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ERP Practice Exam4 7115

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ERP

Practice

Exam 4

PM Session

Financial25 Questions

TABLE OF CONTENTS

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

2015 Global Association of Risk Professionals. All rights reserved. It is illegal to reproduce this material

in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

Introduction

Candidates are expected to understand energy risk man-

erasers) available.

exam and set an alarm to alert you when a total of

eectively.

candidates in their preparation for the ERP Exam. This

cell phones, televisions, etc.; put away any study

world, an energy risk manager must be able to identify any

sheet, calculator, and writing instruments (pencils,

agement concepts and approaches. It is very rare that an

be no exceptions to this policy. You will not be allowed

and afternoon session, each containing 70 multiple choice

and Hewlett Packard 20B.

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

minutes in your score.

are derived from these core readings in their entirety. As

better understand the correct and incorrect answers

the exam.

To maximize the eectiveness of the practice exams, candidates are encouraged to follow these recommendations:

based on the distribution of scores from all candidates, so use your scores only to gauge your own

progress and level of preparedness.

2015 Global Association of Risk Professionals. All rights reserved. It is illegal to reproduce this material

in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

Energy Risk

Professional

(ERP ) Exam

Practice Exam 4

Answer Sheet

a.

b.

c.

d.

a.

1.

18.

2.

19.

3.

20.

4.

21.

5.

22.

6.

23.

7.

24.

8.

25.

b.

c.

d.

9.

10.

11.

12.

13.

14.

15.

1.

16.

17.

1.

2015 Global Association of Risk Professionals. All rights reserved. It is illegal to reproduce this material

in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

Energy Risk

Professional

(ERP ) Exam

Practice Exam 4

Questions

1.

2.

An independent refinery has purchased a 3-month cap to hedge its crude oil supply requirement for the next

three months. The cap is written on 180,000 barrels of crude oil per month with a strike price of USD

63.50/bbl and premium of USD 1.80/bbl. The contract requires monthly settlement against the average front

month NYMEX WTI contract. Using the average monthly NYMEX WTI closing prices below, calculate the net

profit required to the refinery in settling the cap.

Month 2: USD 62.30

Month 3: USD 69.80

a.

b.

c.

d.

USD

USD

USD

USD

The economics of forward price formation in which energy commodity market is the least affected by the

concept of convenience yield?

a.

b.

c.

d.

3.

450,000

510,000

720,000

1,038,000

Electricity

Heating oil

Jet fuel

Natural gas

A Texas based refiner purchases NYMEX WTI futures contracts that lock in a price for its crude oil supply for the

next three months. The refiner executes an Exchange Futures for Physical (EFP) contract to ensure physical delivery

of crude at the Port of Houston. How will the refiner report the EFP transaction under the terms of Dodd-Frank?

a.

b.

c.

d.

The

The

The

The

refiner

refiner

refiner

refiner

must report the notional value of the underlying physical crude oil.

must first register as a swap dealer before entering into an EFP contract.

must report the market value of the EFP as a swap at the time it is purchased.

in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

4.

A Texas refinery is negotiating a 2-year OTC crude oil swap with a local crude oil producer in early December

2013, to be cleared through ICE with the following basic terms:

Fixed payer (buyer): Refiner

Floating payer (seller): Producer

Volume: 200,000 barrels

Fixed Price: TBD

Floating Price: Closing ICE Brent Futures Price on February 15, 2014 and 2015

At the time of trade execution, the 1-year and 2-year Brent futures prices are USD 102.65 and USD 104.28, and

the annual zero-coupon bond yields are 1.5% and 2.0% respectively. Consider the following expression:

x

y

z

z

+

=

=

1.02

1.02752

1.02

1.02752 = w

Which variable corresponds to the 2-year swap price?

a.

b.

c.

d.

5.

w

x

y

z

Acme Plastics is a large manufacturing plant that uses crude oil as a feedstock for their manufacturing

processes. Acme decides to enter into a forward swap transaction to secure the 80,000 barrels of oil they will

need for each of the next two years. The swap has the following terms:

Price of crude oil in year two: USD 104/bbl

One-year zero coupon bond yield: 4%

Two-year zero coupon bond yield: 4.5%

Swap payment terms: two equal annual payments

What is the amount per barrel (in USD) Acme will pay on this swap?

a.

b.

c.

d.

91.46

93.51

97.50

101.66

in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

In early March 2014 the spot price of Brent crude oil is USD 107.90 and estimated monthly crude oil storage

costs are USD 0.75/bbl. Traders are using the following market data to identify potential market opportunities.

Brent crude oil futures contract prices:

US Treasury zero-coupon bond yields:

6.

The breakeven forward price (is USD) required for a 6-month storage arbitrage to be profitable assuming storage costs are paid at the beginning of each month with no market convenience yield is approximately:

a.

b.

c.

d.

7.

What best approximates (in USD) the zero coupon bond position required to synthetically replicate a long

18-month forward position on 250,000 barrels of Brent crude oil?

a.

b.

c.

d.

8.

111.09

113.79

115.73

118.53

24,781,000

25,982,000

26,270,000

27,732,000

You hold a large position of deep in-the-money put options on NYMEX Crude Oil Futures. In the past week,

NYMEX Crude Oil Futures have risen sharply, causing the gamma of the position to become more negative.

What action can you take to increase the gamma of the position the most?

a.

b.

c.

d.

Buy at-the-money options

Sell out-of-the money options

Buy out-of-the-money options

in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

9.

Use the temperature data below to calculate Cooling Degree Days (CDD) for a 7-day period:

High

Temperature

71F

75F

72F

69F

64F

65F

64F

a.

b.

c.

d.

10.

Low

Temperature

62F

63F

65F

67F

61F

59F

58F

Average

Temperature

66.5F

69.0F

68.5F

68F

62.5F

62F

61F

9.5

12

14.5

17

A credit analyst is evaluating the liquidity of an integrated petroleum producer to assess its ability to meet

scheduled debt payments. The analyst has the following information from the producers most recent quarterly

financial statement:

USD

Sales and other operating income

9,347,000

1,316,000

1,543,000

876,000

781,000

297,000

484,000

Calculate the firms free cash flow for the most recent quarter.

a.

b.

c.

d.

USD

USD

USD

USD

-392,000

-95,000

1,151,000

2,027,000

in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

11.

12.

An airline uses NYMEX Ultra-Low Sulfur Diesel (ULSD) futures contracts to hedge its short jet fuel exposure.

Use the volatility and correlation data below to calculate the minimum variance hedge ratio.

ULSD futures price volatility: 16.54%

Correlation between jet fuel and ULSD futures price returns: 0.823

a.

b.

c.

d.

0.727

0.883

0.932

1.132

Consider a netting set containing six equal counterparty exposures totaling GBP 3,600,000. The average

correlation between the positions is 0.15 and the future values of the exposures are normally distributed.

What is the best estimate for the expected net exposure?

a.

b.

c.

d.

13.

GBP

GBP

GBP

GBP

794,000

1,273,000

1,944,000

3,112,000

The following table summarizes the 4-year implied probability of default associated with four midsize oil

exploration and production companies.

Company

Year 1

Year 2

Year 3

Year 4

Company A

0.04%

0.17%

0.37%

0.53%

Company B

0.42%

1.05%

1.61%

2.32%

Company C

4.68%

8.41%

11.6%

13.8%

Company D

26.5%

33.1%

39.0%

44.2%

Which company is most likely to have a Moodys/Standard & Poors rating of B1/B+?

a.

b.

c.

d.

Company

Company

Company

Company

A

B

C

D

in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

14.

Recovery rate: 36%

Default probability: 8%

Credit spread: 4.5%

a.

b.

c.

d.

15.

7.80%

8.18%

10.68%

11.02%

Assume an energy commodity position has an average 10-day price return of 0.75% and a daily standard deviation of 1.25%. If daily price returns are independent and normally distributed, what is the portfolios 10-day,

95% VaR?

a.

b.

c.

d.

10

787,500

1,664,000

2,625,000

3,375,000

A credit risk analyst is evaluating a new one-year bond priced at par that pays an annual coupon. The bond

has a default probability of 12% with an estimated recovery rate of 40%. Assuming the analyst is risk neutral

and the 1-year risk free rate is 2.5%, what is the minimum coupon she would be willing to accept to invest in

the bond?

a.

b.

c.

d.

16.

USD

USD

USD

USD

5.75%

6.27%

6.43%

7.00%

in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

17.

18.

Use data from the credit report below to approximate the original exposure on the underlying bond position.

Recovery rate: 32%

Loss given default: USD 5,850,000

Expected loss: USD 3,910,500

a.

b.

c.

d.

USD

USD

USD

USD

4,620,000

6,174,000

8,603,000

11,197,000

A crude oil trader holds a long position in 100 call options on Brent Crude oil futures. The trader has identified

a second option on the same underlying contract that can be used to hedge market risk in her position.

What combination of the hedge option and the underlying futures contract will best neutralize the delta and

gamma of the traders position assuming the following market risk characteristics for the positions:

Delta

Gamma

a.

b.

c.

d.

19.

Long Option

0.613

0.0723

Hedge Option

-0.55

-0.0950

Sell 76 options and buy 19 futures contracts.

Sell 111 options and buy 3 futures contracts.

Buy 111 options and buy 3 futures contracts.

The following table represents the distribution of operational loss events from a sample of drilling companies

over a 6-month period:

Loss Events

0

1

2

3

4

Percentage of Observations

18%

36%

29%

13%

4%

Calculate the standard deviation for the distribution of operational loss events assuming a mean of 1.49.

a.

b.

c.

d.

1.05

1.11

1.22

1.34

in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

11

20.

A risk analyst has performed a regression analysis on ICE National Balancing Point (NBP) natural gas spot

price returns over the past 500 days in order to estimate the parameters for a simple mean reversion model.

The regression analysis includes the following coefficients for a linear relationship where:

y = 0.0285 x (Log of daily NBP Spot Prices) + 0.0188

Using terms from the linear relationship above, what is the best estimate of the mean reversion rate for NBP

natural gas spot prices?

a.

b.

c.

d.

21.

Which of the following best describes the relationship between risk-neutral default probabilities and historical

default probabilities?

a.

b.

c.

d.

22.

Theoretical default probabilities are typically higher than historical default probabilities due to liquidity

risk premiums

Historical default probabilities are typically higher than theoretical default probabilities due to negative

skew in bond returns

Theoretical default probabilities are typically higher than historical default probabilities for investment

grade credits and lower than historical default probabilities for non-investment grade credits

Historical default probabilities are typically higher than theoretical default probabilities for investment

grade credits and lower than theoretical default probabilities for non-investment grade credits

Which of the following mitigation actions, if taken by a central counterparty, will most likely increase risk on

an exchange traded futures contract?

a.

b.

c.

d.

12

2

9

14

21

Reduce margin requirements on contracts with low volatility and high liquidity.

Auction the right to replace contracts that are in default.

Increase margin requirements on contracts with large, highly concentrated positions.

in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

23.

To hedge the price exposure to its future production, power generator X is entering into a fixed price forward

sale contract with a load serving entity Y. Which of the following factors is least relevant for the evaluation of

Xs expected loss of its credit risk exposure to Y?

a.

b.

c.

d.

24.

The proper application of Key Performance Indicators (KPIs) and Key Risk Indicators (KRIs) in the pursuit of

an organizations risk management objectives is best described as:

a.

b.

c.

d.

25.

Ys credit rating

Xs target credit rating

Contractual payment term for X and Y to settle electric power delivered

Bilateral margining agreement between X and Y

The use of KPIs exclusively to develop an effective forward looking assessment of trends in operational

risk factors.

The integration of KPI objectives and KRI limits to create a single comprehensive risk-weighted metric.

The monitoring of KRIs to assess shifts in risk exposure and adjustment of business strategy and

operational procedures to better meet return on risk objectives identified by KPIs.

The replacement of KPIs with KRIs and adjustment of company-wide risk capital allocations to account

for the change in risk monitoring procedures.

A new exploration company is formed to develop and produce oil in the Arctic. How will the company most

likely implement quantitative and qualitative techniques in its risk management process?

a.

b.

c.

d.

Develop an integrated qualitative/quantitative risk strategy from the outset, since each technique is

incomplete when used in isolation

Develop a strategy based on the relative qualitative or quantitative experience of the management team

since either can be an effective risk management technique

Start with qualitative techniques since they are easier to devise and help provide a depth of information;

adopt quantitative techniques as capabilities develop

Start with quantitative techniques since they provide empirical data on degrees of risk exposure; adopt

qualitative techniques as operational experience grows

in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

13

Energy Risk

Professional

(ERP ) Exam

Practice Exam 4

Answers

a.

b.

c.

d.

a.

1.

18.

2.

19.

3.

20.

4.

5.

7.

8.

9.

10.

11.

12.

13.

17.

24.

25.

15.

16.

d.

23.

14.

c.

22.

6.

21.

b.

1.

1.

in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

15

Energy Risk

Professional

(ERP ) Exam

Practice Exam 4

Explanations

1.

An independent refinery has purchased a 3-month cap to hedge its crude oil supply requirement for the next

three months. The cap is written on 180,000 barrels of crude oil per month with a strike price of USD

63.50/bbl and premium of USD 1.80/bbl. The contract requires monthly settlement against the average front

month NYMEX WTI contract. Using the average monthly NYMEX WTI closing prices below, calculate the net

profit required to the refinery in settling the cap.

Month 2: USD 62.30

Month 3: USD 69.80

a.

b.

c.

d.

USD

USD

USD

USD

450,000

510,000

720,000

1,038,000

Answer: a

Explanation: The correct answer is a. By selling a cap, if the settlement price of crude oil is above the strike

price in a given month, the difference between the prices must be paid to the refinery. In this case, the first

and third months are above the strike price; the difference for month 1 is USD 1.60, the difference for month 3

is USD 6.30. Multiplied by the contract size of 180,000/bbl per month gives totals of USD 288,000 and USD

1,134,000 respectively for a total of USD 1,422,000, we then must subtract the premium paid for the cap (USD

1.80 x 180,000 bbl x 3 months = 972,000) from the cap total for a net settlement payment of USD 450,000.

Note: no payment is made in month 2 because the settlement price (USD 62.30) is below the strike price

(USD 63.50), though the cap premium is still paid for month 2.

Reading reference (new): IEA, The Mechanics of the Derivatives Markets: What They Are and How They

Function. (Special Supplement to the Oil Market Report, April 2011).

in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

17

2.

The economics of forward price formation in which energy commodity market is the least affected by the

concept of convenience yield?

a.

b.

c.

d.

Electricity

Heating oil

Jet fuel

Natural gas

Answer: a

Explanation: The correct answer is a. Convenience yield is a theoretical framework often used to explain backwardation in forward energy commodity prices. While most practitioners argue that convenience yield is irrelevant, storable commodities that exhibit seasonal demand patterns do have a positive economic benefit that

accrues to the owner of the underlying physical energy commodity. Commodities which cannot be reliably

stored, like electricity, would naturally not exhibit a convenience yield.

Reading reference: Vincent Kaminski. Energy Markets. Chapter 4 The instruments, pg. 134-138.

3.

A Texas based refiner purchases NYMEX WTI futures contracts that lock in a price for its crude oil supply for the

next three months. The refiner executes an Exchange Futures for Physical (EFP) contract to ensure physical delivery

of crude at the Port of Houston. How will the refiner report the EFP transaction under the terms of Dodd-Frank?

a.

b.

c.

d.

The

The

The

The

refiner

refiner

refiner

refiner

must report the notional value of the underlying physical crude oil.

must first register as a swap dealer before entering into an EFP contract.

must report the market value of the EFP as a swap at the time it is purchased.

Answer: a

Explanation: The correct answer is a. The CFTC determined that a swap of this nature (a physical exchange

transaction) is conducted so that the party engaging in the transaction may take physical delivery of the

contracted commodity. The transaction therefore is considered part of a physical settlement and not a financial swap transaction therefore it is exempt from D-F reporting requirements.

Reading reference: Gordon Goodman. Swaps: Dodd-Frank Memories.

18

in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

4.

A Texas refinery is negotiating a 2-year OTC crude oil swap with a local crude oil producer in early December

2013, to be cleared through ICE with the following basic terms:

Fixed payer (buyer): Refiner

Floating payer (seller): Producer

Volume: 200,000 barrels

Fixed Price: TBD

Floating Price: Closing ICE Brent Futures Price on February 15, 2014 and 2015

At the time of trade execution, the 1-year and 2-year Brent futures prices are USD 102.65 and USD 104.28, and

the annual zero-coupon bond yields are 1.5% and 2.0% respectively. Consider the following expression:

x

y

z

z

+

=

=

1.02

1.02752

1.02

1.02752 = w

Which variable corresponds to the 2-year swap price?

a.

b.

c.

d.

w

x

y

z

Answer: d

Explanation: The correct answer is d. The swap price is the annual fixed payment required to solve for the value

of a 2-year prepaid swap using the assumed forward Brent prices and 1 and 2-year zero-coupon bond rates.

In this case the total value of the swap, w, is equal to = (115.87/1.02) + (117.05)/(1.02752) = 224.47

Using this value, we can then solve for the swap price z which solves the following equation: (z / 1.02) +

( z / 1.02752) = 224.47, which yields 116.45.

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).

in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

19

5.

Acme Plastics is a large manufacturing plant that uses crude oil as a feedstock for their manufacturing

processes. Acme decides to enter into a forward swap transaction to secure the 80,000 barrels of oil they will

need for each of the next two years. The swap has the following terms:

Price of crude oil in year two: USD 104/bbl

One-year zero coupon bond yield: 4%

Two-year zero coupon bond yield: 4.5%

Swap payment terms: two equal annual payments

What is the amount per barrel (in USD) Acme will pay on this swap?

a.

b.

c.

d.

91.46

93.51

97.50

101.66

Answer: a

Explanation: The correct answer is a. To calculate the payment, each year must be factored by the zero

coupon bond yield for the given year:

91/1.04+ 104/1.045^2 =182.91

Dividing this into two equal payments gives an answer of USD 91.46/bbl

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), pages 26 and 27.

20

in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

In early March 2014 the spot price of Brent crude oil is USD 107.90 and estimated monthly crude oil storage

costs are USD 0.75/bbl. Traders are using the following market data to identify potential market opportunities.

Brent crude oil futures contract prices:

US Treasury zero-coupon bond yields:

6.

The breakeven forward price (is USD) required for a 6-month storage arbitrage to be profitable assuming storage costs are paid at the beginning of each month with no market convenience yield is approximately:

a.

b.

c.

d.

111.09

113.79

115.73

118.53

Answer: b

Explanation: The correct answer is b.

Minimum 6-month forward price = [USD 107.90 * exp (0.025)*(6/12)] + (Future value of storage (USD 4.53) = 113.79

Reading reference: Robert McDonald, Fundamentals of Derivatives Markets 3rd Edition, Chapter 6.

7.

What best approximates (in USD) the zero coupon bond position required to synthetically replicate a long

18-month forward position on 250,000 barrels of Brent crude oil?

a.

b.

c.

d.

24,781,000

25,982,000

26,270,000

27,732,000

Answer: a

Explanation: The correct answer is a. The formula to solve is:

S0 = F0e-rT

S0 = 250,000*104.86 * e(-0.0375*1.5) = 24,781,112

Reading reference: Robert McDonald, Derivatives Markets, 3rd Edition, Chapter 6, pages 189-191.

in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

21

8.

You hold a large position of deep in-the-money put options on NYMEX Crude Oil Futures. In the past week,

NYMEX Crude Oil Futures have risen sharply, causing the gamma of the position to become more negative.

What action can you take to increase the gamma of the position the most?

a.

b.

c.

d.

Buy at-the-money options

Sell out-of-the money options

Buy out-of-the-money options

Answer: b

Explanation: Gamma is defined as the rate of change in an options delta per move in the underlying. Because

delta is defined as the rate of change in an options price per move in the underlying, delta is very low for

deep out-of-the-money options and very high for deep-in the money options. Delta changes most rapidly

when an option is at-the-money, so at-the-money options would have the highest gamma as well.

Reading reference: John c. Hull. Risk Management and Financial Institutions, 3rd Edition, Chapter 7.

9.

Use the temperature data below to calculate Cooling Degree Days (CDD) for a 7-day period:

High

Temperature

71F

75F

72F

69F

64F

65F

64F

a.

b.

c.

d.

Low

Temperature

62F

63F

65F

67F

61F

59F

58F

Average

Temperature

66.5F

69.0F

68.5F

68F

62.5F

62F

61F

9.5

12

14.5

17

Answer: b

Explanation: The correct answer is b. Cooling Degree Days are the difference between the daily average

temperatures less 65F, if more than 65 degrees. The average temperatures: 66.5, 69, 68.5, 68, 62.5, 62 and 61,

for a total of 12 CDDs for the week.

Reading reference: Robert McDonald, Derivatives Markets, 3rd Edition, Chapter 6.

22

in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

10.

A credit analyst is evaluating the liquidity of an integrated petroleum producer to assess its ability to meet

scheduled debt payments. The analyst has the following information from the producers most recent quarterly

financial statement:

USD

Sales and other operating income

9,347,000

1,316,000

1,543,000

876,000

781,000

297,000

484,000

Calculate the firms free cash flow for the most recent quarter.

a.

b.

c.

d.

USD

USD

USD

USD

-392,000

-95,000

1,151,000

2,027,000

Answer: c

Explanation: The correct answer is c. Free cash flow is equal to operating cash flow minus capital expenditures and investments. Operating cash flow is equal to net operating profit after taxes plus depreciation and

amortization. So FCF would be 484 + 1,543 876 = 1,151,000.

Answer a subtracts capex from NOPAT but forgets to add D&A

Answer b subtracts capex from pre-tax operating income but forgets to add D&A.

Answer d is operating cash flow and forgets to subtract capex.

Reading reference: Simkins and Simkins, eds. Energy Finance and Economics: Analysis and Valuation, Risk

Management and the Future of Energy. Chapter 9, p. 189-195.

in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

23

11.

An airline uses NYMEX Ultra-Low Sulfur Diesel (ULSD) futures contracts to hedge its short jet fuel exposure.

Use the volatility and correlation data below to calculate the minimum variance hedge ratio.

ULSD futures price volatility: 16.54%

Correlation between jet fuel and ULSD futures price returns: 0.823

a.

b.

c.

d.

0.727

0.883

0.932

1.132

Answer: c

Explanation: The minimum variance hedge ratio is calculated as:

H* = - (a,b) * (a / b), where is the correlation coefficient between returns of the two commodities, a is

the commodity being hedged, and b is the commodity being used as a hedge.

Hence H = -0.823* (0.1873/0.1654), or -0.932.

The correct answer is c.

Reading reference: Miller, Chapter 3, pp. 46-47.

24

in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

12.

Consider a netting set containing six equal counterparty exposures totaling GBP 3,600,000. The average

correlation between the positions is 0.15 and the future values of the exposures are normally distributed.

What is the best estimate for the expected net exposure?

a.

b.

c.

d.

GBP

GBP

GBP

GBP

794,000

1,273,000

1,944,000

3,112,000

Answer: c

Explanation: The correct answer is c.

Since the future values of the exposures are normally distributed, we can calculate the netting factor using

the following equation:

Netting factor = [ sqrt (n + n (n-1) ] / n

Where n is the number of exposures and is the average correlation between the exposures.

Using n=6 and =0.15, in this case the netting factor is 0.540.

The answer is then 3,600,000 * 0.540 = 1,944,000.

Reading reference: Gregory, chapter 8, p. 140.

in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

25

13.

The following table summarizes the 4-year implied probability of default associated with four midsize oil

exploration and production companies.

Company

Year 1

Year 2

Year 3

Year 4

Company A

0.04%

0.17%

0.37%

0.53%

Company B

0.42%

1.05%

1.61%

2.32%

Company C

4.68%

8.41%

11.6%

13.8%

Company D

26.5%

33.1%

39.0%

44.2%

Which company is most likely to have a Moodys/Standard & Poors rating of B1/B+?

a.

b.

c.

d.

Company

Company

Company

Company

A

B

C

D

Answer: c

Explanation: The correct answer is c. A B1/B+ rating is a speculative, or junk, credit rating, which would represent a significant 4-year probability of default. It is not an investment-grade rating, but is also one of the

higher speculative ratings. A 4-year default probability of 0.5% would correspond to an investment-grade rating (potentially A2/A or A3/A-), a 2.3% probability would fall into the low investment-grade category

(Baa/BBB), and a 44.25% probability would correspond to a much lower speculative grade rating in the

Caa2/CCC range.

Reading reference: Burger, Graeber and Schindlmayr, Managing Energy Risk: A Practical Guide for Risk

Management in Power, Gas, and Other Energy Markets, chapter 3.4.

26

in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

14.

Recovery rate: 36%

Default probability: 8%

Credit spread: 4.5%

a.

b.

c.

d.

USD

USD

USD

USD

787,500

1,664,000

2,625,000

3,375,000

Answer: b

Explanation: In order to get the expected loss, first we have to calculate the loss given default. This is equal to

Exposure * (1-Recovery Rate). In this case it is 32,500,000 * (1-36%), or 20,800,000. Then the expected loss is

equal to the loss given default times the probability of default. This is 20,800,000 * 8% = USD 1,664,000.

Reading reference: Malz. Financial Risk Management, Chapter 6, pages 201-203.

15.

A credit risk analyst is evaluating a new one-year bond priced at par that pays an annual coupon. The bond

has a default probability of 12% with an estimated recovery rate of 40%. Assuming the analyst is risk neutral

and the 1-year risk free rate is 2.5%, what is the minimum coupon she would be willing to accept to invest in

the bond?

a.

b.

c.

d.

7.80%

8.18%

10.68%

11.02%

Answer: d

Explanation: The correct answer is d.

In order to consider investing in the risky bond, she would demand a coupon spread z which would satisfy the

following equation:

(1-)(1+r+z) + R > 1+r

where is the probability of default, r is the risk free rate, and R is the recovery rate.

1.025 >= 0.12*0.4+0.88*(1+z). minimum z =11.02%

Reading reference: Malz. Financial Risk Management, Chapter 6.

in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

27

16.

Assume an energy commodity position has an average 10-day price return of 0.75% and a daily standard deviation of 1.25%. If daily price returns are independent and normally distributed, what is the portfolios 10-day,

95% VaR?

a.

b.

c.

d.

5.75%

6.27%

6.43%

7.00%

Answer: a

Explanation: Correct answer is a.

10 day mean return=0.75%

10 day standard deviation =(square root of 10)x1.25%=3.9528%

10-Day, 95% VaR=-(0.75%-1.645x3.9528%)= 5.75%.

B - Incorrect: Assumes daily mean price return multiplied by square root of 10

C - Incorrect: Assumes daily mean price return with no adjustment for time

D - Incorrect: Assumes a two tailed test (confidence interval of 1.96)

Reading reference: Allan Malz, Chapter 3.

17.

Use data from the credit report below to approximate the original exposure on the underlying bond position.

Recovery rate: 32%

Loss given default: USD 5,850,000

Expected loss: USD 3,910,500

a.

b.

c.

d.

USD

USD

USD

USD

4,620,000

6,174,000

8,603,000

11,197,000

Answer: c

Explanation: The correct answer is c. Since Loss Given Default = Exposure * (1-recovery rate), then the exposure is equal to the LGD divided by (1-recovery rate). Therefore the original exposure on the position is

5,850,000 / (1-0.32) or approximately USD 8,602,941.

Reading reference: Allan Malz. Financial Risk Management, Models, History and Institutions, Chapter 6, pages

201203.

28

in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

18.

A crude oil trader holds a long position in 100 call options on Brent Crude oil futures. The trader has identified

a second option on the same underlying contract that can be used to hedge market risk in her position.

What combination of the hedge option and the underlying futures contract will best neutralize the delta and

gamma of the traders position assuming the following market risk characteristics for the positions:

Delta

Gamma

a.

b.

c.

d.

Long Option

0.613

0.0723

Hedge Option

-0.55

-0.0950

Sell 76 options and buy 19 futures contracts.

Sell 111 options and buy 3 futures contracts.

Buy 111 options and buy 3 futures contracts.

Answer: a

Explanation: In order to do a delta - gamma hedge, the gamma must be neutralized first by using the option

provided as a hedge. Since the delta and gamma of the given option are of the opposite side of the portfolio

position, the options must be bought to neutralize the gamma.

The number of contracts needed to neutralize the gamma are: (Gamma of position / Gamma of hedge) *

Number of contracts, i.e. (0.0723/-0.0950) * 100, or 76.1. In other words, 0.76 of an option must be purchased

to hedge the gamma of every existing option in the position.

However, now that the gamma has been neutralized, there remains some residual delta due to the purchase of

the option contracts required to hedge. The delta per contract is now: 0.613 + (-0.55*0.761), or 0.194. Delta

can be hedged with the underlying futures Since the residual delta is positive, then 19 futures contracts must

be sold to hedge the residual delta of the original 100 contract position.

Choices c and d incorrectly neutralize delta first and then solve for residual gamma.

Reading reference: Les Clewlow and Chris Strickland. Energy Derivatives: Pricing and Risk Management, chapter 9,

pp. 967-968.

in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

29

19.

The following table represents the distribution of operational loss events from a sample of drilling companies

over a 6-month period:

Loss Events

0

1

2

3

4

Percentage of Observations

18%

36%

29%

13%

4%

Calculate the standard deviation for the distribution of operational loss events assuming a mean of 1.49.

a.

b.

c.

d.

1.05

1.11

1.22

1.34

Answer: a

Explanation: Correct answer is a.

The first step is to calculate the variance, which is the probability weighted average of the squared difference

between F and its mean. In other words, Variance = (0-1.49)2 * 18% + (1-1.49)2 * 36% + (2-1.49)2 * 29% +

(3-1.49)2 * 13% + (4-1.49)2 * 4% = 1.110.

The standard deviation is the square root of the variance, ie. 1.053.

Reading reference: Michael Miller, Chapter 3.

30

in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

20.

A risk analyst has performed a regression analysis on ICE National Balancing Point (NBP) natural gas spot

price returns over the past 500 days in order to estimate the parameters for a simple mean reversion model.

The regression analysis includes the following coefficients for a linear relationship where:

y = 0.0285 x (Log of daily NBP Spot Prices) + 0.0188

Using terms from the linear relationship above, what is the best estimate of the mean reversion rate for NBP

natural gas spot prices?

a.

b.

c.

d.

2

9

14

21

Answer: c

Explanation: The mean reversion rate can be estimated from the regression results as follows:

0 = 0.0188 (Coefficient for Intercept)

1 = 0.0285 (Coefficient for Slope)

Therefore the mean reversion rate () can be estimated as (1 0.0285/t 0.0020) or 14.25

a is incorrect: 1 = 0.0285/ 0 = 0.0188 = 1.5

Reading reference: Les Clewlow and Chris Strickland, Energy Derivatives: Pricing and Risk Management,

Chapter 2, pages 28-29.

in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

31

21.

Which of the following best describes the relationship between risk-neutral default probabilities and historical

default probabilities?

a.

b.

c.

d.

Theoretical default probabilities are typically higher than historical default probabilities due to liquidity

risk premiums

Historical default probabilities are typically higher than theoretical default probabilities due to negative

skew in bond returns

Theoretical default probabilities are typically higher than historical default probabilities for investment

grade credits and lower than historical default probabilities for non-investment grade credits

Historical default probabilities are typically higher than theoretical default probabilities for investment

grade credits and lower than theoretical default probabilities for non-investment grade credits

Answer: a

Explanation: Correct answer is a. By definition, spreadderived PDs include risk and liquidity premia, thus are

higher than historical data-based PDs.

Reading reference: Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global

Financial Markets, Jon Gregory, Chapter 10.

22.

Which of the following mitigation actions, if taken by a central counterparty, will most likely increase risk on

an exchange traded futures contract?

a.

b.

c.

d.

Reduce margin requirements on contracts with low volatility and high liquidity.

Auction the right to replace contracts that are in default.

Increase margin requirements on contracts with large, highly concentrated positions.

Answer: d

Explanation: A CCPs increasing of margin requirements could create destabilizing market impacts and therefore add systemic risk. An example of this is a contract with large concentrated positions. If the CCP were to

increase the margin requirement, firms holding these positions might be placed into margin calls which could

force them to sell the target security, creating even greater market impact and imposing strains on the funding system and market liquidity.

Reading reference: Jon Gregory. Counterparty Credit Risk: A Continuing Challenge for Global Financial

Markets, Chapter 7, p. 110.

32

in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

23.

To hedge the price exposure to its future production, power generator X is entering into a fixed price forward

sale contract with a load serving entity Y. Which of the following factors is least relevant for the evaluation of

Xs expected loss of its credit risk exposure to Y?

a.

b.

c.

d.

Ys credit rating

Xs target credit rating

Contractual payment term for X and Y to settle electric power delivered

Bilateral margining agreement between X and Y

Answer: b

Explanation: Answer b is correct. The other answers are incorrect: (a) indicates its credit default probability,

(c) drives Xs settlement credit risk exposure to Y, and (d) would effectively reduce Xs credit risk exposure to

Y. However, (b) mainly affects Xs risk appetite and required risk capital requirement, not a factor to be considered when evaluating Xs credit risk exposure to Y, therefore, has little impact on the expected credit loss.

Reading reference: Managing Energy Risk: An Integrated View on Power and Other Energy Markets, Markus

Burger, Bernhard Graeber, and Gero Schindlmayr, Chapter 3.4, Pages 139-140.

24.

The proper application of Key Performance Indicators (KPIs) and Key Risk Indicators (KRIs) in the pursuit of

an organizations risk management objectives is best described as:

a.

b.

c.

d.

The use of KPIs exclusively to develop an effective forward looking assessment of trends in operational

risk factors.

The integration of KPI objectives and KRI limits to create a single comprehensive risk-weighted metric.

The monitoring of KRIs to assess shifts in risk exposure and adjustment of business strategy and

operational procedures to better meet return on risk objectives identified by KPIs.

The replacement of KPIs with KRIs and adjustment of company-wide risk capital allocations to account

for the change in risk monitoring procedures.

Answer: c

Explanation: The correct answer is c. One problem with the use of KPIs for risk management is that they are

backward-looking: they will only show how well the portfolio has met pre-determined goals. KRIs are an

ongoing process of monitoring the portfolio performance to ensure that it stays within pre-determined risk

measurements. Using them together as described in answer c is an effective risk-management strategy.

Adjustments to the portfolio can be made in accordance to the KRIs that can ultimately help the portfolio

reach the KPIs.

Reading reference: John Fraser and Betty Simkins, Enterprise Risk Management: Todays Leading Research

and Best Practices for Tomorrows Executives, Chapter 8, page 128.

in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

33

25.

A new exploration company is formed to develop and produce oil in the Arctic. How will the company most

likely implement quantitative and qualitative techniques in its risk management process?

a.

b.

c.

d.

Develop an integrated qualitative/quantitative risk strategy from the outset, since each technique is

incomplete when used in isolation

Develop a strategy based on the relative qualitative or quantitative experience of the management team

since either can be an effective risk management technique

Start with qualitative techniques since they are easier to devise and help provide a depth of information;

adopt quantitative techniques as capabilities develop

Start with quantitative techniques since they provide empirical data on degrees of risk exposure; adopt

qualitative techniques as operational experience grows

Answer: c

Explanation: The correct answer is c. Enterprises typically begin by using a qualitative approach since it is simpler

to implement, yet gives a full picture of how a risk event may impact operations. Quantitative strategies are often

added to the strategy at a later point.

Reading reference: COSO, Risk Assessment in Practice.

34

in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

Creating a culture of

risk awareness

Global Association of

Risk Professionals

111 Town Square Place

14th Floor

Jersey City, New Jersey 07310

USA

+ 1 201.719.7210

2nd Floor

Bengal Wing

9A Devonshire Square

London, EC2M 4YN

UK

+ 44 (0) 20 7397 9630

www.garp.org

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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