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2015

ERP
Practice
Exam 4
PM Session
Financial25 Questions

ERP Practice Exam 4

TABLE OF CONTENTS

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

ERP Practice Exam 4 Candidate Answer Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3

ERP Practice Exam 4 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5

ERP Practice Exam 4 Answer Sheet/Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .15

ERP Practice Exam 4 Explanations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .17

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.

ERP Practice Exam 4

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 sucient 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 managers 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

eectively.

note the questions answered after the 50-minute mark.

The ERP Practice Exam 4 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 4 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 4 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 4

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 rst 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 eectiveness 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.

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

ERP Practice Exam 4

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.

Correct way to complete

15.

1.

16.

Wrong way to complete

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

ERP Practice Exam 4

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 1: USD 65.10


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

is exempt from reporting the EFP under Dodd-Frank.


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.

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.

ERP Practice Exam 4

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 one: USD 91/bbl


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

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.

ERP Practice Exam 4

Questions 6-7 use the information below


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:

October 2014: USD 112.65

October 2015: USD 104.86


US Treasury zero-coupon bond yields:

March 2014 through September 2014: 2.50%

October 2015: 3.75%

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.

Sell at-the-money options


Buy at-the-money options
Sell out-of-the money options
Buy out-of-the-money options

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

ERP Practice Exam 4

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

Cost of goods sold

1,316,000

Depreciation and amortization expense

1,543,000

Capital expenditures and investments

876,000

Pre-tax operating income

781,000

Income tax paid

297,000

Net operating profit after taxes

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

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

ERP Practice Exam 4

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.

Jet fuel price volatility: 18.73%


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

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

ERP Practice Exam 4

14.

A credit analyst is using the following information to assess a bond investment:

Exposure: USD 32,500,000


Recovery rate: 36%
Default probability: 8%
Credit spread: 4.5%

What is the bonds expected loss?


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%

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

ERP Practice Exam 4

17.

18.

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

Obligor: XYZ Energy


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

Buy 76 options and sell 19 futures contracts.


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

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11

ERP Practice Exam 4

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

Invoke netting agreements on contracts that are in default.


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.

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.

ERP Practice Exam 4

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

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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

ERP Practice Exam 4

a.

b.

c.

d.

a.

1.

18.

2.

19.

3.

20.

4.
5.

7.
8.

9.

10.

11.

12.

13.




17.





24.

25.

Correct way to complete

15.
16.

d.

23.

14.

c.

22.

6.

21.

b.

1.

Wrong way to complete

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.

15

Energy Risk
Professional

(ERP ) Exam
Practice Exam 4
Explanations

ERP Practice Exam 4

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 1: USD 65.10


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).

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.

17

ERP Practice Exam 4

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

is exempt from reporting the EFP under Dodd-Frank.


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

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.

ERP Practice Exam 4

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).

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.

19

ERP Practice Exam 4

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 one: USD 91/bbl


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

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ERP Practice Exam 4

Questions 6-7 use the information below


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:

October 2014: USD 112.65

October 2015: USD 104.86


US Treasury zero-coupon bond yields:

March 2014 through September 2014: 2.50%

October 2015: 3.75%

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.

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21

ERP Practice Exam 4

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.

Sell at-the-money options


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.

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ERP Practice Exam 4

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

Cost of goods sold

1,316,000

Depreciation and amortization expense

1,543,000

Capital expenditures and investments

876,000

Pre-tax operating income

781,000

Income tax paid

297,000

Net operating profit after taxes

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.

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23

ERP Practice Exam 4

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.

Jet fuel price volatility: 18.73%


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.

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ERP Practice Exam 4

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.

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25

ERP Practice Exam 4

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.

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ERP Practice Exam 4

14.

A credit analyst is using the following information to assess a bond investment:

Exposure: USD 32,500,000


Recovery rate: 36%
Default probability: 8%
Credit spread: 4.5%

What is the bonds expected loss?


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.

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27

ERP Practice Exam 4

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.

Obligor: XYZ Energy


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.

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ERP Practice Exam 4

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

Buy 76 options and sell 19 futures contracts.


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.

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ERP Practice Exam 4

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.

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ERP Practice Exam 4

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)

Assuming 500 data points t = 1/500 = 0.0020


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

b is incorrect: 0 = 0.0188/ t 0.0020 = 9

d is incorrect: fictitiously derived by adding a spread of 7 to answer c.


Reading reference: Les Clewlow and Chris Strickland, Energy Derivatives: Pricing and Risk Management,
Chapter 2, pages 28-29.

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ERP Practice Exam 4

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.

Invoke netting agreements on contracts that are in default.


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.

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ERP Practice Exam 4

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.

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ERP Practice Exam 4

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.

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