ERP Practice Exam Part II 2016 PDF

2016
ERP Part II
®
Practice Exam
Energy Risk Professional Examination (ERP) Practice Exam, Part II

Table of Contents
Introduction to 2016 ERP Part II Practice Exam ............................................................................ 1
2016 ERP Part II Practice Exam ‐ Candidate Answer Sheet ........................................................... 3
2016 ERP Part II Practice Exam – Questions ................................................................................. 4
2016 ERP Part II Practice Exam – Answer Key ............................................................................. 31
2016 ERP Part II Practice Exam – Answers & Explanations ......................................................... 32
© 2016 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. i

Introduction
The ERP Exam is a practice‐oriented examination. Its questions are derived from a combination of
theory, as set forth in the core readings, and “real‐world” work experience. Candidates are expected to
understand energy risk management concepts and approaches and how they would apply to an energy
risk manager’s day‐to‐day activities.
The ERP Exam is also a comprehensive examination, testing an energy risk professional on a number of
risk management concepts and approaches. It is very rare that an energy risk manager will be faced with
an issue that can immediately be slotted into just one category. In the real world, an energy risk
manager must be able to identify any number of risk‐related issues and be able to deal with them
effectively.
The ERP Practice Exam, Part II has been developed to aid candidates in their preparation for the ERP
Exam. This practice exam is based on a sample of actual questions from past ERP Exams and is
suggestive of the questions that will be in the 2016 Part II, ERP Exam.
The ERP Practice Exam, Part II contains 60 multiple choice questions. For 2016, the ERP Exam is being
offered in a two‐part format. Part I will consist of 80 questions, focusing on the Physical side of the ERP
curriculum; Part II will consist of 60 questions and will focus on the Financial portion of the curriculum.
Each exam will be four hours in length. Candidates may choose to take both parts on one day, or take
Part I and Part II in consecutive exam cycles.
While we have attempted to make the ERP Practice Exam, Part II as comprehensive as possible, it may
not cover all of the topics to be tested in the 2016 ERP Part II Exam. For a complete list of topics and
core readings, candidates should refer to the 2016 ERP Exam Study Guide. Core readings were selected
in consultation with the Energy Oversight Committee (EOC) to assist candidates in their review of the
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 readings listed in the 2016 ERP
Study Guide in‐depth prior to sitting for the exam.
Suggested Use of Practice Exams
To maximize the effectiveness of the practice exams, candidates are encouraged to follow these
recommendations:
1. Plan a date and time to take the practice exam.
Set dates appropriately to give sufficient study/review time for the practice exam prior to the actual
exam.
in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc 1


2. Simulate the test environment as closely as possible.
• Take the practice exam in a quiet place.
• Have only the practice exam, candidate answer sheet, calculator, and writing instruments
(pencils, erasers) available.
• Minimize possible distractions from other people, cell phones, televisions, etc.; put away any
study material before beginning the practice exam.
• Allocate two minutes per question for the practice exam and set an alarm to alert you when a
total of 120 minutes have passed. Complete the entire exam but note the questions answered
after the 120‐minute mark.
• Follow the ERP calculator policy. Candidates are only allowed to bring certain types of
calculators into the exam room. The only calculators authorized for use on the ERP Exam in 2016
are listed below, there will be no exceptions to this policy. You will not be allowed into the exam
room with a personal calculator other than the following: Texas Instruments BA II Plus (including
the BA II Plus Professional), Hewlett Packard 12C (including the HP 12C Platinum and the
Anniversary Edition), Hewlett Packard 10B II, Hewlett Packard 10B II+ and Hewlett Packard 20B.
3. After completing the ERP Practice Exam, Part II
• Calculate your score by comparing your answer sheet with the practice exam answer key. Only
include questions completed within the first 120 minutes in your score.
• Use the practice exam Answers and Explanations to better understand the correct and incorrect
answers and to identify topics that require additional review. Consult referenced core readings
to prepare for the exam.
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.

in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc. 2

2016 ERP Part II Practice Exam – Candidate Answer Sheet

1. 31.
2. 32.
3. 33.
4. 34.
5. 35.
6. 36.
7. 37.
8. 38.
9. 39.
10. 40.
11. 41.
12. 42.
13. 43.
14. 44.
15. 45.
16. 46.
17. 47.
18. 48.
19. 49.
20. 50.
21. 51.
22. 52.
23. 53.
24. 54.
25. 55.
26. 56.
27. 57.
28. 58. _____________
29. 59. _____________
30. 60. _____________


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

 Trade date: January 25
 Number of contracts: 600
 Purchase price: USD 43.57/bbl
 Initial margin requirement: USD 2,550,000
 Required maintenance threshold: USD 2,000,000

Below what price will a margin call be triggered on the position, assuming the exchange
requires the account balance for all futures positions to be topped‐up to their initial required
margin level (in USD)?

a. 41.81
b. 42.29
c. 42.65
d. 43.47

2. Refined product traders have structured the following straddle position using options on ULSD
futures contracts:

 2‐month NYMEX ULSD call option with a strike price of USD 2.91/gal at a premium of
USD 0.05/gal
 2‐month NYMEX ULSD put option with a strike price of USD 2.91/gal at a premium of
USD 0.09/gal

One day after establishing the position, the NYMEX ULSD prompt‐month futures price is trading
at USD 2.73/gallon. What is the current net profit per straddle in USD?

a. 400
b. 1,680
c. 3,780
d. 5,400


3. An RBOB trader observes the following NYMEX price quotes on May 31:

 August RBOB: USD 1.58/gal
 December RBOB: USD 1.77/gal

She believes the spread between the December and August contracts is too wide and executes
a 10‐contract position on June 1 to benefit from a narrowing of the spread. On June 30, the
contracts close at the following prices:


Ignoring broker costs, margin requirements and other expenses, what is the trader’s 1‐month
profit (in USD) on the position based on the June 30 closing prices?

a. 13,440
b. 37,800
c. 54,600
d. 75,200

4. The market risk manager for a refinery is assessing the economics of using collars to manage
price risk and operating margins. She has summarized the following market data for options on
NYMEX RBOB futures contracts:

RBOB Strike Price Call Premium Put Premium

(USD/bbl) (USD) (USD)
1.51 0.156 0.137
1.59 0.129 0.146

If the prompt‐month NYMEX RBOB futures price is currently USD 1.54/gal, which of the
following transactions will most effectively meet the stated risk management objective?

a. Buying put options @ USD 1.51 strike and selling call options @ USD 1.59 strike
b. Selling put options @ USD 1.51 strike and buying call options @ USD 1.59 strike
c. Buying put options @ USD 1.59 strike and selling call options @ USD 1.51 strike
d. Selling put options @ USD 1.59 strike and buying call options @ USD 1.51 strike


5. A refinery uses NYMEX WTI futures contracts to hedge the purchase of 50,000 barrels of WTI
crude oil in two months. The contracts are purchased at USD 43.00/bbl. Two months later, the
refiner closes the futures position and purchases 50,000 barrels on the spot market. What is the
effective price paid per barrel (in USD) if the futures contract is now trading at USD 44.60/bbl
and the spot price is USD 45.80/bbl?

a. 43.00
b. 44.20
c. 44.60
d. 46.20
6. A commercial airline structures a collar to manage price risk on 50,000 barrels of jet fuel.
The collar includes the following terms:

• Cap: USD 48.00/bbl
• Floor: USD 42.00/bbl
• Tenor: Six months (June to November)
• Valuation Index: Mean of Platts Singapore (MOPS)

The monthly MOPS Index per barrel prices are as follows (in USD/bbl):
Month Price (in USD/bbl)
June 51
July 45
August 49
September 41
October 38
November 35

Using the data above, calculate the airline’s net settlement (in USD) on November 30.
a. 400,000
b. 200,000
c. ‐200,000
d. ‐400,000


7. A risk manager at a large international bank has compiled the following closing price data on
the Brent crude oil futures contract for the past 31 trading days:
49
48
Futures Price (USD) 47
46
45
44
43
42
41
40
2/1/2016 2/11/2016 2/21/2016 3/2/2016

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

a. Exponentially Weighted Moving Average (EWMA) with a lambda of 0.91
b. Exponentially Weighted Moving Average (EWMA) with a lambda of 0.99
c. Eigenvector Weighted Average with a lambda of 0.99
d. Simple Moving Average

8. High price volatility in the Brent crude oil market is expected over the next six months due
primarily to uncertainty about the strength of the global economy. Based on this forecast, a
crude oil trader would most likely maximize her returns by structuring an option strategy using:

a. Long calls.
b. Long puts.
c. Long calls and short puts.
d. Long calls and long puts.


9. If the 10‐day, 95% VaR for a USD 10,000,000 energy commodity portfolio is USD 2,000,000, the
market risk for the portfolio can be interpreted to mean:

a. Portfolio losses over a ten day period are expected to exceed USD 2 million once in every
five 10‐day periods.
b. Portfolio losses over a ten day period are expected to exceed USD 2 million once in every
twenty 10‐day periods.
c. There is a 5% chance that portfolio losses will exceed USD 2 million over the next 10 trading
days.
d. There is a 95% chance that portfolio losses will exceed USD 2 million over the next 10 trading
days.

10. A market risk analyst has applied a factor‐push model to stress test the MtM value of several
combinations of option positions on the April NYMEX WTI futures contract. The model applies a
four standard deviation decline in the price of the underlying futures contract. Each option has
the same expiration date and the current settlement price for the April WTI contract is
USD 45.00/bbl.

Which of the following combinations of options would be the least likely to generate an
extreme loss under the stress testing methodology described above?

a. A long 40 call and a long 50 call
b. A long 42.50 call and a short 47.50 call
c. A long 45 call and a long 45 put
d. A short 40 put and a long 40 call

11. The variance of historical weekly price returns on the SP‐15 peak power futures contract is
0.0323 over a 5‐year period. The best estimate of annual volatility on the SP‐15 contract is:

a. 23.3%.
b. 40.2%.
c. 116.4%.
d. 129.5%.


12. An integrated crude oil producer reports USD 1.5 billion in aggregate swap exposures to three
unique counterparties as follows:

 A USD 400 million foreign currency swap with a Norwegian investment bank that locks
in a fixed USD/NOK exchange rate to fund local operations.
 A USD 700 million swap with a Middle Eastern NOC that establishes a fixed price for oil
produced from a domestic concession.
 A USD 400 million swap with a separate government entity that locks in a fixed purchase
price for a specified volume of natural gas.

Assume that neither government entity counterparty is acting as a utility. Under the provisions
of Dodd‐Frank, the producer:
a. Can apply for an end‐user exemption for all the swaps, since they are used for hedging
purposes.
b. Can apply for an end‐user exemption for the oil and natural gas swaps, but not for the
foreign currency swap.
c. Must register as a swap dealer and does not qualify for the end‐user exemption.
d. Must register as a major swap participant (MSP) but can apply for a reporting exemption for
the foreign currency swap.

13. A US‐based petroleum producer is building an LNG train on the coast of Australia which is
scheduled to be completed in 5 years. To help reduce exposure to foreign currency fluctuations,
the producer has structured a 5‐year, fixed‐for‐floating swap on the Australian dollar (AUD) with
an A‐rated counterparty.

The producer is concerned about a potential deterioration in the credit quality of the
counterparty during the later years of the swap. To help mitigate this potential increase in
counterparty exposure, the producer should use a:

a. CVA adjustment.
b. Reset agreement.
c. Take‐or‐pay provision.
d. Netting agreement.


Questions 14‐15 use the information below:
14. On September 1, 2016, a regional airline contracts to purchase 60,000 gallons of jet fuel from a
local refinery for forward delivery in one year at a fixed‐price of USD 3.88/gal. Terms of the
purchase require the airline to take delivery of the jet fuel on September 1, 2017, after making
payment in full. The continuously compounded risk‐free interest rate is 4% per year.

Assume that by the end of April 2017, the price for jet fuel has risen to USD 4.14/gal. The
refinery’s replacement risk on April 30, 2017 (4 months from the delivery date, in USD) is:

a. 7,407.
b. 9,309.
c. 11,684.
d. 15,393.

15. How will settlement risk on the transaction change if the closing price of jet fuel is USD 4.35/gal
on July 31?

a. Settlement risk increases.
b. Settlement risk remains the same.
c. Settlement risk decreases.
d. Settlement risk cannot be determined from the information provided.

16. A commercial natural gas consumer in Boston hedges 100% of its expected January gas
consumption, which totals 100,000 MMBtu. In order to minimize basis risk in its hedging
strategy, the natural gas consumer should:

a. Buy 10 January 2016 NYMEX natural gas futures contracts and buy an Algonquin Citygate
January 2016 natural gas basis swap covering 100,000 MMBtu.
b. Buy 10 January 2016 NYMEX natural gas futures contracts and sell an Algonquin Citygate
c. Sell 100 January 2016 NYMEX natural gas futures contracts and buy an Algonquin Citygate
d. Sell 100 January 2016 NYMEX natural gas futures contracts and sell an Algonquin Citygate


17. A risk analyst has been asked to model the VaR of a portfolio of power generating assets, using
a modeling approach that captures the potential for price spikes observed in electricity
markets. Which of the following VaR methodologies will provide the greatest flexibility and best
approximation for a portfolio of power generating assets?

a. Delta
b. Delta‐Gamma
c. Historical Simulation using information from the last 90 trading days
d. Monte Carlo Simulation

18. A credit analyst is assessing a USD 7,800,000 credit exposure related to a 10‐year fixed‐rate
bond issued by a Baa3/BBB‐ rated midstream oil and gas company. The par value of the bond is
USD 8,000,000, it has an estimated recovery rate of 41%, and an expected loss of USD 317,500
in the event of default. Calculate the bond’s implied default probability.

a. 5.99%
b. 6.20%
c. 6.23%
d. 6.90%


19. Consider the following model used to estimate the spot electricity price S:

dS = α(µ(t) – log(S))Sdt + σ(t)Sdz + kSdq
Where:
 α and k are constant parameters
 µ(t) and σ(t) are functions of time
 z is a Brownian Motion
 q is a jump process.
Which of the following features of electricity spot price behavior does the model fail to
capture?
a. Mean reversion
b. Price spikes
c. Seasonal patterns
d. Stochastic volatility

20. Which of the following OTC derivative transactions offers the greatest economic benefit to the
respective counterparty identified in a bilateral netting arrangement?

a. A crude oil producer long a put option on WTI futures
b. A gas‐fired electric power generator long a natural gas swap
c. A natural gas producer long a floor on natural gas
d. A refinery long a straddle on gasoline futures


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

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

The best approximation of the CVA for the swap (assuming annual settlements) is:

a. 0.009%.
b. 0.021%.
c. 0.599%.
d. 2.414%.

22. The difference between risk appetite and risk tolerance can best be explained by which of the
following statements?

a. Risk appetite measures the amount of risk an organization is willing to take, while risk
tolerance is used to communicate a level of acceptable risk.
b. Risk appetite expresses a range of risk levels an organization is willing to take, while risk
tolerance is a single definitive figure.
c. Risk appetite is a willingness to embrace risk, while risk tolerance is an aversion to risk.
d. Risk appetite cannot be derived empirically, while risk tolerance is a quantitative measure.

23. Senior management at an energy company can best develop an effective risk appetite
statement, according to the COSO framework, by following which of the following approaches?

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


24. The 1‐day, 95% VaR for a Brent crude oil futures position is EUR 1,500,000, based on a
simulation of 5,000 hypothetical 1‐day returns. When comparing the VaR with the 1‐day, 95%
expected shortfall amount for the position, the expected shortfall represents the:

a. Average of all 1‐day simulated losses that exceeded EUR 1,500,000.
b. Difference between the 99% VaR and the 95% VaR for the position.
c. Difference between the 95% VaR and the average negative 1‐day return for the position.
d. Maximum 1‐day loss that occurred in the simulation.

25. Consider the following three European call options on the prompt‐month NYMEX Henry Hub
natural gas futures contract with the following strikes:

 Option A: USD 2.10/MMBtu
 Option B: USD 2.30/MMBtu
 Option C: USD 2.50/MMBtu
If the prompt‐month Henry Hub futures contract is trading at USD 2.30/MMBtu, which of the
following illustrations most closely depicts the expected shape of implied volatility across the
three option positions?
a.
Option A
Implied Volatility
Option B
Option C
Strike Price


b.
Implied Volatility
Option C
Option B
Option A
Strike Price

c.
Option B
Implied Volatility
Option A Option C
Strike Price


d.
Implied Volatility
Option A Option B Option C
Strike Price

26. A diversified energy firm has chosen to conform to the Basel guidelines for best practices in
backtesting its VaR models. When backtesting a 1‐year, 99% VaR model, a risk analyst finds five
exceptions. How should the analyst interpret this result relative to the Basel requirements?

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

27. Consider a 5‐year USD denominated interest rate swap with semi‐annual payments. Which of
the following best illustrates the potential future exposure (PFE) of the swap over its five year
life?

a.
5.0%
3.0%
1.0%
‐1.0% 0 12 24 36 48 60
‐3.0%
‐5.0%


b.
5.0%
4.0%
3.0%
2.0%
1.0%
0.0%
0 12 24 36 48 60

c.
6.0%
5.0%
4.0%
3.0%
2.0%
1.0%
0.0%
0 12 24 36 48 60

d.
5.0%
4.0%
3.0%
2.0%
1.0%
0.0%
0 12 24 36 48 60


28. Which of the following energy commodity markets is least affected by the concept of
convenience yield?

a. Electricity
b. Heating oil
c. Jet fuel
d. Natural gas

29. The volatility term structure associated with energy commodity forward contracts typically
follows what pattern as contract maturity approaches?

a. Stable
b. Steadily increasing
c. Steadily decreasing
d. Seasonality makes the volatility term structure unpredictable

30. The following table summarizes daily price return data for Henry Hub natural gas and WTI crude
oil over a five‐day period:

Henry Hub WTI
(USD/MMBtu) (USD/bbl)
Day 1 3.98% ‐1.56%
Day 2 ‐2.65% 3.54%
Day 3 2.03% ‐0.59%
Day 4 ‐5.01% 3.89%
Day 5 2.77% 0.23%
Sample Mean Return 0.22% 1.10%
Standard Deviation 0.041 0.028

Which of the following provides the best estimate of correlation between NYMEX Henry Hub
and WTI price returns over this time period?
a. ‐0.80
b. ‐0.30
c. 0.30
d. 0.80


31. A refinery buys a 3‐month cap to manage price volatility on its crude oil supply requirements for
the next three months. The cap is written on 180,000 barrels of crude oil per month at a strike
price of USD 63.50/bbl and premium of USD 1.80/bbl. Settlement occurs on a monthly basis
against the average daily prompt‐month NYMEX WTI contract closing price. Calculate the
cumulative net profit/loss (in USD) earned by the refinery for the 3‐month period using the
average daily prompt‐month NYMEX WTI closing prices below.

 Month 1: USD 65.10/bbl

a. 450,000
b. 510,000
c. 720,000
d. 1,038,000

32. A 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 of Futures for Physical (EFP) contract
to ensure physical delivery of crude at the Port of Houston. Under the reporting requirements
of Dodd‐Frank, the refiner is:

a. Exempt from reporting the EFP transaction.
b. Required to report the notional value of the underlying physical crude oil.
c. Required to first register as a swap dealer before entering into an EFP contract.
d. Required to report the market value of the EFP as a swap at the time it is purchased.

33. An analyst estimates the volatility for WTI crude oil using the EWMA model with a decay factor
(λ) of 0.88. Assume it is August 26 and the estimated volatility on August 25 was 2.355% per
day. If the closing price of WTI crude oil was USD 43.12/bbl and USD 43.33/bbl on August 24
and August 25 respectively, the best estimate of WTI crude oil volatility today (August 26) is
closest to:

a. 1.77%.
b. 1.87%.
c. 2.13%.
d. 2.22%.


Questions 34–35 use the information below
In early March 2016, the spot price of Brent crude oil is USD 47.90/bbl and estimated monthly
storage costs are USD 0.75/bbl. Traders use the following market data to assess the
opportunity to execute a storage arbitrage transaction:
Brent crude oil futures contract prices:
 October 2016: USD 51.24/bbl

US Treasury zero‐coupon bond yields:
 March 2016 through September 2016: 2.50%
 October 2017: 3.75%

34. Calculate the breakeven forward price (in USD) required for a 6‐month storage arbitrage to be
profitable assuming storage costs are paid at the beginning of each month.
a. 111.09
b. 113.79
c. 115.73
d. 118.53

35. In a separate transaction, the traders structure an 18‐month forward contract to purchase
250,000 barrels of Brent crude oil and purchase a zero‐coupon Treasury bond to fund the
forward settlement. Which of the following most closely matches face amount of the zero
coupon bond position?
a. 12,612,000
b. 12,851,000
c. 13,095,000
d. 14,114,000


36. Counterparty risk can be divided into settlement and pre‐settlement risk exposures. When
compared to pre‐settlement risk events, the impact of settlement risk events for a given
exposure is generally much:
a. Larger, but settlement risk events occur much less frequently.
b. Larger, but settlement risk events occur much more frequently.
c. Smaller, but settlement risk events occur much less frequently.
d. Smaller, but settlement risk events occur much more frequently.

37. A trader would like to reduce the gamma on a portfolio of options on NYMEX WTI crude oil
futures. Which of the following transactions will best achieve this objective?
a. Sell at‐the‐money options.
b. Buy at‐the‐money options.
c. Sell out‐of‐the money options.
d. Buy out‐of‐the‐money options.

38. An airline uses NYMEX Ultra‐Low Sulfur Diesel (ULSD) futures contracts to hedge its jet fuel
exposure. Use the data below to calculate the minimum variance hedge ratio.
 Jet fuel price volatility: 22.69%
 ULSD futures price volatility: 18.43%
 Correlation between jet fuel and ULSD futures price returns: 0.726

a. 0.689
b. 0.845
c. 0.894
d. 1.094


39. Credit analysts are performing stress‐tests to assess the impact of various recovery rate
assumptions for a renewable energy bond position. The bond currently has the following credit
risk characteristics, using the base‐case recovery rate assumption:

 Exposure: EUR 13,370,000
 Default probability: 4.50%
 Expected loss: EUR 240,000
If the expected recovery rate assumption is reduced to 30%, the new expected loss (in EUR) for
the exposure will be closest to:
a. 343,000.
b. 421,000.
c. 480,000.
d. 859,000.

40. A netting set contains six equal counterparty exposures totaling GBP 3,600,000. The average
correlation between the positions is 0.15, while the future value of the exposures are normally
distributed. The best estimate for the expected net exposure (in GBP) is approximately:
a. 794,000.
b. 1,273,000.
c. 1,944,000.
d. 3,112,000.


41. The 4‐year implied default probability associated with several midsize oil exploration and
production companies is summarized below:
Company Year 1 Year 2 Year 3 Year 4
W 0.04% 0.17% 0.37% 0.53%
X 0.42% 1.05% 1.61% 2.32%
Y 4.68% 8.41% 11.6% 13.8%
Z 26.5% 33.1% 39.0% 44.2%

Based on these probabilities, a Moody’s/Standard & Poor’s rating of B1/B+ will most likely be
assigned to company:

a. W.
b. X.
c. Y.
d. Z.


42. Mega Power has received a notice of default on several OTC derivative positions from a BB‐
rated counterparty. The trades are accounted for on Mega’s books as follows:
MtM Value Collateral Value

(CAD) (CAD)
Trade A +5,000,000 2,000,000
Trade B ‐9,000,000 0
Trade C +7,000,000 3,000,000
Trade D +6,000,000 2,000,000

The transactions are covered by an ISDA CSA which includes a closeout netting agreement.
Assuming a recovery value of zero, Mega’s total net exposure (in CAD) to the counterparty is:
a. 2,000,000.
b. 11,000,000.
c. 16,000,000.
d. 18,000,000.

43. A credit analyst assesses a pending offering of a 1‐year bond, priced at par, which pays an
annual coupon. The bond has a default probability of 12% with an estimated recovery rate of
40%. If the 1‐year risk free rate is 2.5%, and the analyst is risk‐neutral, what is the minimum
coupon the analyst will accept to invest in the bond?
a. 7.80%
b. 8.18%
c. 10.68%
d. 11.02%


44. A distribution of operational loss events from a sample of drilling companies over a 6‐month
period are summarized below:

Loss Events Percentage of Observations
0 18%
1 36%
2 29%
3 13%
4 4%

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

a. 1.05
b. 1.11
c. 1.22
d. 1.34

45. 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. Results from the regression analysis include the following coefficients
for a linear relationship where:
y = 0.0285 x (Log of daily NBP Spot Prices) + 0.0188
Using results from the regression analysis, what is the best estimate of the mean reversion rate
(in days) for NBP natural gas spot prices?
a. 2
b. 9
c. 14
d. 21


46. TLE is an electric utility company that owns and operates several natural gas‐fired generators
servicing a large metropolitan region in southern Ohio. TLE typically purchases exchange
traded CDD and HDD contracts to help manage the economic risk associated with a significant
deviation from average temperatures during the summer and winter months.
The chart below summarizes local temperature data for one week during the peak summer
cooling season:
High Low Average

Temperature Temperature Temperature
Sunday 96°F 58°F 77°F
Monday 88°F 64°F 76°F
Tuesday 93°F 71°F 82°F
Wednesday 84°F 58°F 71°F
Thursday 73°F 49°F 61°F
Friday 85°F 63°F 74°F
Saturday 101°F 73°F 87°F

Calculate the number of Cooling Degree Days (CDD) for the week.
a. 73
b. 77
c. 89
d. 95

47. Under the terms of a CDD contract, TLE will receive:
a. Settlement payments when cumulative CDDs are greater than a pre‐defined local
temperature index for a given month.
b. Carbon emission credits equivalent to the total number of CDDs registered during the term
of the contract.
c. Surplus fixed price power to meet consumer demand when the contracted CDD threshold is
exceeded.
d. Weather allowances that provide for the temporary increase in local retail electricity prices
when observed CDDs exceed a pre‐defined threshold for a given month.


48. An analyst at XYZ Energy is reviewing the company’s credit risk exposure. Given the data in the
credit report data below, what is XYZ’s original exposure (in USD) on this bond position?

Obligor XYZ Energy
Recovery rate 32%
Loss given default USD 5,850,000
Expected loss USD 3,910,500

a. 4,620,200
b. 6,173,500
c. 8,602,900
d. 11,196,500

49. The risk associated with an exchange traded futures position will most likely increase if the
central counterparty:
a. Invokes a netting agreement on trades that are in default.
b. Reduces the margin requirement on a commodity with low volatility and high liquidity.
c. Conducts an auction to replace positions that are in default.
d. Increases the margin requirement on a commodity with large, highly concentrated positions.

50. Which of the following best describes the application of Key Performance Indicators (KPIs) and
Key Risk Indicators (KRIs) in the pursuit of an organization’s risk management objectives?
a. Use KPIs exclusively to develop an effective forward looking assessment of trends in
operational risk factors.
b. Integrate KPI objectives and KRI limits to create a single comprehensive risk‐weighted metric.
c. Monitor KRIs to assess trends in risk exposure while adjusting its business strategy and
operational procedures to help achieve performance objectives identified by KPIs.
d. Replace KPIs with KRIs and adjust company‐wide risk capital allocations to account for
changes in risk monitoring procedures.


51. A new exploration company is formed to develop and produce oil in the Arctic and the
company has just formed its risk management group. Which of the following best describes the
optimal implementation of quantitative and qualitative techniques in the company’s risk
management process?
a. Develop an integrated qualitative/quantitative risk strategy from the outset, since each
technique is incomplete when used in isolation.
b. Develop a strategy based on the relative qualitative or quantitative experience of the
management team since either can be an effective risk management technique.
c. Begin by developing qualitative techniques since they are easier to devise and will
provide a better depth of information; adopt quantitative techniques as capabilities develop.
d. Begin by developing quantitative techniques since they provide empirical data on degrees of
risk exposure; adopt qualitative techniques as operational experience grows.

52. Which of the following describes the primary advantage of using the bowtie model in an ERM
framework?
a. It predicts all likely outcomes of a risk event.
b. It ranks all possible causes of a risk event in likelihood of occurrence.
c. It tracks risk exposures for a specific event all the way from causes to consequences.
d. It calculates the most cost‐effective way to limit a risk event.

53. Consider a power marketing firm that owns and operates several small utility companies that
supply electricity to retail customers. Which strategy should the power marketer follow to best
implement the use of KRIs within this network of utility companies?
a. Allow each utility company to set an individual KRI threshold then aggregate all KRI limits into
a single company‐wide figure for analytical purposes.
b. Set a single KRI threshold for the network that will trigger corrective actions if surpassed.
c. Establish a range of KRI thresholds with specific corrective measures that are triggered
whenever a KRI threshold is surpassed by one of the utilities.
d. Set several KRI thresholds to quantify risk in terms of the actual economic impact on the
organization and use these results to design future risk strategy.


54. Which factor below would most likely cause a refiner to select a 5:3:2 crack spread instead of a
3:2:1 crack spread?
a. Plant configuration
b. Basis spreads
c. Transportation constraints
d. Volumetric supply

55. An ISO assumes peak hour demand is uniformly distributed between 175 MWh and 75MWh
when modeling grid demand. What is the probability that peak hour demand will exceed
100 MWh?
a. 25%
b. 45%
c. 55%
d. 75%

56. A crude oil trader structures a long, 1,000 contract strangle position, using the following options
on the prompt‐month Brent futures contract:

 Call with a strike of USD 58.00
 Put with a strike of USD 56.00

Calculate the payoff (in USD) on the strangle assuming the settlement price on the prompt‐
month Brent futures contract is 53.00/bbl.
a. 0
b. 3,000
c. 5,000
d. 11,000


57. An analyst is assessing a GARCH (1,1) model. The model applies the following expression to
estimate volatility:
σt2 = ω + ασ2(t‐1) + βrt2
Where: rt = εtσt and εt ~ N(0,1).
Assuming that factors α and β are both greater than zero, what assumption is required to
ensure that volatility estimates are bounded?
a. α ≥ 1 and β ≥ 1
b. α ≤ 1 and β ≤ 1
c. α + β ≥ 1
d. α + β ≤ 1

58. The risk manager at an energy trading company has recommended that traders implement a
credit value adjustment (CVA). Which of the following best describes the rationale for using
a CVA?
a. It provides a ratings‐level adjustment that applies expected credit migration data to adjust
counterparty credit ratings.
b. It provides a counterparty‐level adjustment that quantifies the maximum credit exposure for
individual counterparties.
c. It provides a portfolio‐level adjustment that incorporates risk‐neutral counterparty default
probabilities in VaR calculations.
d. It provides a trade‐level adjustment that accounts for counterparty risk in the pricing of
individual transactions.

59. A crude oil producer structures an option strategy to manage the economic impact of a decline
in crude oil prices below USD 45.00/bbl in two years. Assuming an equal volume of oil is
covered in each strategy, which structure will generate the highest net profit if crude oil is
trading at USD 60.00/bbl in two years?
a. Straddle using both a long call and put that each have a USD 45.00/bbl strike price and a
total USD 8.00 premium
b. Long put option with a USD 61.00/bbl strike price and USD 2.00 premium
c. Long put option with a USD 48.00/bbl strike price and USD 6.00 premium
d. Costless collar using a long put with a USD 43.00/bbl strike price and a short call with a
USD 47.00/bbl strike price


60. The primary objective of a stack‐and‐roll position is to:
a. Realize the spread on a call and put option with different maturities on the same underlying
commodity position.
b. Lock in a profit on a commodity trade when there is an expectation that the forward curve
will steepen.
c. Manage price risk on a commodity position when there is a perceived lack of liquidity in
longer dated futures contracts.
d. Hedge cross‐commodity basis risk.


2016 ERP Part II Practice Exam – Candidate Answer Sheet

1. C 31. A
2. B 32. A
3. C 33. D
4. A 34. B
5. B 35. A
6. D 36. A
7. A 37. A
8. D 38. C
9. B 39. B
10. C 40. C
11. D 41. C
12. C 42. A
13. B 43. D
14. D 44. A
15. B 45. C
16. A 46. B
17. D 47. A
18. D 48. C
19. D 49. D
20. B 50. C
21. B 51. C
22. A 52. C
23. D 53. C
24. A 54. A
25. B 55. D
26. B 56. B
27. C 57. D
28. A 58. ______D _____
29. B 59. ______A_ ____
30. A 60. ______C_ ___


2016 ERP Part II Practice Exam – Answers & Explanations

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

 Trade date: January 25
 Number of contracts: 600
 Purchase price: USD 43.57/bbl
 Initial margin requirement: USD 2,550,000
 Required maintenance threshold: USD 2,000,000

Below what price will a margin call be triggered on the position, assuming the exchange
requires the account balance for all futures positions to be topped‐up to their initial required
margin level (in USD)?

a. 41.81
b. 42.29
c. 42.65
d. 43.47

Answer: c

Explanation:
The correct answer is c. The trader can lose no more than (2,550,000 – 2,000,000), or 550,000,
on this trade without receiving a call. In order to find the correct price, we must first find the
gain or loss on the trade per dollar change in the WTI futures contracts, which is 600 contracts *
1,000 barrels per contract, or USD 600,000. Therefore, the contract can trade no lower than
43.57 ‐ (550,000 / 600,000), or USD 42.65/bbl, before the trader gets a call.

Reading reference: IEA, “The Mechanics of the Derivatives Markets: What They Are and How
They Function” (Special Supplement to the Oil Market Report, April 2011), Or Kaminski Chapter
4, Pages 116‐117.


2. Refined product traders have structured the following straddle position using options on ULSD
futures contracts:

 2‐month NYMEX ULSD call option with a strike price of USD 2.91/gal at a premium of
USD 0.05/gal
 2‐month NYMEX ULSD put option with a strike price of USD 2.91/gal at a premium of
USD 0.09/gal

One day after establishing the position, the NYMEX ULSD prompt‐month futures price is trading
at USD 2.73/gallon. What is the current net profit per straddle in USD?

a. 400
b. 1,680
c. 3,780
d. 5,400

Correct answer: b

Explanation:
The correct answer is b. At a closing price of 2.73/gal, the profit is 2.91 ‐ 2.73 ‐ 0.05 ‐ 0.09 =
0.04 multiplied by 42,000 gallons per contract. In this situation, the “long put” provided the
profit, while the premium payments reduced the profit.

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


3. An RBOB trader observes the following NYMEX price quotes on May 31:


She believes the spread between the December and August contracts is too wide and executes
a 10‐contract position on June 1 to benefit from a narrowing of the spread. On June 30, the
contracts close at the following prices:


Ignoring broker costs, margin requirements and other expenses, what is the trader’s 1‐month
profit (in USD) on the position based on the June 30 closing prices?

a. 13,440
b. 37,800
c. 54,600
d. 75,200

Answer: c

Explanation:
The correct answer is c. The trader’s expectations were that the spread of USD 0.19/gal would
narrow; therefore she buys the low price contract and sells the high price contract. She bought
the August contract (USD 1.58) and sold the December contract (USD 1.77) for a spread of
USD 0.19/gal. In June, she closes out her position by selling the August contract for USD
1.63/gal and buys the December contract for USD 1.69/gal. Since she transacted for 10
contracts at 42,000 gallons per contract, her net profit is 420,000 x USD 0.13, or USD 54,600.
Had the trader thought the spread would widen, she would have reversed the transactions.

Reading reference: Vincent Kaminski, Energy Markets, Chapter 4, pages 142‐144, 149.


4. The market risk manager for a refinery is assessing the economics of using collars to manage
price risk and operating margins. She has summarized the following market data for options on
NYMEX RBOB futures contracts:

RBOB Strike Price Call Premium Put Premium

(USD/bbl) (USD) (USD)
1.51 0.156 0.137
1.59 0.129 0.146

If the prompt‐month NYMEX RBOB futures price is currently USD 1.54/gal, which of the
following transactions will most effectively meet the stated risk management objective?
a. Buying put options @ USD 1.51 strike and selling call options @ USD 1.59 strike
b. Selling put options @ USD 1.51 strike and buying call options @ USD 1.59 strike
c. Buying put options @ USD 1.59 strike and selling call options @ USD 1.51 strike
d. Selling put options @ USD 1.59 strike and buying call options @ USD 1.51 strike

Answer: a
Explanation:
The correct answer is a. The collar will help the refiner to hedge price risk and, by extension,
margins on its refining operation for the month of October. In this case, the refiner will lock in a
range of selling prices between 1.51 and 1.59 (less any cost of implementing the trade). If the
RBOB price rallies over 1.59, the sold call will be assigned to the refiner so the refiner will
realize an effective price of 1.59. If the price falls below 1.51, the refiner can exercise the put
option to lock in the price at that level.

Reading reference: Vincent Kaminski, Energy Markets, Chapter 18.


5. A refinery uses NYMEX WTI futures contracts to hedge the purchase of 50,000 barrels of WTI
crude oil in two months. The contracts are purchased at USD 43.00/bbl. Two months later, the
refiner closes the futures position and purchases 50,000 barrels on the spot market. What is the
effective price paid per barrel (in USD) if the futures contract is now trading at USD 44.60/bbl
and the spot price is USD 45.80/bbl?

a. 43.00
b. 44.20
c. 44.60
d. 46.20
Correct answer: b
Explanation:
The correct answer is b. The effective price paid (in dollars per barrel) is the final spot price less
the gain on the futures, or 45.80 – (44.60 ‐ 43.00) = 44.20. This can also be calculated as the
initial futures price plus the final basis, 43.00 + 1.20 = 44.20.

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


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

• Cap: USD 48.00/bbl
• Floor: USD 42.00/bbl
• Tenor: Six months (June to November)
• Valuation Index: Mean of Platts Singapore (MOPS)

The monthly MOPS Index per barrel prices are as follows (in USD/bbl):
Month Price (in USD/bbl)
June 51
July 45
August 49
September 41
October 38
November 35

Using the data above, calculate the airline’s net settlement (in USD) on November 30.
a. 400,000
b. 200,000
c. ‐200,000
d. ‐400,000

Answer: d
Explanation:
The correct answer is d. Because the airline is a consumer of jet fuel, the airline will purchase a
costless collar composed of one long 48 call funded by a short 42 put. Settlement payments will
be made for June, August and September, the months that the index price is set beyond the
cap/floor price threshold. For June the airline will receive USD 150,000 (51 – 48 x 50,000); in
August, they will receive USD 50,000 (49 – 48 x 50,000); in September the airline will pay USD
50,000 (42 – 41 x 50,000); in October the airline will pay USD 200,000 (42‐38 x 50,000); and in
November the airline will pay USD 350,000 (42 ‐ 35 x 50,000). This results in a total settlement
after six months of USD ‐400,000 (i.e. the airline will pay a total of USD 400,000).

Reading reference: Vincent Kaminski, Energy Markets, Chapter 18, Transactions in the Oil
Markets.

7. A risk manager at a large international bank has compiled the following closing price data on
the Brent crude oil futures contract for the past 31 trading days:
49
48
Futures Price (USD) 47
46
45
44
43
42
41
40
2/1/2016 2/11/2016 2/21/2016 3/2/2016

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

a. Exponentially Weighted Moving Average (EWMA) with a lambda of 0.91
b. Exponentially Weighted Moving Average (EWMA) with a lambda of 0.99
c. Eigenvector Weighted Average with a lambda of 0.99
d. Simple Moving Average

Answer: a

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

Reading reference: Clewlow and Strickland, Chapter 10, Pages 184‐185.


8. High price volatility in the Brent crude oil market is expected over the next six months due
primarily to uncertainty about the strength of the global economy. Based on this forecast, a
crude oil trader would most likely maximize her returns by structuring an option strategy using:

a. Long calls.
b. Long puts.
c. Long calls and short puts.
d. Long calls and long puts.
Answer: d

Explanation:
The correct answer is d. An option strategy that would best meet this goal is a straddle
strategy, which entails buying both long calls and long puts on the same asset and strike price
(typically close to the current price.) Given the Trader’s view of being long volatility, a Straddle
would maximize profit in times of high market price volatility – the greater the price movement
in either direction, the greater the profit.
Choices a and b are incorrect because they are directional bets in only one direction, and if
Brent moves in the other direction, the trader will realize a loss. C is incorrect as it describes a
collar strategy, which would establish a range on the profit earned during times of high price
volatility, thus most likely not achieving the goal of maximizing potential profit.
Reading reference: International Energy Agency. The Mechanics of the Derivatives Markets. (Pg
84). April 2011.


9. If the 10‐day, 95% VaR for a USD 10,000,000 energy commodity portfolio is USD 2,000,000, the
market risk for the portfolio can be interpreted to mean:

a. Portfolio losses over a ten day period are expected to exceed USD 2 million once in every
five 10‐day periods.
b. Portfolio losses over a ten day period are expected to exceed USD 2 million once in every
twenty 10‐day periods.
c. There is a 5% chance that portfolio losses will exceed USD 2 million over the next 10 trading
days.
d. There is a 95% chance that portfolio losses will exceed USD 2 million over the next 10 trading
days.

Correct answer: b

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


10. A market risk analyst has applied a factor‐push model to stress test the MtM value of several
combinations of option positions on the April NYMEX WTI futures contract. The model applies a
four standard deviation decline in the price of the underlying futures contract. Each option has
the same expiration date and the current settlement price for the April WTI contract is
USD 45.00/bbl.

Which of the following combinations of options would be the least likely to generate an
extreme loss under the stress testing methodology described above?

a. A long 40 call and a long 50 call
b. A long 42.50 call and a short 47.50 call
c. A long 45 call and a long 45 put
d. A short 40 put and a long 40 call

Correct Answer: c

Explanation:
The correct answer is c. A factor‐push model is only useful when the maximum loss on the
position occurs when the risk factor has been “pushed” or stressed the hardest. Therefore the
return profile of the underlying position with respect to the risk factor needs to be monotonic
(i.e. steadily increasing or decreasing for every value of the risk factor.) In cases where a
position has non‐monotonicity, or the maximum loss occurs when the value of the risk factor is
not at an extreme, a factor‐push model will not predict the maximum loss. In this case, answer
choice C would be correct, since the greatest loss would take place if the underlying remained
at USD 45.00/bbl and the position would actually increase in value if the factor was pushed in
either direction.

Reading reference: Dowd, Managing Market Risk, Chapter 13, Pages 303‐304.


11. The variance of historical weekly price returns on the SP‐15 peak power futures contract is
0.0323 over a 5‐year period. The best estimate of annual volatility on the SP‐15 contract is:

a. 23.3%.
b. 40.2%.
c. 116.4%.
d. 129.5%.

Answer: d
Explanation:
The correct answer is d. Historical volatility is derived by multiplying the standard deviation
(square root of variance) of price changes by the square root of time (52), the factor required to
annualize the weekly prices observed in the sample.

Reading reference: Les Clewlow and Chris Strickland, Energy Derivatives: Pricing and Risk
Management, Chapter 3


12. An integrated crude oil producer reports USD 1.5 billion in aggregate swap exposures to three
unique counterparties as follows:

 A USD 400 million foreign currency swap with a Norwegian investment bank that locks
in a fixed USD/NOK exchange rate to fund local operations.
 A USD 700 million swap with a Middle Eastern NOC that establishes a fixed price for oil
produced from a domestic concession.
 A USD 400 million swap with a separate government entity that locks in a fixed purchase
price for a specified volume of natural gas.

Assume that neither government entity counterparty is acting as a utility. Under the provisions
of Dodd‐Frank, the producer:

a. Can apply for an end‐user exemption for all the swaps, since they are used for hedging
purposes.
b. Can apply for an end‐user exemption for the oil and natural gas swaps, but not for the
foreign currency swap.
c. Must register as a swap dealer and does not qualify for the end‐user exemption.
d. Must register as a major swap participant (MSP) but can apply for a reporting exemption for
the foreign currency swap.

Answer: c

Explanation:
The producer must register as a swap dealer since it did not meet the “de minimus” test, which
requires participants hold no more than USD 8 billion in aggregate total exposure, but only 800
million in aggregate gross notional exposure from government entities (acting as “utilities”) and
USD 25 million in aggregate gross notional exposure from government entities not acting as
utilities. Therefore, since the bank’s total exposure of USD 1.1 billion with government
counterparties is over both limits, the producer must register as a swap dealer.

Reading reference: Gordon Goodman. “Swaps: Dodd‐Frank Memories.”


13. A US‐based petroleum producer is building an LNG train on the coast of Australia which is
scheduled to be completed in 5 years. To help reduce exposure to foreign currency fluctuations,
the producer has structured a 5‐year, fixed‐for‐floating swap on the Australian dollar (AUD) with
an A‐rated counterparty.

The producer is concerned about a potential deterioration in the credit quality of the
counterparty during the later years of the swap. To help mitigate this potential increase in
counterparty exposure, the producer should use a:

a. CVA adjustment.
b. Reset agreement.
c. Take‐or‐pay provision.
d. Netting agreement.

Answer: b

Explanation:
The correct answer is b. A reset agreement stipulates that the mark‐to‐market be settled at
certain designated points in time. At these points, a cash payment is made that reflects the
current mark‐to‐market and the terms of the swap are reset at the prevailing rate so that
exposure becomes 0 after every reset is made. This allows exposure to be “paid out” more
frequently and reduces the amount of exposure which could potentially be outstanding in later
years of the agreement when the health of the counterparty is much less certain.

Reading reference: Jon Gregory. Counterparty Credit Risk: A Continuing Challenge for Global
Financial Markets, Chapter 4, Page 51.


14. On September 1, 2016, a regional airline contracts to purchase 60,000 gallons of jet fuel from a
local refinery for forward delivery in one year at a fixed‐price of USD 3.88/gal. Terms of the
purchase require the airline to take delivery of the jet fuel on September 1, 2017, after making
payment in full. The continuously compounded risk‐free interest rate is 4% per year.

Assume that by the end of April 2017, the price for jet fuel has risen to USD 4.14/gal. The
refinery’s replacement risk on April 30, 2017 (4 months from the delivery date, in USD) is:

a. 7,407.
b. 9,309.
c. 11,684.
d. 15,393.
Answer: d
Explanation:
The correct answer is d. The replacement risk can be calculated by using the following equation:
R = Volume x Price Difference x (discount factor, at t =4/12 and r =0.04)
R = 60,000 * (4.14‐3.88) * exp(‐0.04 x 4/12) = 15,393

Reading reference: Markus Burger, Bernhard Graeber, and Gero Schindlmayr. Managing
Energy Risk: An Integrated View on Power and Other Energy Markets. Chapter 3.4


15. How will settlement risk on the transaction change if the closing price of jet fuel is USD 4.35/gal
on July 31?

a. Settlement risk increases.
b. Settlement risk remains the same.
c. Settlement risk decreases.
d. Settlement risk cannot be determined from the information provided.
Correct answer: b
Explanation:
The correct answer is b. The settlement risk is constant based on the original terms of the fixed
price purchase contract. Replacement risk will change with the spot price of the underlying
commodity, but not the settlement risk.

Reading reference: Markus Burger, Bernhard Graeber, and Gero Schindlmayr. Managing
Energy Risk: An Integrated View on Power and Other Energy Markets. Chapter 34.


16. A commercial natural gas consumer in Boston hedges 100% of its expected January gas
consumption, which totals 100,000 MMBtu. In order to minimize basis risk in its hedging
strategy, the natural gas consumer should:

a. Buy 10 January 2016 NYMEX natural gas futures contracts and buy an Algonquin Citygate
b. Buy 10 January 2016 NYMEX natural gas futures contracts and sell an Algonquin Citygate
c. Sell 100 January 2016 NYMEX natural gas futures contracts and buy an Algonquin Citygate
d. Sell 100 January 2016 NYMEX natural gas futures contracts and sell an Algonquin Citygate

Answer: a

Explanation:
The correct answer is a. Basis refers to the difference in price between a forward (futures)
market and a cash (spot) market. In the natural gas markets, the primary type of basis risk is
locational basis risk. A basis swap is contract which provides the buyer or seller of the swap to
hedge their exposure to basis risk. (Note: 1 natural gas future contract unit represents 10,000
MMBtu).

Reading reference: Vincent Kaminski. Energy Markets. (Pgs 852‐854, 884, 892 GARP materials).
2013


17. A risk analyst has been asked to model the VaR of a portfolio of power generating assets, using
a modeling approach that captures the potential for price spikes observed in electricity
markets. Which of the following VaR methodologies will provide the greatest flexibility and best
approximation for a portfolio of power generating assets?

a. Delta
b. Delta‐Gamma
c. Historical Simulation using information from the last 90 trading days
d. Monte Carlo Simulation
Correct answer: d
Explanation:
The correct answer is d. A Monte Carlo simulation will better account for market behavior like
price jumps that are often found in energy commodities (particularly electricity) and option
pricing than the other methods; the historical simulation would also provide a good
approximation however the relatively short “lookback” period is not sufficient to capture price
jumps.
Management. Chapter 10.


18. A credit analyst is assessing a USD 7,800,000 credit exposure related to a 10‐year fixed‐rate
bond issued by a Baa3/BBB‐ rated midstream oil and gas company. The par value of the bond is
USD 8,000,000, it has an estimated recovery rate of 41%, and an expected loss of USD 317,500
in the event of default. Calculate the bond’s implied default probability.

a. 5.99%
b. 6.20%
c. 6.23%
d. 6.90%

Answer: d
Explanation:
The correct answer is d. Per the following formula:
Expected loss = Loss Given Default x probability of default
In this example Loss Given Default can be derived by multiplying the Credit Exposure by (1‐
Recovery Rate) = USD 4,602,000. Using this information along with the Expected Loss of USD
317,500, the implied probability of default is 6.90% or USD 317,500/USD 4,602,000.
Note: The par value of the bonds is not used in the calculation.
Reading reference: Allan Malz. Financial Risk Management, Chapter 6, Pages 201 – 203.


19. Consider the following model used to estimate the spot electricity price S:

dS = α(µ(t) – log(S))Sdt + σ(t)Sdz + kSdq
Where:
 α and k are constant parameters
 µ(t) and σ(t) are functions of time
 z is a Brownian Motion
 q is a jump process.
Which of the following features of electricity spot price behavior does the model fail to
capture?
a. Mean reversion
b. Price spikes
c. Seasonal patterns
d. Stochastic volatility

Answer: d

Explanation:
The volatility term is simply σ(t)S, implying seasonal patterns in volatility can be captured (by a
periodic function of time) but not stochastic (random) volatility changes.
• Answer A: this process is mean reverting with rate α
• Answer B: the jump term kSdq can capture spikes
• Answer C: σ(t) and µ(t) can both capture seasonal patterns in the mean level and vol

Management, Ch 2, p26


20. Which of the following OTC derivative transactions offers the greatest economic benefit to the
respective counterparty identified in a bilateral netting arrangement?

a. A crude oil producer long a put option on WTI futures
b. A gas‐fired electric power generator long a natural gas swap
c. A natural gas producer long a floor on natural gas
d. A refinery long a straddle on gasoline futures

Answer: b
Explanation:
The correct answer is b. To provide economic benefit in a netting arrangement a derivative
position must have the potential to have a negative mark‐to‐market. Long option positions in
which the premium is paid upfront would be the least beneficial to a netting arrangement
making a, b, and c incorrect. The long (fixed‐rate payer) position in a natural gas swap would
have the greatest likelihood of creating a negative MtM and therefore the greatest economic
benefit in a netting arrangement.

Financial Markets, Chapter 4.


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

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

The best approximation of the CVA for the swap (assuming annual settlements) is:

a. 0.009%.
b. 0.021%.
c. 0.599%.
d. 2.414%.

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

Reading reference: Jon Gregory. Counterparty Credit Risk: The New Challenge for Global
Financial Markets, Chapter 7, Pages 167‐172.


22. The difference between risk appetite and risk tolerance can best be explained by which of the
following statements?

a. Risk appetite measures the amount of risk an organization is willing to take, while risk
tolerance is used to communicate a level of acceptable risk.
b. Risk appetite expresses a range of risk levels an organization is willing to take, while risk
tolerance is a single definitive figure.
c. Risk appetite is a willingness to embrace risk, while risk tolerance is an aversion to risk.
d. Risk appetite cannot be derived empirically, while risk tolerance is a quantitative measure.

Answer: a
Explanation:
The correct answer is a. This is the correct definition of risk appetite and risk tolerance.

Reading reference: John Fraser and Betty Simkins, Enterprise Risk Management: Today’s
Leading Research and Best Practices for Tomorrow’s Executives, Chapter 16, Pages 287‐289.


23. Senior management at an energy company can best develop an effective risk appetite
statement, according to the COSO framework, by following which of the following approaches?

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

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

Reading reference: Larry Rittenberg and Frank Martens. Enterprise Risk Management –
Understanding and Communicating Risk Appetite. COSO (January 2012). Pages 4‐10.


24. The 1‐day, 95% VaR for a Brent crude oil futures position is EUR 1,500,000, based on a
simulation of 5,000 hypothetical 1‐day returns. When comparing the VaR with the 1‐day, 95%
expected shortfall amount for the position, the expected shortfall represents the:

a. Average of all 1‐day simulated losses that exceeded EUR 1,500,000.
b. Difference between the 99% VaR and the 95% VaR for the position.
c. Difference between the 95% VaR and the average negative 1‐day return for the position.
d. Maximum 1‐day loss that occurred in the simulation.

Answer: a

Explanation:
Correct answer is A. Expected shortfall is a measure of loss expectations above the VaR
threshold. It represents the average loss for a given confidence interval (X), and time period
(T), conditional on the loss being greater than the Xth percentile of the loss distribution.

Reading reference: John C. Hull. “Risk Management and Financial Institutions”, 3rd Edition,
Chp. 9, pages 187‐188.


25. Consider the following three European call options on the prompt‐month NYMEX Henry Hub
natural gas futures contract with the following strikes:

 Option A: USD 2.10/MMBtu
 Option B: USD 2.30/MMBtu
 Option C: USD 2.50/MMBtu
If the prompt‐month Henry Hub futures contract is trading at USD 2.30/MMBtu, which of the
following illustrations most closely depicts the expected shape of implied volatility across the
three option positions?

a.
Option A
Implied Volatility
Option B
Option C
Strike Price


b.
Implied Volatility
Option C
Option B
Option A
Strike Price

c.
Option B
Implied Volatility
Option A Option C
Strike Price


d.
Implied Volatility
Option A Option B Option C
Strike Price

Answer: b
Explanation:
The correct answer is b. Out‐of‐the‐money (OTM) calls and put options tend to show increasing
implied volatilities as the option strikes make the options move further and further out of the
money.

Management. (Lacima Publications, 2000). Chapter 3 ‐ Volatility Estimation in Energy Markets.


26. A diversified energy firm has chosen to conform to the Basel guidelines for best practices in
backtesting its VaR models. When backtesting a 1‐year, 99% VaR model, a risk analyst finds five
exceptions. How should the analyst interpret this result relative to the Basel requirements?

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

Answer: b
Explanation:
The correct answer is b. Between 5 and 9 exceptions to a 99% VaR model in a 250‐day period
puts the model in the “yellow zone” where further actions must be taken in order for the model
to continue being used. One potential solution could be raising the “safety multiplier”, which is
an adjustment made to the model result to account for model risk (or for a bank, an adjustment
to the VaR model result to dictate its economic capital requirement). Ten or more exceedances
puts the model into the “red zone” where it must be substantially revised before being
considered usable.
Management (Lacima Publications, 2000). Chapter 10 ‐ Value‐at‐Risk.

27. Consider a 5‐year USD denominated interest rate swap with semi‐annual payments. Which of
the following best illustrates the potential future exposure (PFE) of the swap over its five year
life?

a.
5.0%
3.0%
1.0%
‐1.0% 0 12 24 36 48 60
‐3.0%
‐5.0%


b.
5.0%
4.0%
3.0%
2.0%
1.0%
0.0%
0 12 24 36 48 60

c.
6.0%
5.0%
4.0%
3.0%
2.0%
1.0%
0.0%
0 12 24 36 48 60

d.
5.0%
4.0%
3.0%
2.0%
1.0%
0.0%
0 12 24 36 48 60

Answer: c


Explanation:
The correct answer is c. PFE increases rapidly during the early period of the swap due to
uncertainty over future payments, but decreases towards 0 in later periods due to the roll‐off
of payments over time. These two offsetting factors produce a peak in PFE near the middle of
the swap duration period.

Reading reference: Jon Gregory. Counterparty Credit Risk and Credit Value Adjustment: A
Continuing Challenge for Global Financial Markets. (West Sussex, UK: John Wiley & Sons, 2012).
Chapter 4 ‐ Netting, Compression, Resets and Termination Features.

28. Which of the following energy commodity markets is least affected by the concept of
convenience yield?

a. Electricity
b. Heating oil
c. Jet fuel
d. 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. Storable commodities that exhibit
seasonal demand patterns 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. (2012). Chapter 4 – Energy Markets: The
Instruments, Pages 134‐138.


29. The volatility term structure associated with energy commodity forward contracts typically
follows what pattern as contract maturity approaches?

a. Stable
b. Steadily increasing
c. Steadily decreasing
d. Seasonality makes the volatility term structure unpredictable

Answer: b
Explanation:
The correct answer is b. As energy forward contracts get closer to their maturity date, price
volatility tends to increase. This is attributed to several interconnected factors, such as traders
having more information about the contract as it draws closer to maturity, which causes a rise
in trades of that forward contract which, in turn, increases price volatility.
Management, Chapter 3, Page 39.


30. The following table summarizes daily price return data for Henry Hub natural gas and WTI crude
oil over a five‐day period:

Henry Hub WTI
(USD/MMBtu) (USD/bbl)
Day 1 3.98% ‐1.56%
Day 2 ‐2.65% 3.54%
Day 3 2.03% ‐0.59%
Day 4 ‐5.01% 3.89%
Day 5 2.77% 0.23%
Sample Mean Return 0.22% 1.10%
Standard Deviation 0.041 0.028

Which of the following provides the best estimate of correlation between NYMEX Henry Hub
and WTI price returns over this time period?
a. ‐0.80
b. ‐0.30
c. 0.30
d. 0.80

Answer: a
Explanation:
The correlation can be calculated as follows:


Covariance terms:
Commodity A Commodity B
μa) * (B – μb)
Day 1 3.98% ‐1.56% ‐0.00099985
Day 2 ‐2.65% 3.54% ‐0.00070068
Day 3 2.03% ‐0.59% ‐0.00030558
Day 4 ‐5.01% 3.89% ‐0.00145924
Day 5 2.77% 0.23% ‐0.00022201
Sample mean 0.22% 1.10%

Sample standard deviation 0.041 0.028

Covariance: = ‐0.00092184
,
Correlation ρab/σaσb ‐0.7961

Since the sample mean is derived from the observations, we have to divide by (n‐1) and not n,
to account for the lost degree of freedom. This makes the correlation calculation ‐0.80 and not
‐0.64 as it would have been if the means had been known previously rather than taken from the
sample.

Also, with an understanding of correlation this question can be answered without performing
the calculation by simply examining the chart. In each instance, when the return of commodity
A is above its mean, commodity B’s return is below its mean. This would imply a strong negative
correlation, and since the other answers are far away from that, A can be safely chosen without
doing the calculation.

Reading reference: Michael Miller. Mathematics and Statistics for Financial Risk Management,
2nd Edition. (Hoboken, NJ: John Wiley and Sons, 2014). Chapter 3 ‐ Basic Statistics


31. A refinery buys a 3‐month cap to manage price volatility on its crude oil supply requirements for
the next three months. The cap is written on 180,000 barrels of crude oil per month at a strike
price of USD 63.50/bbl and premium of USD 1.80/bbl. Settlement occurs on a monthly basis
against the average daily prompt‐month NYMEX WTI contract closing price. Calculate the
cumulative net profit/loss (in USD) earned by the refinery for the 3‐month period using the
average daily prompt‐month NYMEX WTI closing prices below.


a. 450,000
b. 510,000
c. 720,000
d. 1,038,000

Correct 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.

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


32. A 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 of Futures for Physical (EFP) contract
to ensure physical delivery of crude at the Port of Houston. Under the reporting requirements
of Dodd‐Frank, the refiner is:

a. Exempt from reporting the EFP transaction.
b. Required to report the notional value of the underlying physical crude oil.
c. Required to first register as a swap dealer before entering into an EFP contract.
d. Required to 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 Dodd‐Frank
reporting requirements.

Reading reference: Gordon Goodman. “Swaps: Dodd‐Frank Memories.”

33. An analyst estimates the volatility for WTI crude oil using the EWMA model with a decay factor
(λ) of 0.88. Assume it is August 26 and the estimated volatility on August 25 was 2.355% per
day. If the closing price of WTI crude oil was USD 43.12/bbl and USD 43.33/bbl on August 24
and August 25 respectively, the best estimate of WTI crude oil volatility today (August 26) is
closest to:

a. 1.77%.
b. 1.87%.
c. 2.13%.
d. 2.22%.

Answer: d

Explanation:
The correct application of the EWMA formula as follows:
Return = (43.33/43.12) ‐1 = 0.00487
Volatility = SQRT(0.88*(2.355%)^2+(1‐0.88)*(‐0.00487)^2) = 2.216%
Reading reference: John C. Hull. “Risk Management and Financial Institutions”, 3rd Edition,
Chp. 10, pages 211‐213.


Questions 34–35 use the information below
In early March 2016, the spot price of Brent crude oil is USD 47.90/bbl and estimated monthly
storage costs are USD 0.75/bbl. Traders use the following market data to assess the
opportunity to execute a storage arbitrage transaction:
Brent crude oil futures contract prices:

US Treasury zero‐coupon bond yields:
 March 2016 through September 2016: 2.50%
 October 2017: 3.75%

34. Calculate the breakeven forward price (in USD) required for a 6‐month storage arbitrage to be
profitable assuming storage costs are paid at the beginning of each month.

a. 111.09
b. 113.79
c. 115.73
d. 118.53
Correct 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


35. In a separate transaction, the traders structure an 18‐month forward contract to purchase
250,000 barrels of Brent crude oil and purchase a zero‐coupon Treasury bond to fund the
forward settlement. Which of the following most closely matches face amount of the zero
coupon bond position?
a. 12,612,000
b. 12,851,000
c. 13,095,000
d. 14,114,000
Correct answer: a
Explanation: The correct answer is a. The formula to solve is:
S0 = F0e‐rT
S0 = 250,000*53.37* e(‐0.0375*1.5) = 12,612,702
Reading reference: Robert McDonald, Derivatives Markets, 3rd Edition, Ch. 6, Pages 189 – 191.

36. Counterparty risk can be divided into settlement and pre‐settlement risk exposures. When
compared to pre‐settlement risk events, the impact of settlement risk events for a given
exposure is generally much:
a. Larger, but settlement risk events occur much less frequently.
b. Larger, but settlement risk events occur much more frequently.
c. Smaller, but settlement risk events occur much less frequently.
d. Smaller, but settlement risk events occur much more frequently.

Answer: a

Explanation:
Settlement risk is the risk of counterparty default during the settlement of the transaction,
while pre‐settlement risk occurs prior to the maturity and/or settlement. Settlement risk
exposures are much larger than pre‐settlement risk exposures since settlement risk entails the
full value of the underlying contract, while pre‐settlement risk is just the mark‐to‐market (i.e.
profit). However, since settlement risk is limited to an extremely short period of time in most
cases relative to the length of the contract, settlement risk events occur much less frequently.

Reading reference: Gregory, chapter 3, p. 23.


37. A trader would like to reduce the gamma on a portfolio of options on NYMEX WTI crude oil
futures. Which of the following transactions will best achieve this objective?
a. Sell at‐the‐money options.
b. Buy at‐the‐money options.
c. Sell out‐of‐the money options.
d. Buy out‐of‐the‐money options.

Answer: a

Explanation:
The correct answer is a. Gamma is defined as the rate of change in an option’s delta per move in
the underlying. Because delta is defined as the rate of change in an option’s 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. (Hoboken: John
Wiley & Sons, 2015). Chapter 8 – How Traders Manage Risk.


38. An airline uses NYMEX Ultra‐Low Sulfur Diesel (ULSD) futures contracts to hedge its jet fuel
exposure. Use the data below to calculate the minimum variance hedge ratio.
 Jet fuel price volatility: 22.69%
 ULSD futures price volatility: 18.43%
 Correlation between jet fuel and ULSD futures price returns: 0.726

a. 0.689
b. 0.845
c. 0.894
d. 1.094

Answer: c

Explanation:
The correct answer is c. The minimum variance hedge ratio is calculated as:

H* = ρ (a,b) * (σa / σb), where ρ 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 = 0.726 * (0.2269/0.1843), or 0.894

The correct answer is c.

Reading reference: Michael Miller. Mathematics and Statistics for Financial Risk Management,
2nd Edition. (Hoboken, NJ: John Wiley and Sons, 2014). Chapter 3 – Basic Statistics. Pages 58‐
59.


39. Credit analysts are performing stress‐tests to assess the impact of various recovery rate
assumptions for a renewable energy bond position. The bond currently has the following credit
risk characteristics, using the base‐case recovery rate assumption:

 Exposure: EUR 13,370,000
 Default probability: 4.50%
 Expected loss: EUR 240,000
If the expected recovery rate assumption is reduced to 30%, the new expected loss (in EUR) for
the exposure will be closest to:

a. 343,000.
b. 421,000.
c. 480,000.
d. 859,000.

Answer: b

Explanation:
The correct answer is b.
First, since the default probability is given, calculate the amount that would be lost under a zero
recovery scenario. That is: 13370000 * 4.5% = EUR 601650. The original assumed recovery
rate is then (601650‐240000)/601650, or 60%.
Using the new recovery rate assumption of 30% the correct expected loss is: 601650 * (1‐30%)
= 421,155.

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


40. A netting set contains six equal counterparty exposures totaling GBP 3,600,000. The average
correlation between the positions is 0.15, while the future value of the exposures are normally
distributed. The best estimate for the expected net exposure (in GBP) is approximately:
a. 794,000.
b. 1,273,000.
c. 1,944,000.
d. 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) ρ ] / n

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

Using n = 6 and ρ = 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, Page 140.


41. The 4‐year implied default probability associated with several midsize oil exploration and
production companies is summarized below:
Company Year 1 Year 2 Year 3 Year 4
W 0.04% 0.17% 0.37% 0.53%
X 0.42% 1.05% 1.61% 2.32%
Y 4.68% 8.41% 11.6% 13.8%
Z 26.5% 33.1% 39.0% 44.2%

Based on these probabilities, a Moody’s/Standard & Poor’s rating of B1/B+ will most likely be
assigned to company:

a. W.
b. X.
c. Y.
d. Z.

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


42. Mega Power has received a notice of default on several OTC derivative positions from a BB‐
rated counterparty. The trades are accounted for on Mega’s books as follows:
MtM Value Collateral Value

(CAD) (CAD)
Trade A +5,000,000 2,000,000
Trade B ‐9,000,000 0
Trade C +7,000,000 3,000,000
Trade D +6,000,000 2,000,000

The transactions are covered by an ISDA CSA which includes a closeout netting agreement.
Assuming a recovery value of zero, Mega’s total net exposure (in CAD) to the counterparty is:

a. 2,000,000.
b. 11,000,000.
c. 16,000,000.
d. 18,000,000.

Answer: a

Explanation:
Correct answer is a. Mega’s net exposure is reduced by both the netting agreement and the
existence of collateral, since Mega has the right to receive the collateral in the event of default.
Without the collateral, Mega’s exposure would be (5+7+6‐9) or 9 million CAD due to the netting
agreement. The collateral reduces the exposure by a further 7 million, making the overall
exposure CAD 2 million.

Reading reference: Gregory, Counterparty Credit Risk, Chapter 5


43. A credit analyst assesses a pending offering of a 1‐year bond, priced at par, which pays an
annual coupon. The bond has a default probability of 12% with an estimated recovery rate of
40%. If the 1‐year risk free rate is 2.5%, and the analyst is risk‐neutral, what is the minimum
coupon the analyst will accept to invest in the bond?
a. 7.80%
b. 8.18%
c. 10.68%
d. 11.02%

Correct 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‐π)(1+r+z) + πR > 1+r

where π 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


44. A distribution of operational loss events from a sample of drilling companies over a 6‐month
period are summarized below:

Loss Events Percentage of Observations
0 18%
1 36%
2 29%
3 13%
4 4%

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

a. 1.05
b. 1.11
c. 1.22
d. 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, or 1.053.

Reading reference: Michael Miller, Mathematics and Statistics for Financial Risk Management,
2nd Edition, chapter 3.


45. 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. Results from the regression analysis include the following coefficients
for a linear relationship where:
y = 0.0285 x (Log of daily NBP Spot Prices) + 0.0188
Using results from the regression analysis, what is the best estimate of the mean reversion rate
(in days) for NBP natural gas spot prices?
a. 2
b. 9
c. 14
d. 21
Correct answer: c
Explanation:
The correct answer is c. The mean reversion rate can be estimated from the regression results
as follows:
α0 = 0.0188 (Coefficient for Intercept)
α1 = 0.0285 (Coefficient for Slope)
Assuming 500 data points Δt = 1/500 = 0.0020
Therefore, the mean reversion rate (α) can be estimated as (α1/Δt) or 14.25
a is incorrect: α1 = 0.0285/ α0 = 0.0188 = 1.5
b is incorrect: α0 = 0.0188/ Δt 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.


46. TLE is an electric utility company that owns and operates several natural gas‐fired generators
servicing a large metropolitan region in southern Ohio. TLE typically purchases exchange
traded CDD and HDD contracts to help manage the economic risk associated with a significant
deviation from average temperatures during the summer and winter months.
The chart below summarizes local temperature data for one week during the peak summer
cooling season:
High Low Average

Temperature Temperature Temperature
Sunday 96°F 58°F 77°F
Monday 88°F 64°F 76°F
Tuesday 93°F 71°F 82°F
Wednesday 84°F 58°F 71°F
Thursday 73°F 49°F 61°F
Friday 85°F 63°F 74°F
Saturday 101°F 73°F 87°F

Calculate the number of Cooling Degree Days (CDD) for the week.
a. 73
b. 77
c. 89
d. 95
Answer: b
Explanation:
The correct answer is b. To calculate Cooling Degree Days (CDD) for each day, if the average
temperature is above 65 degrees, subtract the day’s average temperature from 65 to get that
day’s CDD. If the average temperature for that day is 65 degrees or below, the CDD for that day
is zero. In this case, the CDD = 12 + 11 + 17 + 6 + 0 + 9 + 22 = 77.

Reference: Robert McDonald. Derivatives Markets, 3rd Edition. (Pearson: 2013). Chapter 6 ‐
Commodity Forwards and Futures.


47. Under the terms of a CDD contract, TLE will receive:
a. Settlement payments when cumulative CDDs are greater than a pre‐defined local
temperature index for a given month.
b. Carbon emission credits equivalent to the total number of CDDs registered during the term
of the contract.
c. Surplus fixed price power to meet consumer demand when the contracted CDD threshold is
exceeded.
d. Weather allowances that provide for the temporary increase in local retail electricity prices
when observed CDDs exceed a pre‐defined threshold for a given month.

Answer: a
Explanation:
The correct answer is a. CDD contracts are available on certain exchanges (like the CME). The
cumulative number of CDDs for a month are calculated and then measured against an historical
average for a location for the same timeframe. If the cumulative CDD total exceeds the
temperature average, the contract pays out (typically USD 100 per registered degree). In this
way, weather‐sensitive market participants can hedge their exposure to abnormally high
temperatures (a Heating Degree Day contract would provide the same hedge against low
temperatures).

Reading reference: Robert McDonald. Derivatives Markets, 3rd Edition. (Pearson: 2013).
Chapter 6 ‐ Commodity Forwards and Futures.


48. An analyst at XYZ Energy is reviewing the company’s credit risk exposure. Given the data in the
credit report data below, what is XYZ’s original exposure (in USD) on this bond position?

Obligor XYZ Energy
Recovery rate 32%
Loss given default USD 5,850,000
Expected loss USD 3,910,500

a. 4,620,200
b. 6,173,500
c. 8,602,900
d. 11,196,500

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 201 – 203.


49. The risk associated with an exchange traded futures position will most likely increase if the
central counterparty:
c. Invokes a netting agreement on trades that are in default.
d. Reduces the margin requirement on a commodity with low volatility and high liquidity.
c. Conducts an auction to replace positions that are in default.
d. Increases the margin requirement on a commodity with large, highly concentrated positions.

Answer: d

Explanation:
The correct answer is d. A CCP’s increasing of margin requirements could create destabilizing
market impacts and therefore add systemic risk. An example of this is a security where large
concentrated positions are held. 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.

Financial Markets, Chapter 7, Page 110.


50. Which of the following best describes the application of Key Performance Indicators (KPIs) and
Key Risk Indicators (KRIs) in the pursuit of an organization’s risk management objectives?

a. Use KPIs exclusively to develop an effective forward looking assessment of trends in
operational risk factors.
b. Integrate KPI objectives and KRI limits to create a single comprehensive risk‐weighted metric.
c. Monitor KRIs to assess trends in risk exposure while adjusting its business strategy and
operational procedures to help achieve performance objectives identified by KPIs.
d. Replace KPIs with KRIs and adjust company‐wide risk capital allocations to account for
changes 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.

Leading Research and Best Practices for Tomorrow’s Executives, Chapter 8, Page 128.


51. A new exploration company is formed to develop and produce oil in the Arctic and the
company has just formed its risk management group. Which of the following best describes the
optimal implementation of quantitative and qualitative techniques in the company’s risk
management process?

a. Develop an integrated qualitative/quantitative risk strategy from the outset, since each
technique is incomplete when used in isolation.
b. Develop a strategy based on the relative qualitative or quantitative experience of the
management team since either can be an effective risk management technique.
c. Begin by developing qualitative techniques since they are easier to devise and will
provide a better depth of information; adopt quantitative techniques as capabilities develop.
d. Begin by developing 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: Larry Rittenberg and Frank Martens. Enterprise Risk Management –
Understanding and Communicating Risk Appetite. COSO (January 2012).

52. Which of the following describes the primary advantage of using the bowtie model in an ERM
framework?

a. It predicts all likely outcomes of a risk event.
b. It ranks all possible causes of a risk event in likelihood of occurrence.
c. It tracks risk exposures for a specific event all the way from causes to consequences.
d. It calculates the most cost‐effective way to limit a risk event.

Answer: c

Explanation:
The correct answer is c; the bowtie model tracks a risk exposure from cause through risk event
to consequence.

Leading Research and Best Practices for Tomorrow’s Executives, Chapter 16, page 292


53. Consider a power marketing firm that owns and operates several small utility companies that
supply electricity to retail customers. Which strategy should the power marketer follow to best
implement the use of KRIs within this network of utility companies?
a. Allow each utility company to set an individual KRI threshold then aggregate all KRI limits into
a single company‐wide figure for analytical purposes.
b. Set a single KRI threshold for the network that will trigger corrective actions if surpassed.
c. Establish a range of KRI thresholds with specific corrective measures that are triggered
whenever a KRI threshold is surpassed by one of the utilities.
d. Set several KRI thresholds to quantify risk in terms of the actual economic impact on the
organization and use these results to design future risk strategy.

Answer: c
Explanation:
The correct answer is c. A key benefit to Key Risk Indicators is that they can be used to
proactively assess and manage risk, allowing for companies to make adjustments as KRI limits
are reached. Further, best practice is to set several KRI levels, each one of which would then
trigger a different risk response, based on the unique needs of a company, division, etc. Setting
one uniform KRI threshold across the organization is not optimal.

Reading reference: John Fraser and Betty Simkins. Enterprise Risk Management: Today’s
Leading Research and Best Practices for Tomorrow’s Executives. (Hoboken: John Wiley & Sons,
2010). Chapter 8 ‐ Identifying and Communicating Key Risk Indicators.


54. Which factor below would most likely cause a refiner to select a 5:3:2 crack spread instead of a
3:2:1 crack spread?
a. Plant configuration
b. Basis spreads
c. Transportation constraints
d. Volumetric supply

Answer: a
Explanation:
The correct answer is a. Refinery configuration risk is an important consideration in the choice
of a crack spread. The 3:2:1 hedge effectively defines a virtual, simplified refinery, but it is
unlikely to match the true underlying exposures of a specific asset. A plant manager with a
non‐standard refinery configuration can use a wider basket of hedge instruments or modify the
proportions in the 3:2:1 basket.

Reading reference: Vincent Kaminski. Energy Markets. (2012). Chapter 18 – Transactions in the
Oil Markets.

55. An ISO assumes peak hour demand is uniformly distributed between 175 MWh and 75MWh
when modeling grid demand. What is the probability that peak hour demand will exceed
100 MWh?

a. 25%
b. 45%
c. 55%
d. 75%

Answer: d

Explanation:
Since this is a uniform distribution, the demand probabilities are distributed evenly across the
given range of 75 to 175 MWh. Therefore, P(D>100) = (Max of range – Threshold) / (Max of
range – Min of range) = (175‐100)/(175‐75) = 0.75.

Reading reference: Michael Miller, Mathematics and Statistics for Financial Risk Management,
2nd Edition (Ch 2, p24 and Ch4, p63)


56. A crude oil trader structures a long, 1,000 contract strangle position, using the following options
on the prompt‐month Brent futures contract:

 Call with a strike of USD 58.00
 Put with a strike of USD 56.00

Calculate the payoff (in USD) on the strangle assuming the settlement price on the prompt‐
month Brent futures contract is 53.00/bbl.
a. 0
b. 3,000
c. 5,000
d. 11,000

Correct answer: b
Explanation:
The correct answer is b.
Strangle payoff for one option = Max (0, Market Price ‐ Call Strike) + Max (0, Put Strike ‐ Market
Price)
= Max (0, USD 53 ‐ USD 58) + Max (0, USD 56 ‐ USD 53)
= Max (0, ‐5) + Max (0, 3) = 3
Total payoff = Number of options * Payoff from one option = 1,000 * USD 3 = USD 3,000
Reading reference: Robert McDonald. Derivatives Markets, 3rd Edition. (Pearson: 2013).
Chapter 4 ‐ Introduction to Risk Management. Pages 91‐97.


57. An analyst is assessing a GARCH (1,1) model. The model applies the following expression to
estimate volatility:
σt2 = ω + ασ2(t‐1) + βrt2
Where: rt = εtσt and εt ~ N(0,1).
Assuming that factors α and β are both greater than zero, what assumption is required to
ensure that volatility estimates are bounded?
a. α ≥ 1 and β ≥ 1
b. α ≤ 1 and β ≤ 1
c. α + β ≥ 1
d. α + β ≤ 1

Answer: d
Explanation:
The correct answer is d. In order to keep this a stationary process and assure that the volatility
stays near the initial variable ω, the combined factors α and β must be less than 1. Otherwise
the volatility estimate could keep increasing and eventually reach levels that are implausible.

Reading reference: John C. Hull. Risk Management and Financial Institutions, Chapter 10


58. The risk manager at an energy trading company has recommended that traders implement a
credit value adjustment (CVA). Which of the following best describes the rationale for using
a CVA?
a. It provides a ratings‐level adjustment that applies expected credit migration data to adjust
counterparty credit ratings.
b. It provides a counterparty‐level adjustment that quantifies the maximum credit exposure for
individual counterparties.
c. It provides a portfolio‐level adjustment that incorporates risk‐neutral counterparty default
probabilities in VaR calculations.
d. It provides a trade‐level adjustment that accounts for counterparty risk in the pricing of
individual transactions.

Correct answer: d
Explanation:
Correct answer is d. CVA is a trade‐level adjustment that quantifies the counterparty risk of the
trade and provides a hurdle by which the trade’s profitability can be assessed. It takes into
consideration counterparty‐level factors such as other existing trades with that counterparty,
netting or collateralization. If a proposed trade is not expected to be profitable once the CVA is
factored in, the trade should not be made. Choice b is an example of a credit limit.

Reading reference: Jon Gregory, Counterparty Credit Risk and Credit Value Adjustment: A
Continuing Challenge for Global Financial Markets. Chapter 3, page 37.


59. A crude oil producer structures an option strategy to manage the economic impact of a decline
in crude oil prices below USD 45.00/bbl in two years. Assuming an equal volume of oil is
covered in each strategy, which structure will generate the highest net profit if crude oil is
trading at USD 60.00/bbl in two years?
a. Straddle using both a long call and put that each have a USD 45.00/bbl strike price and a
total USD 8.00 premium
b. Long put option with a USD 61.00/bbl strike price and USD 2.00 premium
c. Long put option with a USD 48.00/bbl strike price and USD 6.00 premium
d. Costless collar using a long put with a USD 43.00/bbl strike price and a short call with a
USD 47.00/bbl strike price

Answer: a

Explanation:
The correct answer is a. Price increase produces a net profit of USD 7.00 per contract. The long
straddle consists of a long 45.00 call and a long 45.00 put. The long 45.00 put expired worthless
but the long 45.00 put is exercised at USD 15.00 in the money net of the USD 8.00 premium
paid.

Reading reference: Robert McDonald, Fundamentals of Derivatives Markets 3rd Edition, Chapter
4, pages 95‐96.


60. The primary objective of a stack‐and‐roll position is to:
a. Realize the spread on a call and put option with different maturities on the same underlying
commodity position.
b. Lock in a profit on a commodity trade when there is an expectation that the forward curve
will steepen.
c. Manage price risk on a commodity position when there is a perceived lack of liquidity in
longer dated futures contracts.
d. Hedge cross‐commodity basis risk.

Answer: c

Explanation:
The correct answer is c. Stack‐and‐roll is the process of stacking futures contracts in the near‐
term contract and rolling over into the new near‐term contract. There is often more market
liquidity in the near‐term contracts, and the traders may speculate on the shape of the forward
curve and deploy this strategy to make gains. If the new near‐term futures price is lower than
the expiring near‐term price (in backwardation), this strategy is profitable.

Reading reference: Robert McDonald, Fundamentals of Derivatives Markets 3rd Edition, Chapter
6, Page 186.


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2016

RBOB Strike Price Call Premium Put Premium

Option A Option B Option C

Company Year 1 Year 2 Year 3 Year 4

W 0.04% 0.17% 0.37% 0.53%

X 0.42% 1.05% 1.61% 2.32%

Y 4.68% 8.41% 11.6% 13.8%

Z 26.5% 33.1% 39.0% 44.2%

High Low Average

RBOB Strike Price Call Premium Put Premium

Option A Option B Option C

Sample mean 0.22% 1.10%

Sample standard deviation 0.041 0.028

Correlation ρab/σaσb ‐0.7961

Company Year 1 Year 2 Year 3 Year 4

W 0.04% 0.17% 0.37% 0.53%

X 0.42% 1.05% 1.61% 2.32%

Y 4.68% 8.41% 11.6% 13.8%

Z 26.5% 33.1% 39.0% 44.2%

High Low Average

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