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Energy Risk Professional

(ERP®) Examination
Practice Quiz 3: Financial Products
Energy Risk Professional Examination (ERP®) Practice Quiz 3

TABLE OF CONTENTS

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

ERP Practice Quiz 3 Candidate Answer Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3

ERP Practice Quiz 3 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5

ERP Practice Quiz 3 Answer Sheet/Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9

ERP Practice Quiz 3 Explanations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11

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Energy Risk Professional Examination (ERP®) Practice Quiz 3

Introduction Suggested Use of Practice Quizzes


The ERP Practice Quizzes were developed for use in con- To maximize the effectiveness of the practice quizzes,
junction with the ERP Exam Preparation Handbook. The candidates are encouraged to do the following:
Practice Quizzes are designed to simulate both the style and
range of questions found on the ERP Examination, helping 1. Complete ERP Core Readings prior to taking each
ERP Candidates gauge their level of preparedness to take Practice Quiz.
the ERP Examination. Each Practice Quiz includes a series Questions are derived specifically from Core Readings
of ten review questions drawn from specific sections of the and represent a small sampling of the content covered
ERP Examination: Hydrocarbons, Electricity/Renewables, in the Core Readings that proceed each scheduled quiz.
Financial Products, and Modeling/Risk Management tech-
niques. The Practice Quizzes provide candidates with a tool 2. Simulate the test environment as closely as possible.
to review and test their comprehension of key concepts as • Take the practice quiz in a quiet place.
they work through the study plans outlined in the Exam • Have only the practice quiz, candidate answer sheet,
Preparation Handbook. calculator (see the ERP Preparation Handbook for a
listing of GARP-approved calculators), and writing
It is strongly suggested that Practice Quizzes be taken after instruments (pencils, erasers) available.
a candidate completes their review of the core readings pre- • Minimize possible distractions from other people, cell
ceding each quiz (please see the 15- and 20-week reading phones, televisions, etc.; put away any study material
plans outlined in the ERP Exam Preparation Handbook for before beginning the practice exam.
more information). Practice Quizzes include explanations of • Allocate two minutes per question for the practice quiz
the correct answer for each question so that candidates can and set an alarm to alert you when a total of 20
better understand their incorrect replies and identify areas minutes have passed.
of weakness that need reinforcement.
3. After completing each ERP Practice Quiz
• Calculate your score by comparing your answer
sheet with the practice exam answer key.
• Use the practice quiz Answers and Explanations to
better understand the correct and incorrect answers
and to identify any topics that require additional
review. Consult the referenced core readings to
continue your preparation for the exam.

© 2012 Global Association of Risk Professionals. All rights reserved. It is illegal to reproduce this material 1
in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.
Energy Risk
®
Professional(ERP )
Examination
Practice Quiz 3

Answer Sheet
Energy Risk Professional Examination (ERP®) Practice Quiz 3

a. b. c. d.

1.

2.

3.

4.

5.

6.

7.

8.

9.

10.

Correct way to complete

1.    

Wrong way to complete

1. 3 8

© 2012 Global Association of Risk Professionals. All rights reserved. It is illegal to reproduce this material 3
in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.
Energy Risk
®
Professional(ERP )
Examination
Practice Quiz 3

Questions
Energy Risk Professional Examination (ERP®) Practice Quiz 3

1. Alonzo has been asked to evaluate the performance of a speculative position in natural gas futures that
involved two contracts with the following characteristics:
• Contract A has an initial value of USD 4.00 and a terminal value of USD 4.10
• Contract B has an initial value of USD 4.20 and a terminal value of USD 4.25

Assuming Alonzo configured a trade with the expectation that the spread between contract A and contract B
would widen, what would be Alonzo’s profit/loss on the transaction?

a. –USD 0.15
b. –USD 0.05
c. USD 0.10
d. USD 0.15

2. Which of the following statements correctly explains a key characteristic of a bull spread option structure?

a. The maximum profit occurs when the futures price equals the strike price of the out-of-money call option.
b. Upside profit potential is unlimited.
c. The structure is created by buying an out-of-the-money put option and selling an out-of-the-money
call option.
d. The structure is created by selling an out-of-the-money put option and buying an out-of-the-money
call option.

3. Heating oil is quoted on the spot market at USD 3.40/gal. Financing for the purchase of a contract is
available for USD 0.20/gal per month while the cost of storage for the physical commodity is USD 0.15/gal
per month. The price for a 1-month heating oil futures contract is USD 3.75/gal. Given these parameters,
what would be your strategy to set up a profitable, riskless cash/futures arbitrage trade?

a. Do nothing; no strategy would result in a riskless profit.


b. Buy cash heating oil at USD 3.40/gal and simultaneously sell futures contracts for an equal number of
units at USD 3.75/gal.
c. Sell cash heating oil at USD 3.40/gal and simultaneously buy futures contracts for an equal number of
units at USD 3.75/gal.
d. Buy heating oil on the spot market at USD 3.40, store it for one month and then sell it on the spot market.

© 2012 Global Association of Risk Professionals. All rights reserved. It is illegal to reproduce this material 5
in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.
Energy Risk Professional Examination (ERP®) Practice Quiz 3

4. Assume a call option with a strike price of USD 50.00 is selling at USD 6.00. If the delta of the option is .55,
what will be the estimated option premium if the value of the underlying asset changes by USD 2.00?

a. USD 6.10
b. USD 6.50
c. USD 7.10
d. USD 8.00

5. 1 are bilateral contracts to buy or sell a specific amount of a commodity at a fixed price at some time
in the future, 2 are standardized contracts to buy or sell a commodity at some time in the future
through the use of a commodity exchange, which acts as a central counterparty for all transactions.

1 2
a. Forwards Futures
b. Swaps Forwards
c. Futures Forwards
d. Swaps Futures

6. Which of the following statements about contango and backwardated markets is correct?

a. Commodity markets must be either contango or backwardated markets.


b. A backwardated market is one where cash prices are greater than a series of futures prices.
c. Partial or complete full carry has no impact on the whether a market is in contango or backwardation.
d. A carrying charge is associated with a backwardated or inverted market.

7. Assume you hold the following option contracts on WTI futures:


• Short one May 2012 put option with a strike price of USD 99.00
• Long one May 2012 call option with a strike price of USD 106.00

If the current WTI spot price is USD 102.50, what is the value of the combined positions?

a. -USD 3.50
b. USD 0.00
c. USD 3.50
d. USD 7.00

6 © 2012 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 Examination (ERP®) Practice Quiz 3

8. Stebbins Heating Oil is a supplier to residential consumers in the northeastern United States. In July,
Stebbins estimated the average heating oil requirement for the season to be 1,200 gallons per customer
based on normal weather conditions and purchased a sufficient number of heating oil futures contracts with
different delivery dates throughout the winter to fulfill the estimated demand. In September, several long
term meteorological forecasts predict a 70% probability of a warmer than normal winter, with a 1% probability
of a colder than normal winter. Assuming Stebbins’ customers have contracted to purchase their required
heating oil at a fixed price, and a warmer than normal winter will reduce heating oil demand by 20%, what
should Stebbins do to improve the hedge of its supply obligation?

a. Buy put options covering 20% of its original supply obligation.


b. Buy call options covering 20% of its original supply obligation.
c. Sell 20% of its original futures position and buy additional supply on the spot market as needed.
d. Sell excess supply on the spot market as needed throughout the winter.

9. Assume a natural gas-fired power generation plant has a heat rate of 7.00. If the plant’s natural gas fuel
costs are USD 4.25/MMBtu and it sells electricity for USD 76.25/MWh, what is the spark spread for the plant?

a. 17.94
b. 46.29
c. 46.50
d. 125.50

10. Katherine Klein is the Chief Financial Officer for Interstate Trucking Company. She is considering the use of
commodity swaps as an alternative to Interstate’s current hedging strategy of using call options on futures
contracts to protect against rising diesel fuel prices. Which of the following statement(s) about the use of
commodity swaps is/are correct?

I. Interstate Trucking will sell a commodity swap to hedge the risk of rising diesel fuel prices.
II. Interstate Trucking will have counterparty credit exposure on the commodity swap.

a. Statement I only
b. Statement II only
c. Both statements
d. Neither statement

© 2012 Global Association of Risk Professionals. All rights reserved. It is illegal to reproduce this material 7
in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.
Energy Risk
®
Professional(ERP )
Examination
Practice Quiz 3

Answers
Energy Risk Professional Examination (ERP®) Practice Quiz 3

a. b. c. d.

1. 

2. 

3. 

4. 

5. 

6. 

7. 

8. 

9. 

10. 

Correct way to complete

1.    

Wrong way to complete

1. 3 8

© 2012 Global Association of Risk Professionals. All rights reserved. It is illegal to reproduce this material 9
in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.
Energy Risk
®
Professional(ERP )
Examination
Practice Quiz 3

Explanations
Energy Risk Professional Examination (ERP®) Practice Quiz 3

1. Alonzo has been asked to evaluate the performance of a speculative position in natural gas futures that
involved two contracts with the following characteristics:
• Contract A has an initial value of USD 4.00 and a terminal value of USD 4.10
• Contract B has an initial value of USD 4.20 and a terminal value of USD 4.25

Assuming Alonzo configured a trade with the expectation that the spread between contract A and contract B
would widen, what would be Alonzo’s profit/loss on the transaction?

a. –USD 0.15
b. –USD 0.05
c. USD 0.10
d. USD 0.15

Correct answer: b

Explanation: Answer b is correct. Under the assumption that the spread between contract A and contract B
would widen Alonzo would have initially sold contract A at USD 4.00 and purchased contract B at USD 4.20.
In fact the spread narrowed and Alonzo realized a net loss on the trade of USD 0.05 as he was forced to
close out contract A at USD 4.10 (loss of USD -0.10), and contract B at USD 4.25 (gain of USD 0.05).
Reading reference: Fundamentals of Trading Energy Futures & Options, 2nd Edition, Errera,
Chapter 4, pages 59-62.

2. Which of the following statements correctly explains a key characteristic of a bull spread option structure?

a. The maximum profit occurs when the futures price equals the strike price of the out-of-money call option.
b. Upside profit potential is unlimited.
c. The structure is created by buying an out-of-the-money put option and selling an out-of-the-money
call option.
d. The structure is created by selling an out-of-the-money put option and buying an out-of-the-money
call option.

Correct answer: a

Explanation: Answer a is correct because the maximum profit occurs when the futures price equals the
strike price of the out-of-money call option. For this structure, an ATM call is purchased and OTM call,
with a higher striking price, is sold. Both options have the same tenor. The sale of the call “caps” the upside
of the lower strike long call. This is the point where the bull spread shows its maximum profit — the futures
prices equals the strike price of the short call. The lower strike price call has its own floor. See page 75 for a
complete discussion.
Reading reference: Managing Energy Price Risk, Kaminski, Chapter 2, page 75.

© 2012 Global Association of Risk Professionals. All rights reserved. It is illegal to reproduce this material 11
in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.
Energy Risk Professional Examination (ERP®) Practice Quiz 3

3. Heating oil is quoted on the spot market at USD 3.40/gal. Financing for the purchase of a contract is
available for USD 0.20/gal per month while the cost of storage for the physical commodity is USD 0.15/gal
per month. The price for a 1-month heating oil futures contract is USD 3.75/gal. Given these parameters,
what would be your strategy to set up a profitable, riskless cash/futures arbitrage trade?

a. Do nothing; no strategy would result in a riskless profit.


b. Buy cash heating oil at USD 3.40/gal and simultaneously sell futures contracts for an equal number of
units at USD 3.75/gal.
c. Sell cash heating oil at USD 3.40/gal and simultaneously buy futures contracts for an equal number of
units at USD 3.75/gal.
d. Buy heating oil on the spot market at USD 3.40, store it for one month and then sell it on the spot market.

Correct answer: a

Explanation: Answer a is correct, there is no riskless arbitrage opportunity in this situation since the 1-month
futures contract (USD 3.75/gal) is equal to the spot price with financing and storage costs (USD 3.40 +
USD 0.20 +USD 0.15 = USD 3.75), therefore the correct decision is to do nothing. Note: purchasing heating
oil at USD 3.40 and storing it for a month for sale back onto the spot market (answer d) could net a profit if
the spot price has risen above the 1-month futures price of USD 3.75, but this is not a riskless strategy since
there is no guarantee that the prices will rise above this level.
Reading reference: Fundamentals of Trading Energy Futures and Options, 2nd Edition, Errera and Brown,
Chapter 3, pages 40-45.

4. Assume a call option with a strike price of USD 50.00 is selling at USD 6.00. If the delta of the option is .55,
what will be the estimated option premium if the value of the underlying asset changes by USD 2.00?

a. USD 6.10
b. USD 6.50
c. USD 7.10
d. USD 8.00

Correct answer: c

Explanation: Answer c is correct; it is the correct application of the delta valuation formula: USD 6.00 +
(.55 x USD 2.00) = USD 7.10. All other answers are incorrect.
Reading reference: Managing Energy Price Risk, Kaminski, Chapter 2, pages 58-60.

12 © 2012 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 Examination (ERP®) Practice Quiz 3

5. 1 are bilateral contracts to buy or sell a specific amount of a commodity at a fixed price at some time
in the future, 2 are standardized contracts to buy or sell a commodity at some time in the future
through the use of a commodity exchange, which acts as a central counterparty for all transactions.

1 2
a. Forwards Futures
b. Swaps Forwards
c. Futures Forwards
d. Swaps Futures

Correct answer: a

Explanation: Answer a is correct. Forwards are bilateral agreements, their specifications are set by the
parties, while futures must be standardized so that they are fully interchangeable via an exchange (for
example, NYMEX Crude Oil contracts are all for lot sizes of 1,000 barrels per contract). Swaps are typically
traded via an OTC exchange and not bilaterally.
Reading reference: Derivatives Markets, McDonald, Chapter 6.

6. Which of the following statements about contango and backwardated markets is correct?

a. Commodity markets must be either contango or backwardated markets.


b. A backwardated market is one where cash prices are greater than a series of futures prices.
c. Partial or complete full carry has no impact on the whether a market is in contango or backwardation.
d. A carrying charge is associated with a backwardated or inverted market.

Correct answer: b

Explanation: The correct answer is b; a backwardated market is marked by spot prices being higher than
futures prices, typically because of a shortage in supply or unexpectedly high demand. Answer a is incorrect
because, the markets can be either contango or backwardated or some combination of the two. (for example,
natural gas with its seasonal structure is typically in contango for part of the year and backwardated for the
rest). Answer c also incorrect since a market in “full carry” would be in contango. . Answer d is incorrect
since, a “carrying charge” is associated with a contango market (also, referred to as a carrying charge market).
Reading reference: Fundamentals of Trading Energy Futures & Options, 2nd Edition, Errera and Brown,
Chapter 3, pages 38-39.

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in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.
Energy Risk Professional Examination (ERP®) Practice Quiz 3

7. Assume you hold the following option contracts on WTI futures:


• Short one May 2012 put option with a strike price of USD 99.00
• Long one May 2012 call option with a strike price of USD 106.00

If the current WTI spot price is USD 102.50, what is the value of the combined positions?

a. -USD 3.50
b. USD 0.00
c. USD 3.50
d. USD 7.00

Correct answer: c

Explanation: Answer c is correct. The payoff from the short put is -max[K-S,0] = -max[99-102.5,0] = 0 while
the payoff for the long call is max[S-K,0] = max[106-102.5,0]=3.50.
Reading reference: Managing Energy Price Risk, Kaminski, Chapter 2.

8. Stebbins Heating Oil is a supplier to residential consumers in the northeastern United States. In July,
Stebbins estimated the average heating oil requirement for the season to be 1,200 gallons per customer
based on normal weather conditions and purchased a sufficient number of heating oil futures contracts with
different delivery dates throughout the winter to fulfill the estimated demand. In September, several long
term meteorological forecasts predict a 70% probability of a warmer than normal winter, with a 1% probability
of a colder than normal winter. Assuming Stebbins’ customers have contracted to purchase their required
heating oil at a fixed price, and a warmer than normal winter will reduce heating oil demand by 20%, what
should Stebbins do to improve the hedge of its supply obligation?

a. Buy put options covering 20% of its original supply obligation.


b. Buy call options covering 20% of its original supply obligation.
c. Sell 20% of its original futures position and buy additional supply on the spot market as needed.
d. Sell excess supply on the spot market as needed throughout the winter.

Correct answer: a

Explanation: The best way for Stebbins to offset a volume risk scenario would be by selling put options — if
the winter is indeed warmer than expected, Stebbins can sell their excess volume though the puts; if the winter
is not warmer than expected, they will have the needed volume for their customers on hand. Answer b is
ncorrect, this would be the appropriate strategy for a colder than expected winter; answer c is not a wise
strategy since spot prices could climb steeply if there is a sudden cold spell or a supply disruption; answer d
also is not the best strategy since if the winter is warmer than expected, there may not be sufficient demand
on the market for additional supplies of heating oil and the prices will likely be below what Stebbins paid in
the original futures contracts.
Reading reference: Surviving Energy Prices, Beutel, Chapter 3, pages 29-30.

14 © 2012 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 Examination (ERP®) Practice Quiz 3

9. Assume a natural gas-fired power generation plant has a heat rate of 7.00. If the plant’s natural gas fuel
costs are USD 4.25/MMBtu and it sells electricity for USD 76.25/MWh, what is the spark spread for the plant?

a. 17.94
b. 46.29
c. 46.50
d. 125.50

Correct answer: c

Explanation: The correct answer is c. The spark spread is the price of electricity minus the price of fuel (here
natural gas) multiplied by the heat rate; in this case 76.25 – (4.25 * 7) = 46.50. Answer a is simply the cost of
electricity divided by the fuel cost; b is electricity multiplied by gas and divided by the heat rate; d is electricity
multiplied by heat rate divided by the fuel costs, all are incorrect formulas.
Reading reference: Energy Trading & Investing, Edwards, Chapter 2.2, page 109.

10. Katherine Klein is the Chief Financial Officer for Interstate Trucking Company. She is considering the use of
commodity swaps as an alternative to Interstate’s current hedging strategy of using call options on futures
contracts to protect against rising diesel fuel prices. Which of the following statement(s) about the use of
commodity swaps is/are correct?

I. Interstate Trucking will sell a commodity swap to hedge the risk of rising diesel fuel prices.
II. Interstate Trucking will have counterparty credit exposure on the commodity swap.

a. Statement I only
b. Statement II only
c. Both statements
d. Neither statement

Correct answer: b

Explanation: Answer b is correct. Statement II is correct as commodity swaps are traded OTC and have
financial settlement and, therefore, credit counterparty risk. Statement I is incorrect because consumers like
Tonka Trucking would typically buy a commodity swap to hedge price risk.
Reading reference: Managing Energy Price Risk, Kaminski, Chapter 1, pages 22-30.

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