sell put options @ USD 3.29 strike and buy call options @ USD 3.21 strike

Answer: a Explanation: The correct answer is a. The collar will help the refiner to hedge price risk and, by extension, margins on its refining operation for the month of October. In this case, the refiner will lock in a range of selling prices between 3.21 and 3.29 (less any cost of implementing the trade). If the RBOB price rallies over 3.29, the sold call will be assigned to the refiner so the refiner will realize an effective price of 3.29. If the price falls below 3.21, the refiner can exercise the put option to lock in the price at that level. Reading reference (new): Vincent Kaminski, Energy Markets, Chapter 18.

18

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ERP® Practice Exam 3

5.

A petroleum commodities trader observes the following NYMEX price quotes. He believes the spread is too wide and executes a ten-contract position to benefit from a narrowing of the spread: • •

August RBOB: USD 2.58/gal December RBOB: USD 2.74/gal

On June 30, the contracts close at the following prices: • •

August RBOB: USD 2.63/gal December RBOB: USD 2.68/gal

What is the trader’s profit (ignoring broker costs, margin requirements and other expenses) on the position based on the June 30 closing prices? a. b. c. d.

USD USD USD USD

5,040 29,400 46,200 67,200

Answer: c Explanation: Answer “c” is correct. The trader’s expectations were that the spread of USD 0.16/gal would narrow; therefore he buys the low price contract and sells the high price contract. He bought the August contract (USD 2.58) and sold the December contract (USD 2.74) for a spread of USD 0.16/gal. In June, he closes out her position by selling the August contract for USD 2.63/gal and buys the December contract for USD 2.68/gal. Since he transacted for 10 contracts at 42,000 gallons per contract, his net profit is 420,000 x USD 0.11, or USD 46,200. Had the trader thought the spread would widen, he would have reversed the transactions. Reading reference: Vincent Kaminski, Energy Markets, Chapter 4, pages 142-144, 149.

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19

ERP® Practice Exam 3

Questions 6-7 use the information below: A risk manager at a large international bank, has compiled the following closing price data on the Brent Crude Oil futures contract for the past 31 trading days:

Futures Price (USD)

120 115 110 105 100 10/1/2013

6.

10/16/2013 Time

10/31/2013

Which quantitative approach will produce the most conservative (highest) 1-day, 95% VaR estimate for the bank’s Brent crude oil futures portfolio? a. b. c. d.

Exponentially Weighted Moving Average with a lambda of 0.91 Exponentially Weighted Moving Average with a lambda of 0.99 Eigenvector Weighted Average with a lambda of 0.99 Simple Moving Average

Answer: a Explanation: The correct answer is a. The EWMA will weight recent observations more heavily than older observations. An EWMA model with a lambda of 1 is equal to a simple moving average, and for lambdas just below 1, the most recent observations are weighted slightly more. As the decay factor (lambda) is decreased, the weightings of the most recent observations increase dramatically. Reading reference: Clewlow and Strickland, Chapter 10, pp. 184-185.

20

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ERP® Practice Exam 3

7.

While backtesting a 1-year, 99% VaR model, the risk manager finds six exceptions to the VaR model. How should he interpret this result relative to Basel requirements? a. b. c. d.

The model is in the “green zone” and is acceptable to use with no further revision The model is in the “yellow zone” and further adjustments must be made such as increasing the safety multiplier used with the model The model is in the “red zone” and must be dramatically revised before it can be used further The model is in the “red zone” and the model must be discarded

Answer: b Explanation: Between 5 and 9 exceptions to a 99% VAR model in a 250-day period puts the model in the “yellow zone” where further actions must be taken in order for the model to continue being used. One potential solution could be raising the “safety multiplier,” which is the number by which the 99% VaR is multiplied by to create the bank’s capital cushion. 10 or more exceedences puts the model into the “red zone” where it must be substantially revised to continue being used (and the bank often pays a penalty in that case.) Reading reference: Clewlow and Strickland, Chapter 10, p. 205.

8.

The 10-day, 95% VaR for a USD 10,000,000 energy commodity portfolio is USD 2,000,000. Based on the VaR calculation, what is the correct interpretation of market risk for the portfolio? a. b. c. d.

Portfolio losses over a ten day period are expected to exceed USD 2 million once in every five, ten-day periods Portfolio losses over a ten day period are expected to exceed USD 2 million once in every twenty, ten-day periods There is a 5% chance that portfolio losses will exceed USD 2 million during the next ten trading days There is a 95% chance that portfolio losses will exceed USD 2 million during the next ten trading days

Answer: b Explanation: The correct answer is b. A 95% confidence level means that there is a one-in-20, or a 5% chance, that a loss should exceed the portfolio VaR over the time period that the VaR specifies. In this case, the 10day VaR of 2 million indicates that the portfolio should be expected to lose more than USD 2 million once in every 20 ten-day periods. Reading reference: Les Clewlow and Chris Strickland. Energy Derivatives: Pricing and Risk Management. Chapter 10.

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21

ERP® Practice Exam 3

9.

A commercial airline structures a collar to manage price risk on 50,000 barrels of jet fuel. The collar includes the following terms: • • • •

Cap: USD 125/bbl Floor: USD 115/bbl Tenor: Six months (June to November) Valuation Index: Mean of Platts Singapore (MOPS)

The monthly MOPs Index per barrel are as follows: • • •

June: USD 132 July: USD 120 August: USD 111

• • •

September: USD 128 October: USD 122 November: USD 115

Calculate the net payment owed to/from the airline at settlement on November 30? a. b. c. d.

The The The The

airline airline airline airline

receives USD 300,000 pays USD 300,000 receives USD 500,000 pays USD 500,000

Answer: a Explanation: Because the airline is a consumer of oil, the airline will purchase a costless collar composed of one long 125 call funded by a short 115 put. Settlement payments will be made for June, August and September, the months that the index price is set beyond the cap/floor price threshold. For June the airline will receive USD 350,000 (132 – 125 x 50,000); in September, they will receive USD 150,000 (128 – 125 x 50,000); in August the airline will pay USD 200,000 (115 – 111 x 50,000) resulting in a total settlement after six months of USD 300,000. Reading reference: Vincent Kaminski, Energy Markets, Chapter 18, Transactions in the Oil Markets.

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ERP® Practice Exam 3

10.

A market risk analyst has applied a factor-push model to stress test the MtM value of several combinations of option positions on the April 2015 NYMEX WTI futures contract. The model applies a four standard deviation decrease in the price of the underlying futures contract. Each option has the same expiration date and the current settlement price for the April 2015 WTI contract is USD 105. What combination of options will be least impacted by the factor-push model? a. b. c. d.

A A A A

long 95 call and a long 115 call long 100 call and a short 110 call long 105 call and a long 105 put short 100 put and a long 100 call

Answer: c Explanation: A factor-push model is only useful when the maximum loss on the position occurs when the risk factor has been “pushed” or stressed the hardest. Therefore the return profile of the underlying position with respect to the risk factor needs to be monotonic (i.e. steadily increasing or decreasing for every value of the risk factor.) In cases where a position has non-monotonicity, or the maximum loss occurs when the value of the risk factor is not at an extreme, a factor push model will not predict the maximum loss. In this case choice a would be correct, since the greatest loss would take place if the underlying remained at USD 105 and the position would actually increase in value if the factor was pushed in either direction. Reading reference: Dowd, Managing Market Risk, Chapter 13, pp. 303-304.

Questions 11-12 use the information below: A credit analyst at a regional commercial bank has been asked to assess the credit fundamentals related to four different energy companies. To complete the analysis the analyst has assembled the following data from the most recently published balance sheet for each entity: Balance Sheet (in Millions USD) Cash Short-term investments Accounts receivable Inventory Total current assets

Company A 1,675 1,767 888 4,467 8,797

Company B 5,643 8,259 1,337 21,785 37,024

Company C 7,610 5,659 4,296 2,145 19,710

Company D 15,376 5,297 6,489 45,832 72,994

Property, plant and equipment Total assets

13,370 22,167

17,812 54,836

3,899 23,609

27,432 100,426

Total current liabilities Long term debt Total liabilities Total shareholder equity

5,770 10,000 16,770 6,397

12,893 15,555 28,448 26,388

4,252 3,210 7,462 16,147

48,659 0 48,659 51,767

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23

ERP® Practice Exam 3

11.

Which of the following relationships will provide the best measure of financial leverage used by each company? a. b c. d.

(Total Liabilities) (Total Shareholder Equity) (Long Term Debt) (Total Current Assets) (Long Term Assets) (Total Current Liabilities) (Total Liabilities-Long Term Debt) (Total Assets)

Answer: a Explanation: One of the most important debt management ratios is the debt/equity ratio, which assesses the financial leverage of the firm by comparing its level of debt financing to its total net worth. This is expressed as Total liabilities/Total net worth, where total net worth is equal to the firm’s total shareholder equity. Reading reference: Betty Simkins and Russell Simkins, eds. Energy Finance and Economics: Analysis and Valuation, Risk Management, and the Future of Energy, Chapter 9, p. 200.

12.

Using the Quick Ratio as a guideline, which company has the highest relative short-term liquidity risk? a. b. c. d.

Company Company Company Company

A B C D

Answer: d Explanation: The Quick Ratio is a more conservative form of the Current Ratio which assumes that a firm will not be able to easily liquidate its inventory, and in a crisis that a firm will not get full market value for its inventory. Hence it is a measure of the liquid assets a firm has available to pay back its current obligations. The formula for the Quick Ratio is as follows: (Current assets-Inventory) (Current Liabilities) In this case, Company D has the lowest Quick Ratio, at (72,994 – 45,832) / 48,659, or 0.52. This is because most of Company D’s current assets are held as inventory, which is not easily liquidated. The Quick Ratios for companies A, B and C are 0.86, 1.18, and 4.13 respectively. Reading reference: Betty Simkins and Russell Simkins , eds. Energy Finance and Economics: Analysis and Valuation, Risk Management, and the Future of Energy, Chapter 9, p. 197.

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ERP® Practice Exam 3

13.

The variance of historical weekly price returns on the SP-15 on-peak power futures contract is .0323 over a 5-year period. What is the best estimate of annual volatility on the SP15 contract. a. b. c. d.

23.3% 40.2% 116.4% 129.5%

Answer: d Explanation: Answer d is the correct answer. As per the text, historical volatility is derived by multiplying the standard deviation (square root of variance) of price changes by the square root of time (52), the factor required to annualize the weekly prices observed in the sample. Reading reference: Les Clewlow and Chris Strickland, Energy Derivatives: Pricing and Risk Management, Chapter 3.

14.

Which VaR methodology provides the greatest flexibility and best approximation for a portfolio of power generating assets? a. b. c. d.

Delta Delta-Gamma Historical Simulation using information from the last 90 trading days Monte Carlo Simulation

Answer: d Explanation: A Monte Carlo simulation will better account for market behavior like price jumps that are often found in energy commodities (particularly electricity) and option pricing than the other methods; the historical simulation would also provide a good approximation however the relatively short “lookback” period is not sufficient to capture price jumps. Reading reference: Les Clewlow and Chris Strickland. Energy Derivatives: Pricing and Risk Management. Chapter 10.

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25

ERP® Practice Exam 3

15.

A US based petroleum producer is building an LNG train on the coast of Australia which is scheduled to be completed in five years. To help mitigate foreign currency fluctuations the producer has structured a 5-year, fixed-for-floating swap on the Australian dollar (AUD) with an A rated counterparty. The producer is concerned about migration of the counterparty’s credit rating in the later years of the swap. Which of the following structures will help reduce the producer’s potential long-term counterparty exposure? a. b. c. d.

A A A A

CVA adjustment reset agreement take-or-pay provision netting agreement

Answer: b Explanation: A reset agreement stipulates that the mark to market be settled at certain designated points in time. At these points a cash payment is made that reflects the current mark to market and the terms of the swap are reset at the prevailing rate, so that exposure becomes 0 after every reset is made. This allows exposure to be “paid out” more frequently and reduces the amount of exposure which could potentially be outstanding in later years of the agreement when the health of the counterparty is much less certain. Reading reference: Jon Gregory. Counterparty Credit Risk: A Continuing Challenge for Global Financial Markets, Chapter 4.

Questions 16-17 use the information below: On September 1, 2014, a regional airline contracts to purchase 60,000 gallons of jet fuel from a local refinery for forward delivery in one-year at a fixed-price of USD 3.88/gallon. Terms of the purchase require the airline to take delivery of the jet fuel on September 1, 2015, after making payment in full. The continuously compounded risk-free interest rate is 4% per year.

16.

How will settlement risk on the transaction change if the closing price of jet fuel is USD 4.35/gallon on July 31? a. b. c. d.

Settlement Settlement Settlement Settlement

risk risk risk risk

increases. remains the same. decreases. cannot be determined from the information provided.

Answer: b Explanation: The settlement risk is constant based on the original terms of the fixed price purchase contract. Replacement risk will change with the spot price of the underlying commodity, but not the settlement risk. Reading reference: Markus Burger, Bernhard Graeber, and Gero Schindlmayr. Managing Energy Risk: An Integrated View on Power and Other Energy Markets. Chapter 3.4.

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ERP® Practice Exam 3

17.

Assume that by the end of April 2015, the price for jet fuel has risen to USD 4.14/gallon. What is the refinery’s replacement risk on April 30, 2015 (four months from the delivery date)? a. b. c. d.

USD USD USD USD

7,407 9,309 11,684 15,393

Answer: d Explanation: The correct answer is d. The replacement risk can be calculated by using the following equation: R = Volume x Price Difference x (discount factor, at t =4/12 and r =0.04) R = 60,000* (4.14-3.88) * exp(-0.04 x 4/12) = 15,393. Reading reference: Markus Burger, Bernhard Graeber, and Gero Schindlmayr. Managing Energy Risk: An Integrated View on Power and Other Energy Markets. Chapter 3.4.

18.

Assume the daily change in Brent Crude Oil prices and Newcastle Coal prices are independent. What is the probability that the price of Brent Crude Oil and Newcastle Coal will both increase by more than 2% on a given day based on the following: • •

40% probability that Brent Crude Oil price will increase more than 2% 15% probability that Newcastle Coal price will increase more than 2%

a. b. c. d.

6% 9% 11% 55%

Answer: a Explanation: Correct answer is a. The joint probability of two independent events represents the product of the probabilities for each independent outcome. In this case the joint probability is represented by P[B] * P[D] or 6% B is incorrect: 9% = ((P[B]+P[D]))⁄((P[B]* P[D]) ) C is incorrect: 11% = ((P[B]*P[D]))⁄((P[B]+ P[D]) ) D in incorrect: 55% = P[B] + P[D] Reading reference: Michael Miller. Mathematics and Statistics for Financial Risk Management, 2nd Edition. Chapter 2.

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27

ERP® Practice Exam 3

19.

Consider a USD 7,200,000 credit exposure related to a 10-year fixed-rate bond issued by a Baa3/BBB- rated midstream oil and gas company. Assuming a USD 8,000,000 par value and an estimated recovery rate of 43%, what is the bond’s implied default probability if the expected loss is USD 291,500? a. b. c. d.

6.19% 6.40% 6.83% 7.10%

Answer: d Explanation: Correct answer is d. Per the following formula: Expected loss = Loss Given Default x probability of default In this example Loss Given Default can be derived by multiplying the Credit Exposure by (1-Recovery Rate) = USD 4,104,000. Using this information along with the Expected Loss of USD 291,500, the implied probability of default is 7.10% or USD 291,500/USD 4,104,000. Note that the par value of the bonds is not used in the calculation. Reading reference: Allan Malz. Financial Risk Management, Chapter 6, pages 201-203.

20.

When executed, which of the following long option positions has the greatest potential for wrong-way risk with the referenced counterparty? a. b. c. d.

At-the-money call option on an oil future with a BBB rated oil producer At-the-money put option on an oil future with an AA rated shipping company Out-of-the-money put option on an oil future with a BBB rated shipping company Out-of-the-money put option on an oil future with an AA rated oil producer

Answer: d Explanation: Wrong-way risk arises in cases when the credit risk of the counterparty increases as your exposure to that counterparty increases. In other words, there is a positive correlation between your exposure to a counterparty and the credit risk (or default probability) of that counterparty. Choice D has the most wrong way risk: this option position increases in value as the price of oil decreases, but the oil producer’s credit risk would be increasing at the same time. The farther the option becomes in-the-money, the greater the probability of counterparty defaulting. That is the wrong-way risk. Reading reference: Jon Gregory. Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets, Chapter 15.

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ERP® Practice Exam 3

21.

What OTC derivative transaction provides the greatest economic benefit (to the counterparty identified) in a bilateral netting arrangement? a. b. c. d.

A A A A

crude oil producer long a put option on WTI futures gas-fired electric power generator long a natural gas swap natural gas producer long a floor on natural gas refinery long a straddle on gasoline futures

Answer: b Explanation: Answer b is correct. To provide economic benefit in a netting arrangement, a derivative position must have the potential to have a negative mark-to-market. Long option positions in which the premium is paid upfront would be the least beneficial to a netting arrangement making a, c and d incorrect. The long (fixed- rate payer) position in a natural gas swap would have the greatest likelihood of creating a negative MtM and therefore the greatest economic benefit in a netting arrangement. Reading reference: Jon Gregory. Counterparty Credit Risk: A Continuing Challenge for Global Financial Markets, Chapter 4.

22.

Which statement best explains the difference between risk appetite and risk tolerance? a. b. c. d.

Risk appetite is a measure of how much risk an organization is willing to take on, while risk tolerance is used to communicate a level of acceptable risk Risk appetite expresses a range of risk levels an organization is willing to endure, while risk tolerance is a single definitive figure Risk appetite is a willingness to embrace risk, while risk tolerance is an aversion to enduring risk Risk appetite cannot be derived empirically, while risk tolerance can

Answer: a Explanation: The correct answer is a; this is the correct definition of risk appetite and risk tolerance. Reading reference: John Fraser and Betty Simkins, Enterprise Risk Management: Today’s Leading Research and Best Practices for Tomorrow’s Executives, Chapter 16, pages 287-289.

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29

ERP® Practice Exam 3

23.

A refined products trader has structured a 1-year fixed-for-floating swap on 150,000 barrels of gasoil with a Ba1/BB+ rated counterparty. The trader has been given the following information from various risk groups within the organization: • • • •

Expected exposure: 3.50% Loss given default: 70% Probability of default: 1-Year: 0.87% Annual continuously compounded risk-free rate: 1.50%

The best approximation of the CVA for the swap (assuming annual settlements) is: a. b. c. d.

0.009% 0.021% 0.599% 2.414%

Answer: b Explanation: The correct answer is b. CVA can be estimated as: CVA ≈ [(1-d) * Bt * EEt * q (tj-1,tj)] calculated at each payment period and summed together. Where (1-d) equals the loss given default (hence d is the recovery rate), Bt is the discount factor at time t, EE is the expected exposure and q (tj-1,tj) is the probability of default during the specified time period. Since this is a 1-year period with an annual payment then only one calculation need be made. Explanations for the distracters: Answer a multiplies by the recovery rate instead of by the loss given default. Answer c omits the expected exposure in the calculation. Answer d omits the probability of default in the calculation. Reading reference: Jon Gregory. Counterparty Credit Risk: The New Challenge for Global Financial Markets, Chapter 7, pages 167-172.

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ERP® Practice Exam 3

24.

What best describes the approach senior management should take to develop an effective risk appetite statement for an energy company according to the COSO framework? a. b. c. d.

Develop a consistent appetite across all risk classes to ensure the policy can be communicated clearly and powerfully across the company Focus on establishing a financial risk appetite benchmark that can ensure the profitability of each operating unit Delegate decisions on risk appetite to individual operational units to ensure fitness for purpose and ownership at the operating level Consider each major risk class separately and set independent risk appetites for each one

Answer: d Explanation: The correct answer is d. The company and its stakeholders will in general have a different risk appetite for different risks, and so different classes of risk must be considered separately. Meeting legislation is necessary, but not necessarily sufficient — risks to reputation or “license to operate” may need tighter control of risks. Risk appetite must be set at the top of the company, and cannot be delegated — though the appetite will be interpreted locally for determining risk tolerances. Reading reference: COSO, “Understanding and Communicating Risk Appetite.” Pages 4-10.

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31

ERP® Practice Exam 3

25.

Risk managers at a nuclear power facility are working with plant engineers to develop an engineering-based model assessment of the potential for a catastrophic operational failure. What best describes the weakness in using this approach to forecast the probability of such an event? a. b. c. d.

It relies on reactive analyses when estimating projections It does not properly account for the interaction between parts of a complex mechanical system It tends to overweight the potential for a plant meltdown while underweighting the potential for less serious operational failures It fails to account for the reaction of plant managers to a crisis situation, likely underestimating the probability of an operational failure

Answer: d Explanation: The correct answer is d. Engineering models focus on physical processes and materials, and do not typically account for the reaction of the humans who operate the equipment during times of crisis. As such, according to the authors, these models may under-report the likelihood of failure by a factor of 10, or more. Reading reference: Robert Bea, Ian Mitroff, Daniel Farber, Howard Foster and Karlene H. Roberts, A New Approach to Risk: The Implications of E3, pages 36-37. 

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About GARP | The Global Association of Risk Professionals (GARP) is a not-for-profit global membership organization dedicated to preparing professionals and organizations to make better informed risk decisions. Membership represents over 150,000 risk management practitioners and researchers from banks, investment management firms, government agencies, academic institutions, and corporations from more than 195 countries and territories. GARP administers the Financial Risk Manager (FRM®) and the Energy Risk Professional (ERP®) Exams; certifications recognized by risk professionals worldwide. GARP also helps advance the role of risk management via comprehensive professional education and training for professionals of all levels. www.garp.org.

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