2017 Erp Part II Practice Exam

2017

ERP Part II ®

Practice Exam

Energy Risk Professional (ERP) Part II Practice Exam

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 across the physical and financial energy markets and be able to deal with them effectively. The 2017 ERP Part I and Part II Practice Exams have been developed to aid candidates in their preparation for the ERP Exam in May and November 2017. These practice exams are based on a sample of actual questions from past ERP Exams and is suggestive of the questions that will be in the 2017 ERP Exam. The 2017 ERP Part I Practice Exam contains 80 multiple choice questions and the 2017 ERP Part II Practice Exam contains 60 multiple-choice questions, the same number of questions that the actual 2017 ERP Exam Part I and 2017 ERP Exam Part II will contain. As such, the Practice Exams were designed to allow candidates to calibrate their preparedness both in terms of material and time. The 2017 ERP Practice Exams do not necessarily cover all topics to be tested in the 2017 ERP Exam as any test samples from the universe of testable possible knowledge points. However, the questions selected for inclusion in the Practice Exams were chosen to be broadly reflective of the material assigned for 2017 as well as to represent the style of question that the Energy Oversight Committee considers appropriate based on assigned material. For a complete list of current topics, core readings, and key learning objectives candidates should refer to the 2017 ERP Exam Study Guide and 2017 ERP Learning Objectives. Core readings were selected in conjunction with the Energy Oversight Committee to assist candidates in their review of the subjects covered by the Exam. Questions for the ERP Exam are derived from the core readings. It is strongly suggested that candidates study these readings in depth prior to sitting for the Exam.

© 2017 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.

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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. 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 4 hours to complete ERP Part I Practice Exam and 4 hours to complete ERP Part II Practice Exam and keep track of your time. The actual ERP Exam Part I and ERP Exam Part II are 4 hours each. 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 2017 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 Exams • Calculate your score by comparing your answer sheet with the practice exam answer key. • 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.


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Common Abbreviations and Acronyms The following is a list of common abbreviations and acronyms that may appear on the ERP Examination: Bbl = Barrel of _________

Gal = Gallon of _____

NGL = Natural gas liquids

Bcf = Billion cubic feet

HDD = Heating degree days

NOC = National oil company

Btu = British Thermal Unit

IOC = Independent oil company

NOK = Norwegian Krone

CAD = Canadian Dollar

IRR = Internal rate of return

NPV = Net present value

CCP = Central counterparty

ISDA = International Swaps and Derivatives Association ISO = Independent system operator

NYMEX = New York Mercantile Exchange

CDD – Cooling degree days CFD = Contract for differences CIF = Cargo, insurance, freight

KPI = Key performance indicator

COSO = Committee of Sponsoring Organizations of the Treadway Commission

KRI = Key risk indicator

CSA = Credit support annex

kWh = Kilowatt hour

CVA = Credit valuation adjustment

LIBOR = London Interbank Offered Rates

DAT = Delivered at terminal

LMP = Locational marginal price

DWT = Deadweight tonnage

LNG = Liquefied natural gas

ERM = Enterprise Risk Management

LPG = Liquefied petroleum gases

EUR = Euro (currency)

MMBtu = One million British Thermal Units

EWMA = Exponentially weighted moving average

kW = Kilowatt

OTC = Over-the-counter PJM = Pennsylvania/New Jersey/Maryland Interconnection (electricity market) PSC = Production sharing contract RBOB = Reformulated blendstock for oxygenate blending (gasoline) RTO = Regional Transmission Organization SGD = Singaporean Dollar SMA = Simple moving average /t = Per ton of _______ ULSD = Ultra-low sulfur diesel

MT = Metric tons

USD = United States dollar

FOB = Free on board

MtM = Mark-to-market

VaR = Value-at-Risk

FTR = Financial transmission right

MW = Megawatt

WTI = West Texas intermediate

MWh = Megawatt hour


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2017 ERP Part II Practice Exam – Candidate Answer Sheet

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16.

31.

46.

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17.

32.

47.

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18.

33.

48.

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34.

49.

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20.

35.

50.

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21.

36.

51.

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37.

52.

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53.

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54.

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40.

55.

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56.

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42.

57.

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28.

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58.

14.

29.

44.

59.

15.

30.

45.

60.


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1.

A commodity trader holds a long position in October WTI futures contracts. Details of the position are summarized below: • • • • •

2.

3.

Trade date: June 25 Number of contracts: 500 Purchase price: USD 53.60/bbl Initial margin requirement: USD 4,020,000 Required maintenance threshold: USD 3,500,000

The exchange requires all futures account to be topped-up to meet initial margin requirements. Below which of the following prices (in USD) will a margin call be triggered on the trader’s position? A. 51.52 B. 52.56 C. 53.60 D. 54.64 A Simple Moving Average can be used to estimate the standard deviation of historical price returns for a VaR model. Which of the following statements best describes the primary weakness in applying a SMA to energy commodity price return data? A. The SMA weights all historical price return data equally. B. The SMA over weights the most recent price return data. C. The SMA ignores the impact of jumps in the price return data. D. The SMA ignores the impact of autocorrelation on price return data. To protect against adverse price movements in the refined product markets, a petroleum company creates a straddle position in NYMEX ULSD futures contracts with the following terms: • 2-month NYMEX ULSD call option with a strike price of USD 1.69/gal at a premium of USD 0.04/gal • 2-month NYMEX ULSD put option with a strike price of USD 1.69/gal at a premium of USD 0.07/gal One week after establishing the position, the closing NYMEX ULSD prompt-month futures price is USD 1.82/gallon. Calculate the current net MtM value (in USD) of the straddle position. A. B. C. D.

-10,080 20 840 5,460


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4.

A bank holds a portfolio of derivative transactions with a single counterparty that declares default. The MtM value and pledged collateral for each transaction at the time of default is summarized below: Trade A Trade B Trade C Trade D

MtM value (in EUR) +3,000,000 +10,000,000 -6,000,000 +4,000,000

Collateral value (in EUR) 2,000,000 2,000,000 0 1,000,000

The transactions are covered by an ISDA CSA with a closeout netting agreement. Calculate the bank’s total net exposure (in EUR) to the counterparty, assuming the recovery rate for each trade is 30%.

5.

A. 900,000 B. 2,700,000 C. 4,200,000 D. 5,900,000 The following market prices for NYMEX WTI crude oil futures are quoted at the close of trading on February 1 and April 1, respectively: WTI Futures Price February 1 (USD/bbl)

WTI Futures Price April 1 (USD/bbl)

May

48.93

51.31

June

49.29

51.76

On February 1, a crude oil trader expects the spread between the May and June WTI futures closing price to widen over the next two months. How would the trader structure a calendar spread on February 1 to benefit from this view and what is the realized net profit/loss per contract on the position based on the April 1 closing prices? A. B. C. D.

Long May and short June futures; USD -90 Long June and short May futures; USD -45 Long May and short June futures; USD 45 Long June and short May futures; USD 90


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6.

7.

Seismic surveys are used to test the future viability of crude oil production at 100 potential deepwater drilling sites. A survey will produce a positive test result for 100% of sites that are commercially viable, and a negative test result for 85% of sites that are not viable. If 1 drilling site out of 100 is commercially viable, the probability that a site is viable given a positive test result is approximately: A. 0.1%. B. 6.0%. C. 15.0%. D. 94.0%. The primary economic objectives at a refinery are to manage price risk and maximize operating margins. To help achieve these objectives, the risk management team plans to structure a collar using the following options on NYMEX RBOB futures contracts: RBOB Strike Price (USD/bbl)

Call Premium (USD)

Put Premium (USD)

1.54

0.128

0.092

1.57

0.105

0.087

If the prompt-month NYMEX RBOB futures price is currently USD 1.558/gal, which of the following sets of transactions will most effectively achieve the refiner’s economic objectives?

8.

A. Buy USD 1.57 put options and sell USD 1.54 call options. B. Buy USD 1.54 put options and sell USD 1.57 call options. C. Sell USD 1.54 put options and buy USD 1.57 call options. D. Sell USD 1.57 put options and buy USD 1.54 call options. A natural gas trader has arranged a 6-month storage contract in June, based on the expectation that the spread between summer and winter natural gas prices will increase. The trader plans to withdraw injected natural gas at expiration of the storage contract. Which of the following structures has she most likely arranged? A. Park-and-loan B. Cash-and-carry C. Exchange-for-physical D. Contract-for-differences


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9.

10.

A USD 8,500,000 commodity portfolio has a 10-day, 95% VaR of USD 900,000. Which of the following statements correctly describes the practical interpretation of the VaR amount? A. The probability of portfolio losses exceeding USD 900,000 over the next 10 trading days is 5%. B. The probability of portfolio losses exceeding USD 900,000 over the next 10 trading days is 95%. C. Portfolio losses during a 10-day period are expected to exceed USD 900,000 once in every five 10-day period. D. Portfolio losses during a 10-day period are expected to exceed USD 900,000 once in every twenty 10-day periods. A factor-push model is applied to stress test the MtM value of several combinations of option positions on the July NYMEX WTI futures contract. The modeling parameters assume 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 July WTI contract is USD 55.00/bbl. Which of the following combinations of options would be least likely to generate an extreme loss under the stress testing methodology described above? A. B. C. D.

11.

12.

A long 50 call and a long 60 call A long 55 call and a long 55 put A long 52.50 call and a short 47.50 call A long 50 call and a short 50 put

The variance of historical monthly price returns on the SP-15 peak power futures contract is 0.0902 over a 3-year period. Which of the following volatilities represents the annual volatility on the SP-15 contract based on the monthly price return data for the 3-year period? A. 30.0% B. 82.1% C. 104.4% D. 216.6% A Japanese refinery pays USD 5.80/contract to buy 500, European style call options on the prompt Brent Crude futures contract. The call options have a strike price of USD 53.25/bbl and expire in three months. If the prompt Brent futures contract is trading at USD 54.75/bbl and the current 3-month risk-free rate is 2.50%, which of the following amounts (in USD) will the refinery need to pay for 500 European style put options with the same maturity and strike price? A. 2,131 B. 2,145 C. 2,155 D. 2,168


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13.

14.

A US-based producer is building an LNG train in Australia which is scheduled to be completed in five years. To help reduce exposure to foreign currency fluctuations, the producer has structured a 5-year, fixed-forfloating swap on the Australian dollar (AUD) with an A-rated counterparty. If the producer is concerned about a potential deterioration in the credit quality of the counterparty during the later years of the swap, which of the following provisions should it incorporate in the counterparty arrangement? A. CVA B. Netting C. Reset D. Take-or-pay

Six months ago, a shipping company entered into a 1-year forward contract to purchase 50,000 MT of bunker fuel from a counterparty at a price of USD 162/MT. Current market pricing for bunker fuel is summarized below: • • •

Spot price: USD 184/MT 6-month forward price: USD 194/MT 1-year forward price: USD 206/MT Calculate the shipping company’s credit exposure (in USD) if the counterparty defaults today (assume discounting has no impact). A. B. C. D. 15.

1,100,000 1,600,000 2,300,000 8,100,000 A natural gas market analyst applies a linear regression analysis on daily price data for a 1-year (365 day) period to estimate the mean reversion rate of natural gas spot prices at Henry Hub. If estimates from the regression imply a mean reversion rate of 14, which of the following number of days best approximates the half-life for price shocks during the period? A. 18 B. 20 C. 26 D. 28


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16.

17.

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19.

A commercial natural gas end-user in the northeast United States hedges 100% of its expected February gas consumption totaling 150,000 MMBtu. Which of the following sets of transactions should the end-user execute in order to best minimize basis risk in its operation. A. Buy 15 February NYMEX natural gas futures contracts and sell a Transco zone 6 natural gas basis swap for February covering 150,000 MMBtu. B. Sell 150 February NYMEX natural gas futures contracts and buy a Transco zone 6 natural gas basis swap for February covering 150,000 MMBtu. C. Buy 15 February NYMEX natural gas futures contracts and buy a Transco zone 6 natural gas basis swap for February covering 150,000 MMBtu. D. Sell 150 February NYMEX natural gas futures contracts and sell a Transco zone 6 natural gas basis swap for February covering 150,000 MMBtu. A separate estimate of correlation between risk factors is typically not required when applying which of the following VaR methodologies? A. Delta-gamma B. Delta-normal C. Historical Simulation D. Monte Carlo Simulation A credit analyst is assessing a USD 16,000,000 credit exposure related to a 10-year, fixed rate bond issued by a Baa1/BBB+ rated midstream oil and gas company. The bond has a par value of USD 15,600,000, an estimated recovery rate of 63%, and an expected loss of USD 720,000 in the event of default. Calculate the implied default probability on the bond? A. 9.20% B. 10.86% C. 12.16% D. 16.90% An electricity market analyst is using the following model to estimate the spot price S: dS = α(µ(t) – log(S))Sdt + σ(t)Sdz + kSdq Based on the parameters above, which of the following features of electricity markets does the model rely on for estimating the spot price? A. B. C. D.

Convenience yield Seasonality Stochastic volatility Storage Constraints


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20.

21.

22.

23.

Under terms of a bilateral netting agreement, which of the following OTC derivative transactions would offer the greatest benefit to the counterparty identified in the transaction? A. A refinery long a straddle on gasoline futures. B. A natural gas producer long a floor on natural gas. C. A crude oil producer long a put option on WTI futures. D. A gas-fired electric power generator long a natural gas swap. 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 applies the following information to price counterparty risk into the transaction: • 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% Which of the following pairs of statements correctly differentiates risk appetite and risk tolerance? A. Risk appetite is a willingness to embrace risk; risk tolerance is an aversion to risk. B. Risk appetite cannot be derived empirically; risk tolerance is a quantitative measure. C. Risk appetite expresses a range of risk levels an organization is willing to take; risk tolerance is a single definitive figure. D. Risk appetite measures the amount of risk an organization is willing to take; risk tolerance is used to communicate a level of acceptable risk. When calibrating model parameters, which one of the following applications is most appropriate for estimating the predictive power of the price return data used in an energy price forecasting model? A. R2 B. Q-Q plot C. Autocorrelation D. Skew and kurtosis


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24.

25.

The 1-day, 95% VaR for a Brent crude oil futures position is EUR 1,500,000, based on 5,000 simulated 1-day returns. Which of the following statements best describes the 1-day, 95% expected shortfall? A. The maximum 1-day simulated loss. B. The average simulated 1-day loss that exceeds EUR 1,500,000. C. The difference between the 1-day, 95% VaR and the 1-day, 99% VaR. D. The difference between the 1-day, 95% VaR and the average simulated 1-day return for the position. The following call and put option contracts are available on the prompt month Brent crude oil futures contract: Contract Option

Strike (USD)

Expiration

W X Y Z

52 62 62 72

June 30, 2015 June 30, 2015 June 30, 2015 June 30, 2015

Call Call Put Put

Assume the underlying futures contract is trading at USD 62. Which of the following combinations of the option contracts is required to estimate implied volatility? a. b. c. d.

W and X X and Y W and Z Y and Z


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26.

27.

A market risk analyst at a diversified energy company has identified seven exceptions when backtesting a 1-day, 99% VaR model for the past year (250 trading days). Which of the following describes the proper interpretation of these results in accordance with standards published by the Bank for International Settlements (BIS) Basel Committee? A. The VaR model is in the “green zone” and is acceptable to use with no further revision. B. The VaR model is in the “yellow zone” and required further adjustment such as increasing the safety multiplier assumption. C. The VaR model is in the “orange zone” and must be substantially modified. D. The VaR model is in the “red zone” and must be replaced. Consider the following information related to bonds issued by two different IOCs: Position size

Bond 1 USD 100,000

Bond 2 USD 50,000

Probability of default

6%

5%

Expected recovery rate 20% 40% Assuming bond defaults are independent, which of the following amounts (in USD) is closest to the 95% Credit VaR for the combined position? A. B. C. D. 28.

0 30,000 80,000 110,000

Which of the following best describes the relationship between risk-neutral default probabilities and historical default probabilities? A. Theoretical default probabilities are typically higher than historical default probabilities due to liquidity risk premiums. B. Historical default probabilities are typically higher than theoretical default probabilities due to negative skew in bond returns. C. Theoretical default probabilities are typically higher than historical default probabilities for investment grade credits and lower than historical default probabilities for non-investment grade credits. D. Historical default probabilities are typically higher than theoretical default probabilities for investment grade credits and lower than theoretical default probabilities for non-investment grade credits.


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29.

30.

As a crude oil forward contract approaches expiration, it’s price return volatility will typically increase, due primarily to an increasingly higher: A. sensitivity to seasonal market fundamentals. B. rate of mean reversion toward an average long-term market price. C. volume of trading activity as market participants react to new information. D. number of market positions closed to avoid physical delivery obligations. The following table summarizes daily price return data for Henry Hub natural gas and WTI crude oil over a five-day period: Rotterdam coal Brent (USD/1,000 MT) (USD/bbl) Day 1 2.78% 0.83% Day 2

1.98%

3.01%

Day 3

-2.67%

1.14%

Day 4

1.76%

3.56%

Day 5

-2.77%

0.23%

Sample Mean Return Standard Deviation

0.22% 0.025

1.75% 0.014

Which of the following values is the best estimate of the correlation between Rotterdam coal and Brent crude oil price returns for the period? A. B. C. D.

-0.46 -0.39 0.39 0.46


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31.

32.

33.

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 prices summarized below: • Month 1: USD 65.10/bbl • Month 2: USD 62.30/bbl • Month 3: USD 69.80/bbl Which of the following amounts (in USD) represents the cumulative net profit/loss earned by the refinery for the 3-month period? A. 450,000 B. 510,000 C. 720,000 D. 1,038,000 An airline executes an OTC jet fuel swap with a bank counterparty. The airline is classified as a qualified end user and the bank is classified as a major swap participant. Which of the following describes the specific requirements for reporting the swap to a swap data repository (SDR) under Dodd-Frank rules? A. The bank and airline are both exempt from reporting the exposure to a SDR. B. The bank is responsible for reporting the exposure to a SDR. C. The airline is responsible for reporting the exposure to a SDR. D. The airline and bank are both responsible for reporting their pro-rata portion of the exposure to a SDR. An analyst has been asked to estimate the volatility for Brent crude oil using the EWMA model with a decay factor (λ) of 0.93. The estimated volatility yesterday was 2.75% per day. The market price of Brent crude oil was USD 56.22 yesterday and USD 55.94 the day before yesterday. Which of the following volatilities is the best estimate of Brent crude oil volatility today? A. 0.66% B. 0.87% C. 2.59% D. 2.66% © 2017 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.

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34.

In early March 2017, 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 data to assess the economics of a storage arbitrage transaction: Brent crude oil futures contract prices: • •

October 2017: USD 51.24/bbl October 2018: USD 53.37/bbl

US Treasury zero-coupon bond yields: • March 2017 through September 2017: 2.50% • October 2018: 3.75% 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. B. C. D.

35.

47.09 53.03 55.73 58.53 A power trader manages the following portfolio of power positions and natural gas hedges. The power and gas positions have the following individual 1-day, 99% VaR amounts: • Power: 1.8 million • Natural gas: 2.0 million If the correlation between power and natural gas price returns is 0.80, assuming a mean zero normal distribution, which of the following amounts (in USD) best approximates the 1-day, 99% VaR of the portfolio? A. B. C. D.

36.

3.10 million 3.20 million 3.60 million 3.80 million When compared to pre-settlement risk, settlement risk exposures are typically: A. Larger and occur more frequently. B. Larger and occur less frequently. C. Smaller and occur more frequently. D. Smaller and occur less frequently. © 2017 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.

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37.

38.

Which of the following transactions will best reduce the gamma on a portfolio of options on NYMEX WTI crude oil futures contracts? A. Buy at-the-money options. B. Buy out-of-the-money options. C. Sell at-the-money options. D. Sell out-of-the money options. A global shipping company is short bunker fuel. To hedge the exposure, it purchases fuel oil futures based on the following historical return data: • • •

Standard deviation of bunker fuel price returns: 8.43% Standard deviation of fuel oil price returns: 9.98% Correlation between bunker fuel and fuel oil price returns: 0.863 The minimum variance hedge ratio required to properly size the futures position is closest to: A. B. C. D. 39.

40.

0.616. 0.729. 1.022. 1.210. A petroleum producer is assessing macroeconomic risk associated with its production activity in a small, oil-rich host country. A recent decline in global crude oil prices has weakened the local economy and increased the probability that the government will default on its sovereign debt. Which of the following describes the most likely outcome of a sovereign debt default by the host country? A. Short-term political unrest that triggers a longer-term increase in financing costs. B. Sharp increases in inflation and interest rates that create hyperinflation. C. A deep economic recession that produces multiple years of negative year-over-year GDP growth. D. Cancellation of outstanding sovereign debt obligations that results in a total loss of investor capital. A netting set includes five equal counterparty exposures totaling EUR 4,750,000 with an average correlation between the positions of 0.28. Assuming the future value of the exposures are normally distributed, which of the following amounts (in EUR) represents the best estimate of the expected net exposure? A. 794,000 B. 1,273,000 C. 1,944,000 D. 3,092,000


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41.

42.

43.

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 implied default probabilities, a Moody’s/Standard & Poor’s rating of B1/B+ will most likely be assigned to which of the following companies? A. W B. X C. Y D. Z Which of the following market factors will most likely be undetected by an LNG exporter that applies a KPI analysis to its operations? A. Fuel lost due to leakages in the LNG train. B. Delays caused by operational inefficiencies in the LNG tanker loading process. C. A decline in global gas prices due to a current economic downturn in Asia. D. Anticipated natural gas shortages due to more stringent fracking regulations in the US. 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 the coefficients in the linear relationship, which of the following amounts (in days) is the best estimate of the mean reversion rate for NBP natural gas spot prices? A. B. C. D.

2 9 14 21


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44.

Consider an electric utility company that serves a large region in the southeastern United States. The company purchases exchange traded CDD contracts to help manage the economic risk associated with a significant deviation from average temperatures during the summer. The chart below summarizes regional average temperature data for one week during the peak summer cooling season:

High Temperature

Low Average Temperature Temperature

Sunday

86°F

69°F

78°F

Monday

89°F

71°F

80°F

Tuesday

91°F

76°F

84°F

Wednesday

95°F

80°F

88°F

Thursday

101°F

81°F

91°F

Friday

93°F

71°F

82°F

Saturday

82°F

64°F

73°F

Calculate the number of Cooling Degree Days (CDD) for the week.

45.

A. 7 B. 65 C. 91 D. 121 A natural gas fired generation plant has a daily fuel requirement of 10,000 MMBtu. The risk management team is using the following NYMEX gas forward curve to price a swap: November December January

Henry Hub USD/MMBtu

WaHa Location USD/MMBtu

Day Count

4.20 4.41 4.63

4.07 4.28 4.77

30 31 31

Ignoring the impact of discounting, which of the following amounts (in USD) most closely approximates the fixed price on a November to January NYMEX Henry Hub strip? A. B. C. D.

4.36 4.38 4.40 4.42


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46.

47.

48.

49.

A bank has sold an OTC fixed-for-floating RBOB swap to a BB-rated refiner. The swap is subject to a close-out agreement and the bank currently reports a positive MtM on the position. Which of the following steps will the bank most likely take if the refiner declares default on the exposure? A. Reassign the defaulted position to a solvent counterparty. B. Auction off the exposure to other potential counterparties. C. Terminate the position and become a creditor to the refiner’s estate. D. File a claim with the central counterparty equivalent to the MtM value of the defaulted position. Which of the following statements best describes the primary objective for structuring a stack-and-roll position? A. Hedge cross-commodity basis risk B. Lock in a positive spread when there is an expectation that the forward curve will steepen. C. Realize the spread on a series of call and put options on the same underlying prompt contract. D. Manage commodity price risk when the market is perceived to lack liquidity in longer dated futures contracts. A crude oil refiner structures a cross-hedge to protect the value of its asphalt production. The refiner consumes 1.5 barrels of crude oil to produce 1 gallon of asphalt. If the hedge ratio is 0.1875, which of the following number of crude oil futures contracts is required to hedge 42,000 gallons of asphalt production? A. 1 B. 5 C. 8 D. 12 A risk analyst is developing a probability density function to model price returns associated with a portfolio of electricity futures contracts. The analyst might choose to use a t-distribution as an alternative to a normal distribution because the t-distribution can display: A. Excess kurtosis. B. Higher variance. C. Mean reversion. D. Negative skewness. © 2017 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.

20


50.

51.

Which of the following statements is a correct assumption to make when estimating the recovery rate for an individual counterparty exposure? A. The recovery rate is negatively correlated with default rates. B. The recovery rate is positively correlated with counterparty credit spreads. C. The recovery rate associated with subordinated debt is higher than senior unsecured debt. D. The recovery rate associate with OTC derivative transactions is lower than subordinated debt. An energy futures portfolio consists of contracts covering 40,000 gallons of RBOB and 60,000 gallons of ULSD. The current pricing for each prompt month contract is summarized below: RBOB ULSD

Bid (USD/gal) 1.235 1.108

Offer (USD/gal) 1.257 1.129

Calculate the expected cost of liquidating the portfolio (in USD) under normal market conditions with sufficient market liquidity.

52.

A. 1,070 B. 1,250 C. 2,140 D. 2,510 A refinery processes 6,000,000 barrels of crude oil per month. It creates a financial position that replicates a 3:2:1 refining spread to hedge its monthly production of gasoline and heating oil. To hedge the gasoline portion of the 3:2:1 spread, the refinery will: A. Buy 2,000 NYMEX RBOB futures contracts. B. Buy 4,000 NYMEX RBOB futures contracts. C. Sell 2,000 NYMEX RBOB futures contracts. D. Sell 4,000 NYMEX RBOB futures contracts.


21


53.

54.

55.

Management at a refinery strategically shifts production away from gasoline to increase its production of distillates. Which of the following spread positions will best hedge production if distillates account for 50% of the refiner’s new product mix? A. 2:1:1 crack spread hedge B. 4:3:1 crack spread hedge C. 5:3:2 crack spread hedge D. 6:2:1 crack spread hedge Assume two 100 MW generators supply power to the grid at a cost of USD 45.00/MWh and USD 5.00/MWh, respectively. Peak hourly demand is assumed to be uniformly distributed between 65 MWh and 185 MWh. Calculate the probability that the market clearing price during a peak hour is less than USD 55.00/MWh. A. 25.0% B. 29.2% C. 32.2% D. 35.0% A crude oil producer maintains a long put option position consisting of 500 contracts on crude oil futures with a strike price of USD 35/bbl. The position is currently delta neutral with a gamma of 0.038 and a vega of 5.7. The producer is required to neutralize gamma while keeping the position delta neutral. An option with the following delta and gamma has been identified: • Delta: 0.52 • Gamma: 0.048 Which of the following sets of transactions will the producer execute to neutralize the option position’s gamma and delta, respectively? A. B. C. D.

Sell 206 options; buy 396 futures. Sell 328 options; buy 632 futures. Sell 396 options; buy 206 futures. Sell 632 options; buy 328 futures


22


56.

A GARCH (1,1) 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 remain balanced and plausible? A. B. C. D.

57.

α + β ≤ 1 α + β ≥ 1 α ≤ 1 and β ≤ 1 α ≥ 1 and β ≥ 1 The following natural gas pricing data is available for the month of February: • •

Published AECO hub price: USD 2.03/MMBtu Henry Hub settlement price: USD 1.96/MMBtu

The current pipeline capacity charge for gas shipments between Henry Hub and AECO is USD 0.08/MMBtu. Calculate the realized AECO basis (in USD/MMBtu) for the month.

58.

A. -0.15 B. -0.07 C. 0.01 D. 0.07 A crude oil producer typically sells forward contracts to hedge price risk on its expected future production. As an alternative to selling a forward contract at USD 35.00/bbl, the producer buys a 2-year put option on crude oil futures. The put option has a USD 35.00/bbl strike and a premium of USD 3.25/bbl. If the annualized risk-free rate is 1.50%, the economic return on the put option will outperform the economic return on the forward contract when the price (in USD/bbl) of crude oil at option expiration is: A. Below 31.65. B. Above 31.65. C. Below 38.35. D. Above 38.35.


23


59.

Which of the following corporate stakeholders will typically serve as the first line of defense within an effective ERM framework? A. B. C. D.

60.

Chief Risk Officer Chief Compliance Officer Individual business line managers Functionally independent corporate risk department

A risk analyst at a refinery is calculating the 10-day, 95% VaR on a 100,000 barrel Brent crude oil position currently valued at USD 3,250,000. Using a daily returns for Brent crude oil prices over the past 12 months, the analyst applies a simple moving average to estimate the volatility factor used in the VaR model. Noticing higher crude oil price volatility over the past month, the analyst applies an EWMA with a lambda of 0.99 to adjust the volatility factor used in the VaR model. Applying the new volatility estimate will most likely cause the new VaR amount to: A. Increase slightly relative to the original VaR. B. Increase sharply relative to the original VaR. C. Decrease slightly relative to the original VaR. D. Decrease sharply relative to the original VaR.


24


2017 ERP Part II Practice Exam – Candidate Answer Sheet

1.

B

16.

C

31.

A

46.

C

2.

A

17.

C

32.

B

47.

D

3.

C

18.

C

33.

D

48.

D

4.

A

19.

B

34.

B

49.

A

5.

D

20.

D

35.

C

50.

A

6.

B

21.

B

36.

B

51.

A

7.

B

22.

D

37.

C

52.

D

8.

A

23.

A

38.

B

53.

A

9.

D

24.

B

39.

A

54.

B

10.

B

25.

B

40.

D

55.

C

11.

C

26.

B

41.

C

56.

A

12.

C

27.

C

42.

D

57.

D

13.

C

28.

A

43.

C

58.

A

14.

B

29.

C

44.

D

59.

C

15.

A

30.

D

45.

D

60.

A


25


2017 ERP Part II Practice Exam – Answers & Explanations 1.

A commodity trader holds a long position in October WTI futures contracts. Details of the position are summarized below: • Trade date: June 25 • Number of contracts: 500 • Purchase price: USD 53.60/bbl • Initial margin requirement: USD 4,020,000 • Required maintenance threshold: USD 3,500,000 The exchange requires all futures accounts to be topped-up to meet initial margin requirements. Below which of the following prices (in USD) will a margin call be triggered on the trader’s position? A. 51.52 B. 52.56 C. 53.60 D. 54.64 Correct answer: B Explanation: The trader can lose no more than (4,020,000 – 3,500,000), or 520,000, 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 500 contracts * 1,000 barrels per contract, or USD 500,000. Therefore, the contract can trade no lower than 53.60 - (520,000 / 500,000), or USD 52.56/bbl, before the trader gets a call. Reading reference: Jon Gregory. Central Counterparties, Chapter 3.


26


2.

A Simple Moving Average can be used to estimate the standard deviation of historical price returns for a VaR model. Which of the following statements best describes the primary weakness in applying a SMA to energy commodity price return data? 1. The SMA weights all historical price return data equally. 2. The SMA over weights the most recent price return data. 3. The SMA ignores the impact of jumps in the price return data. 4. The SMA ignores the impact of autocorrelation on price return data. Correct answer: A Explanation: A potential flaw with SMA is that all returns are given equal weight, even though price returns from a few months ago may have little relevance to current market conditions. A way of addressing this concern is through the Exponentially Weighted Moving Average, which gives more “weight” to more recent data returns. Reading reference: Les Clewlow and Chris Strickland. Energy Derivatives: Pricing and Risk Management, Chapter 10 © 2017 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.

27


3.

To protect against adverse price movements in the refined product markets, a petroleum company creates a straddle position in NYMEX ULSD futures contracts with the following terms: • •

2-month NYMEX ULSD call option with a strike price of USD 1.69/gal at a premium of USD 0.04/gal 2-month NYMEX ULSD put option with a strike price of USD 1.69/gal at a premium of USD 0.07/gal

One week after establishing the position, the closing NYMEX ULSD prompt-month futures price is USD 1.82/gallon. Calculate the current net MtM value (in USD) of the straddle position. A. -10,080 B. 20 C. 840 D. 5,460 Correct answer: C Explanation: Based on the closing NYMEX ULSD prompt-month futures price of USD 1.74/gal, the current net MtM value of the straddle is calculated as follows: 1.82 - 1.69 - 0.04 - 0.07 = 0.02 multiplied by 42,000 gallons per contract resulting in a net MtM value of USD 840. In this scenario, the call option generates a profit which is offset by the premium paid for each option. Reading reference: S. Mohamed Dafir and Vishnun N. Gajjala. Fuel Hedging and Risk Management, Chapter 4.


28


4.

A bank holds a portfolio of derivative transactions with a single counterparty that declares default. The MtM value and pledged collateral for each transaction at the time of default is summarized below: Trade A Trade B Trade C Trade D

MtM value (in EUR) +3,000,000 +10,000,000 -6,000,000 +4,000,000

Collateral value (in EUR) 2,000,000 2,000,000 0 1,000,000

The transactions are covered by an ISDA CSA with a closeout netting agreement. Calculate the bank’s total net exposure (in EUR) to the counterparty, assuming the recovery rate for each trade is 30%. A. 900,000 B. 2,700,000 C. 4,200,000 D. 5,900,000 Correct answer: A Explanation: Exposure is reduced by both the netting agreement and the collateral. The bank has 17,000,000 of net exposures at the time of default. Since 30% of this amount is immediately recovered, that leaves it with 11,900,000 of exposures outstanding. During the closeout, this is netted against the negative exposure leaving it with a balance of 5,900,000. Since EUR 5,000,000 in pledged collateral is available, that leaves a total net exposure of EUR 900,000. B is incorrect as it assumes 30% is recovered from the netted amount of 11,000,000 instead of the gross amount of 17,000,000, with the collateral being collected afterward for a net remaining exposure of 2,700,000. The bank did not default (the counterparty did) so this is impossible. C is incorrect as it applies the recovery rate after all netting and collateral adjustments. E.g., 0.7*6,000,000 = 4,200,000. D is incorrect as it doesn’t factor in the netted trade for which the bank has negative exposure Reading reference: Jon Gregory, Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets, 2nd Edition, Chapter 4.


29


5.

The following market prices for NYMEX WTI crude oil futures are quoted at the close of trading on February 1 and April 1, respectively: WTI Futures Price February 1 (USD/bbl)

WTI Futures Price April 1 (USD/bbl)

May

48.93

51.31

June

49.29

51.76

On February 1, a crude oil trader expects the spread between the May and June WTI futures closing price to widen over the next two months. How would the trader structure a calendar spread on February 1 to benefit from this view and what is the realized net profit/loss per contract on the position based on the April 1 closing prices? A. Long May and short June futures; USD -90 B. Long June and short May futures; USD -45 C. Long May and short June futures; USD 45 D. Long June and short May futures; USD 90 Correct answer: D Explanation: A futures position taken with the expectation that the spread will widen assumes the the higher priced June contract is purchased at USD 49.29/bbl and the lower priced May contract is sold at USD 48.93/bbl. By April 1, the spread between the two contracts had widened by USD 0.09/bbl (0.36 spread in February vs. 0.45 spread in April), thus creating a gain of USD 90 per contract (0.09*1,000 bbls). Reading reference: Robert McDonald. Derivatives Markets, 3rd Edition, Chapter 6.


30


6.

Seismic surveys are used to test the future viability of crude oil production at 100 potential deepwater drilling sites. A survey will produce a positive test result for 100% of sites that are commercially viable, and a negative test result for 85% of sites that are not viable. If 1 drilling site out of 100 is commercially viable, the probability that a site is viable given a positive test result is approximately: A. 0.1%. B. 6.0%. C. 15.0%. D. 94.0%. Correct answer: B Explanation: Assume P(F) is the probability that a reservoir is commercially viable and P(T) probability that the test is positive. P(NF) and P(NT) are the probabilities of the opposite events. From the text we understand that: P(T|F)=100%, P(T|NF)=15%,P(F)=1/100. We can therefore derive: P(T)=P(T|F)*P(F)+P(T|NF)*P(NF)=100%*1/100+15%*99/100=15.85% P(F|T)=P(F and T)/P(T) =P(T|F)*P(F)/P(T)=(100%*1/100)/15.85% = 6.30% More simply: For every 100 reservoirs the seismic survey will produce 1 positive test result for a reservoir that is viable and for 15% of the other 99 reservoirs (approximately 15) the survey will produce a positive result for reservoirs that are not viable. Therefore, there will be approximately 16 positive test results for every 100 observations; for any positive report there is only (1/16) or approximately a 6.30% chance that a reservoir is actually viable. Reading reference: Michael Miller, Mathematics and Statistics for Financial Risk Management, 2nd Edition, Chapter 2.


31


7.

The primary economic objectives at a refinery are to manage price risk and maximize operating margins. To help achieve these objectives, the risk management team plans to structure a collar using the following options on NYMEX RBOB futures contracts: RBOB Strike Price (USD/bbl)

Call Premium (USD)

Put Premium (USD)

1.54

0.128

0.092

1.57

0.105

0.087

If the prompt-month NYMEX RBOB futures price is currently USD 1.558/gal, which of the following sets of transactions will most effectively achieve the refiner’s economic objectives? A. Buy USD 1.57 put options and sell USD 1.54 call options. B. Buy USD 1.54 put options and sell USD 1.57 call options. C. Sell USD 1.54 put options and buy USD 1.57 call options. D. Sell USD 1.57 put options and buy USD 1.54 call options. Correct answer: B Explanation: 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 1.54 and 1.57 (less any cost of implementing the trade). If the RBOB price rallies over 1.57, the short call will be assigned to the refiner so the refiner will realize an effective price of 1.57. If the price falls below 1.54, the refiner can exercise the put option to lock in the price at that level. Reading reference: Vincent Kaminski, Energy Markets, Chapter 18.


32


8.

A natural gas trader has arranged a 6-month storage contract in June, based on the expectation that the spread between summer and winter natural gas prices will increase. The trader plans to withdraw injected natural gas at expiration of the storage contract. Which of the following structures has she most likely arranged? A. Park-and-loan B. Cash-and-carry C. Exchange-for-physical D. Contract-for-differences Correct answer: A Explanation: A park-and-loan structure involves buying a commodity in the cheaper months (when demand is lower) and storing to the expensive months (when demand is higher). As such, participants in the natural gas markets know that if the spread between winter and summer months rises the profit can increase by injecting in the summer and selling in the winter. Reading reference: Glen Swindle. Valuation and Risk Management in Energy Markets, Chapter 2.


33


9.

A USD 8,500,000 commodity portfolio has a 10-day, 95% VaR of USD 900,000. Which of the following statements correctly describes the practical interpretation of the VaR amount? A. The probability of portfolio losses exceeding USD 900,000 over the next 10 trading days is 5%. B. The probability of portfolio losses exceeding USD 900,000 over the next 10 trading days is 95%. C. Portfolio losses during a 10-day period are expected to exceed USD 900,000 once in every five 10-day period. D. Portfolio losses during a 10-day period are expected to exceed USD 900,000 once in every twenty 10-day periods. Correct answer: D Explanation: 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 twenty, 10-day periods. Reading reference: John C. Hull. Risk Management and Financial Institutions, 4th Edition. Chapter 12.


34


10.

A factor-push model is applied to stress test the MtM value of several combinations of option positions on the July NYMEX WTI futures contract. The modeling parameters assume 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 July WTI contract is USD 55.00/bbl. Which of the following combinations of options would be least likely to generate an extreme loss under the stress testing methodology described above? A. A long 50 call and a long 60 call B. A long 55 call and a long 55 put C. A long 52.50 call and a short 47.50 call D. A long 50 call and a short 50 put Correct answer: B Explanation: A factor-push model is only useful when the maximum loss on the position occurs when the risk factor has been “pushed” or stressed the hardest. Therefore, the return profile of the underlying position with respect to the risk factor needs to be monotonic (i.e. steadily increasing or decreasing for every value of the risk factor.) In cases where a position has non-monotonicity, or the maximum loss occurs when the value of the risk factor is not at an extreme, a factor-push model will not predict the maximum loss. In this case, the combination of a long 55 call and a long 55 put would create the greatest loss if the underlying remained at USD 55.00/bbl. The position would actually increase in value if the factor was pushed in either direction. Reading reference: Dowd, Managing Market Risk, Chapter 13. © 2017 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.

35


11.

The variance of historical monthly price returns on the SP-15 peak power futures contract is 0.0902 over a 3year period. Which of the following volatilities represents the annual volatility on the SP-15 contract based on the monthly price return data for the 3-year period? 1. 30.0% 2. 82.1% 3. 104.4% 4. 216.6% Correct answer: C Explanation: Historical volatility is derived by multiplying the standard deviation (square root of variance) of price changes by the square root of time (12), the factor required to annualize the monthly prices observed in the sample: (sqrt 0.0902)*(sqrt 12) = 0.30033 * 3.46410 = 104.4% Reading reference: Les Clewlow and Chris Strickland, Energy Derivatives: Pricing and Risk Management, Chapter 3.


36


12.

A Japanese refinery pays USD 5.80/contract to buy 500, European style call options on the prompt Brent Crude futures contract. The call options have a strike price of USD 53.25/bbl and expire in three months. If the prompt Brent futures contract is trading at USD 54.75/bbl and the current 3-month risk-free rate is 2.50%,, which of the following amounts (in USD) will the refinery need to pay for 500 European style put options with the same maturity and strike price? A. 2,131 B. 2,145 C. 2,155 D. 2,168 Correct answer: C Explanation: Using the Put-Call Parity relationship: 𝐶 = 𝑃 + 𝑒 '( )'* 𝐹 − 𝐾 𝑃 = 500 𝑥 [5.80 − 𝑒 '.456 7 .56) 𝑥 54.75 − 53.25 = USD 2,155 Reading reference: S. Mohamed Dafir and Vishnun N. Gajjala. Fuel Hedging and Risk Management, Chapter 4. © 2017 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.

37


13.

A US-based producer is building an LNG train in Australia which is scheduled to be completed in five 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. If the producer is concerned about a potential deterioration in the credit quality of the counterparty during the later years of the swap, which of the following provisions should it incorporate in the counterparty arrangement? A. CVA B. Netting C. Reset D. Take-or-pay Correct answer: C Explanation: A reset agreement stipulates that the mark-to-market be settled at certain designated points in time. At these points, a cash payment is made that reflects the current mark-to-market and the terms of the swap are reset at the prevailing rate so that exposure becomes 0 after every reset is made. This allows exposure to be “paid out” more frequently and reduces the amount of exposure which could potentially be outstanding in later years of the agreement when the health of the counterparty is much less certain. Reading reference: Jon Gregory. Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets, 2nd Edition, Chapter 4.


38


14.

Six months ago, a shipping company entered into a 1-year forward contract to purchase 50,000 MT of bunker fuel from a counterparty at a price of USD 162/MT. Current market pricing for bunker fuel is summarized below: • • •

Spot price: USD 184/MT 6-month forward price: USD 194/MT 1-year forward price: USD 206/MT Calculate the shipping company’s credit exposure (in USD) if the counterparty defaults today (assume discounting has no impact). A. 1,100,000 B. 1,600,000 C. 2,300,000 D. 8,100,000 Correct answer: B Explanation: Credit exposure defines the loss in the case the counterparty defaults. It is equal to the replacement risk of entering into a new contract (i.e. the incremental cost) plus the settlement risk (if any). In this case, since there are now six months to maturity, the shipper is essentially holding a 6-month forward contract. The replacement risk is therefore: (194-162) * 50,000 = 1,600,000. Since the shipping company has not paid the counterparty yet, there is zero settlement risk. Reading reference: Markus Burger, Bernhard Graeber, and Gero Schindlmayr. Managing Energy Risk: An Integrated View on Power and Other Energy Markets. 2nd Edition, Chapter 3 (Section 3.4).


39


15.

A natural gas market analyst applies a linear regression analysis on daily price data for a 1-year (365 day) period to estimate the mean reversion rate of natural gas spot prices at Henry Hub. If estimates from the regression imply a mean reversion rate of 14, which of the following number of days best approximates the half-life for price shocks during the period? A. 18 B. 20 C. 26 D. 28 Correct answer: A Explanation: Using the half-life estimate provided in the text as follows: T1/2= ln(2)/α, where α is mean reversion rate = ln(2)/14 = 0.049511 = 0.049511*365 = 18.07 days B is incorrect: 14/ln(2) = 20.2 C is incorrect: 365/14 = 26.1 D is incorrect: 14*0.5 = 28 Reading reference: Les Clewlow and Chris Strickland, Energy Derivatives: Pricing and Risk Management, Chapter 2.


40


16.

A commercial natural gas end-user in the northeast United States hedges 100% of its expected February gas consumption totaling 150,000 MMBtu. Which of the following sets of transactions should the end-user execute in order to best minimize basis risk in its operation. A. Buy 15 February NYMEX natural gas futures contracts and sell a Transco zone 6 natural gas basis swap for February covering 150,000 MMBtu. B. Sell 150 February NYMEX natural gas futures contracts and buy a Transco zone 6 natural gas basis swap for February covering 150,000 MMBtu. C. Buy 15 February NYMEX natural gas futures contracts and buy a Transco zone 6 natural gas basis swap for February covering 150,000 MMBtu. D. Sell 150 February NYMEX natural gas futures contracts and sell a Transco zone 6 natural gas basis swap for February covering 150,000 MMBtu. Correct answer: C Explanation: 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 that can help mitigate basis risk exposure. Note: In sizing the transaction keep in mind that one natural gas future contract represents 10,000 MMBtu. Reading reference: Vincent Kaminski. Energy Markets, Chapter 11


41


17.

A separate estimate of correlation between risk factors is typically not required when applying which of the following VaR methodologies? A. Delta-gamma B. Delta-normal C. Historical Simulation D. Monte Carlo Simulation Correct answer: C Explanation: An historical simulation based VaR methodology relies on historical data that typically incorporates the underlying correlation between risk factors. The Delta-gamma, Delta-normal, and Monte Carlo methodologies require a separate estimate of volatilities and correlation between risk factors. Reading reference: Les Clewlow and Chris Strickland. Energy Derivatives: Pricing and Risk Management, Chapter 10.


42


18.

A credit analyst is assessing a USD 16,000,000 credit exposure related to a 10-year, fixed rate bond issued by a Baa1/BBB+ rated midstream oil and gas company. The bond has a par value of USD 15,600,000, an estimated recovery rate of 63%, and an expected loss of USD 720,000 in the event of default. Calculate the implied default probability on the bond? A. 9.20% B. 10.86% C. 12.16% D. 16.90% Correct answer: C Explanation: The implied default probability can be derived using the following relationship: Expected loss (EL) = Loss Given Default (LGD) x probability of default. In this example LGD is derived by multiplying the Credit Exposure by (1-Recovery Rate) = USD 5,920,000. The implied default probability is then the EL of USD 720,000 divided by the LGD USD 5,920,000 or 12.16%. Note: The par value of the bonds is not used in the calculation. Reading reference: Markus Burger, Bernhard Graeber, and Gero Schindlmayr. Managing Energy Risk: An Integrated View on Power and Other Energy Markets, 2nd Edition, Chapter 3 (Section 3.4 Credit Risk only). © 2017 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.

43


19.

An electricity market analyst is using the following model to estimate the spot price S: dS = α(µ(t) – log(S))Sdt + σ(t)Sdz + kSdq Based on the parameters above, which of the following features of electricity markets does the model rely on for estimating the spot price? A. Convenience yield B. Seasonality C. Stochastic volatility D. Storage Constraints Correct answer: B 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. Convenience yield and storage constraints are not relevant to power price formation. Reading reference: Les Clewlow and Chris Strickland. Energy Derivatives: Pricing and Risk Management, Chapter 2.


44


Under terms of a bilateral netting agreement, which of the following OTC derivative transactions would offer the greatest benefit to the counterparty identified in the transaction? A. A refinery long a straddle on gasoline futures. B. A natural gas producer long a floor on natural gas. C. A crude oil producer long a put option on WTI futures. D. A gas-fired electric power generator long a natural gas swap. Correct answer: D

20.

Explanation: 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. Reading reference Jon Gregory. Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets, 2nd Edition, Chapter 4.


45


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 applies the following information to price counterparty risk into the transaction: • Expected exposure: 3.50% • Loss given default: 70% • Probability of default, 1-Year: 0.87% The best approximation of the CVA (as a %) for the swap (assuming annual settlements) is: A. 0.009% B. 0.021% C. 0.610% D. 2.45% Correct answer: B Explanation: CVA can be estimated as follows: CVA ≈ [EE * (1-RR) * PD] Where EE is the Expected Exposure, (1-RR) is the Loss Given Default, and PD is the Probability of Default or CVA ≈ 3.50% * 70% * 0.87% = 0.00021315 or 0.021% Explanations for the distracters: Answer a applies the recovery rate instead of by the loss given default in the calculation. 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 and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets, 2nd Edition, Chapter 12.


46


22.

Which of the following pairs of statements correctly differentiates risk appetite and risk tolerance? A. Risk appetite is a willingness to embrace risk; risk tolerance is an aversion to risk. B. Risk appetite cannot be derived empirically; risk tolerance is a quantitative measure. C. Risk appetite expresses a range of risk levels an organization is willing to take; risk tolerance is a single definitive figure. D. Risk appetite measures the amount of risk an organization is willing to take; risk tolerance is used to communicate a level of acceptable risk. Correct answer: D Explanation: Applies the correct definition of risk appetite and risk tolerance. Reading reference: James Lam, Implementing and Effective Risk Appetite. (The Association of Accountants and Financial Professionals in Business, August 2015). © 2017 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.

47


23.

When calibrating model parameters, which one of the following applications is most appropriate for estimating the predictive power of the price return data used in an energy price forecasting model? A. R2 B. Q-Q plot C. Autocorrelation D. Skew and kurtosis Correct answer: A Explanation: The R2 statistic measures the relative degree of fit for sets of historical data. The Q-Q plot compares actual probabilities with expected probabilities, autocorrelation tests for the existence of correlation between sequenced time-series data, and skew and kurtosis describe the statistical characteristics (moments) of a normal distribution. Reading reference: Rafal Weron, Modeling and Forecasting Electricity Loads and Prices, Chapter 3.


48


24.

The 1-day, 95% VaR for a Brent crude oil futures position is EUR 1,500,000, based on 5,000 simulated 1-day returns. Which of the following statements best describes the 1-day, 95% expected shortfall? A. The maximum 1-day simulated loss. B. The average simulated 1-day loss that exceeds EUR 1,500,000. C. The difference between the 1-day, 95% VaR and the 1-day, 99% VaR. D. The difference between the 1-day, 95% VaR and the average simulated 1-day return for the position. Correct answer: B Explanation: 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, 4th Edition, Chapter 12.

25.

The following call and put option contracts are available on the prompt month Brent crude oil futures contract: Contract Option

Strike (USD)

Expiration

W X Y Z

52 62 62 72

June 30, 2015 June 30, 2015 June 30, 2015 June 30, 2015

Call Call Put Put

Assume the underlying futures contract is trading at USD 62. Which of the following combinations of the option contracts is required to estimate implied volatility? A. W and X B. X and Y C. W and Z D. Y and Z Correct answer: B Explanation: As described in Clewlow and Strickland, Section 3.2.6, ‘In practice, implied volatility is usually quoted for at-the-money options and is often calculated based on the average of an at-the-money straddle (a call and a put with the same strike price). Reading reference: Les Clewlow and Chris Strickland. Energy Derivatives: Pricing and Risk Management, Chapter 3.


49


26.

A market risk analyst at a diversified energy company has identified seven exceptions when backtesting a 1day, 99% VaR model for the past year (250 trading days). Which of the following describes the proper interpretation of these results in accordance with standards published by the Bank for International Settlements (BIS) Basel Committee? A. The VaR model is in the “green zone” and is acceptable to use with no further revision. B. The VaR model is in the “yellow zone” and required further adjustment such as increasing the safety multiplier assumption. C. The VaR model is in the “orange zone” and must be substantially modified. D. The VaR model is in the “red zone” and must be replaced. Correct answer: B Explanation: Between 5 and 9 exceptions places the model in the “yellow zone” where further action must be taken in order for the model to continue being used. One potential solution would be to raise 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. Reading reference: Les Clewlow and Chris Strickland. Energy Derivatives: Pricing and Risk Management, Chapter 10. © 2017 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.

50


27.

Consider the following information related to bonds issued by two different IOCs: Position size

Bond 1 USD 100,000

Bond 2 USD 50,000

Probability of default

6%

5%

Expected recovery rate

20%

40%

Assuming bond defaults are independent, which of the following amounts (in USD) is closest to the 95% Credit VaR for the combined position? A. B. C. D.

0 30,000 80,000 110,000

Correct answer: C Explanation: The credit VaR is equal to the highest potential loss with a probability higher than or equal to the confidence level. In this case it would be a default of bond 1 which would incur a loss of 100,000-20,000, or USD 80,000. The probability of both bonds defaulting is (6% * 5%) or 0.03% so this does not qualify for the Credit VaR. Reading reference: Markus Burger, Bernhard Graeber, and Gero Schindlmayr. Managing Energy Risk: An Integrated View on Power and Other Energy Markets, 2nd Edition, Chapter 3 (Section 3.4 Credit Risk only).


51


28.

Which of the following best describes the relationship between risk-neutral default probabilities and historical default probabilities? A. Theoretical default probabilities are typically higher than historical default probabilities due to liquidity risk premiums. B. Historical default probabilities are typically higher than theoretical default probabilities due to negative skew in bond returns. C. Theoretical default probabilities are typically higher than historical default probabilities for investment grade credits and lower than historical default probabilities for non-investment grade credits. D. Historical default probabilities are typically higher than theoretical default probabilities for investment grade credits and lower than theoretical default probabilities for non-investment grade credits. Correct answer: A Explanation: Spread–derived probability-of-defaults (PDs) include risk and liquidity premiums which typically make then higher than historical PDs. Reading reference: Jon Gregory. Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets, 2nd Edition, Chapter 10.


52


29.

As a crude oil forward contract approaches expiration, it’s price return volatility will typically increase, due primarily to an increasingly higher: A. sensitivity to seasonal market fundamentals. B. rate of mean reversion toward an average long-term market price. C. volume of trading activity as market participants react to new information. D. number of market positions closed to avoid physical delivery obligations. Correct answer: C Explanation: 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. Reading reference: Les Clewlow and Chris Strickland. Energy Derivatives: Pricing and Risk Management, Chapter 3.


53


30.

The following table summarizes daily price return data for Henry Hub natural gas and WTI crude oil over a five-day period: Rotterdam coal Brent (USD/1,000 MT) (USD/bbl) Day 1 2.78% 0.83% Day 2

1.98%

3.01%

Day 3

-2.67%

1.14%

Day 4

1.76%

3.56%

Day 5

-2.77%

0.23%

Sample Mean Return Standard Deviation

0.22% 0.025

1.75% 0.014

Which of the following values is the best estimate of the correlation between Rotterdam coal and Brent crude oil price returns for the period? A. -0.46 B. -0.39 C. 0.39 D. 0.46 Correct answer: D Explanation: The correlation can be calculated as follows:

Commodity A Commodity B

Covariance terms: (𝑨 − μa) * (B – μb)

Day 1

2.78%

0.83%

-0.00023691

Day 2

1.98%

3.01%

0.000221558

Day 3

-2.67%

1.14%

0.0001772

Day 4

1.76%

3.56%

0.000278846

Day 5

-2.77%

0.23%

0.000455066

Sample mean

0.22%

1.75%

Sample standard deviation 0.025

0.014

BCD EF FEC( GEHI(JIKGL *L(DB

Covariance: 𝝆𝒂𝒃

=

Correlation

ρab/σaσb

K

0.0001791516 0.45687

Reading reference: Michael Miller. Mathematics and Statistics for Financial Risk Management, 2nd Edition, Chapter 3. © 2017 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.

54


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 prices summarized below: • Month 1: USD 65.10/bbl • Month 2: USD 62.30/bbl • Month 3: USD 69.80/bbl Which of the following amounts (in USD) represents the cumulative net profit/loss earned by the refinery for the 3-month period? A. 450,000 B. 510,000 C. 720,000 D. 1,038,000 Correct answer: A Explanation: By selling a cap, if the settlement price of crude oil is above the strike price in a given month, the difference between the prices must be paid to the refinery. In this case, the first and third months are above the strike price; the difference for month 1 is USD 1.60, the difference for month 3 is USD 6.30. Multiplied by the contract size of 180,000/bbl per month gives totals of USD 288,000 and USD 1,134,000, respectively, for a total of USD 1,422,000. We then must subtract the premium paid for the cap (USD 1.80 x 180,000 bbl x 3 months = 972,000) from the cap total for a net settlement payment of USD 450,000. Note: no payment is made in month 2 because the settlement price (USD 62.30) is below the strike price (USD 63.50), though the cap premium is still paid for month 2. Reading reference: Vince Kaminski, Energy Markets, Chapter 18


55


32.

An airline executes an OTC jet fuel swap with a bank counterparty. The airline is classified as a qualified enduser and the bank is classified as a major swap participant. Which of the following describes the specific requirements for reporting the swap to a swap data repository (SDR) under Dodd-Frank rules? A. The bank and airline are both exempt from reporting the exposure to a SDR. B. The bank is responsible for reporting the exposure to a SDR. C. The airline is responsible for reporting the exposure to a SDR. D. The airline and bank are both responsible for reporting their pro-rata portion of the exposure to a SDR. Correct answer: B Explanation: When a Category 3 entity (end-user) enters into a swap agreement with a Category 1 entity (swap dealer or major swap participant) or a Category 2 entity (financial entity), then the Category 1 or 2 entity has the reporting obligation. Reading reference: Gordon Goodman. Swaps: Dodd-Frank Memories. © 2017 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.

56


33.

An analyst has been asked to estimate the volatility for Brent crude oil using the EWMA model with a decay factor (λ) of 0.93. The estimated volatility yesterday was 2.75% per day. The market price of Brent crude oil was USD 56.22 yesterday and USD 55.94 the day before yesterday. Which of the following volatilities is the best estimate of Brent crude oil volatility today? A. 0.66% B. 0.87% C. 2.59% D. 2.66% Correct answer: D Explanation: The correct application of the EWMA formula as follows: Return =56.22/55.94-1=0.005. Volatility = sqrt(0.93*0.0275^2+(1-0.93)*0.005^2) or 2.655%. By increasing the decay factor (lambda) in the EWMA model, current price returns will be weighted less heavily in the daily volatility estimate. The model will be less responsive to sharp swings in current market prices that are expected over the next month. Reading reference: John C. Hull. Risk Management and Financial Institutions, 4th Edition, Chapter 10.


57


34.

In early March 2017, 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 data to assess the economics of a storage arbitrage transaction: Brent crude oil futures contract prices: • •

October 2017: USD 51.24/bbl October 2018: USD 53.37/bbl

US Treasury zero-coupon bond yields: • March 2017 through September 2017: 2.50% • October 2018: 3.75% 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. 47.09 B. 53.03 C. 55.73 D. 58.53 Correct answer: B Explanation: Minimum 6-month forward price = [USD 47.90 * exp (0.025)^(6/12)] + (Future value of storage (USD 4.53) = 53.03 Reading reference: Robert McDonald, Fundamentals of Derivatives Markets, 3rd Edition, Chapter 6. © 2017 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.

58


35.

A power trader manages the following portfolio of power positions and natural gas hedges. The power and gas positions have the following individual 1-day, 99% VaR amounts: • Power: 1.8 million • Natural gas: 2.0 million If the correlation between power and natural gas price returns is 0.80, assuming a mean zero normal distribution, which of the following amounts (in USD) best approximates the 1-day, 99% VaR of the portfolio? A. B. C. D.

3.10 million 3.20 million 3.60 million 3.80 million

Correct answer: C Explanation: The 1-day, 99% portfolio VaR can be derived using the following relationship: SQRT((1-day, 99% Power VaR)2+(1-day, 99% Gas VaR)2 + 2*(1-day, 99% Power VaR)*1-day, 99% Gas VaR)*ρ(Power,Gas)) Reading reference: John C. Hull. Risk Management and Financial Institutions, 4th Edition, Chapter 12. © 2017 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.

59


36.

When compared to pre-settlement risk, settlement risk exposures are typically: A. Larger and occur more frequently. B. Larger and occur less frequently. C. c. Smaller and occur more frequently. D. Smaller and occur less frequently. Correct answer: B 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, Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets, 2nd Edition, Chapter 3.


60


37.

Which of the following transactions will best reduce the gamma on a portfolio of options on NYMEX WTI crude oil futures contracts? A. Buy at-the-money options. B. Buy out-of-the-money options. C. Sell at-the-money options. D. Sell out-of-the money options. Correct answer: C Explanation: 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, 4th Edition, Chapter 8.


61


38.

A global shipping company is short bunker fuel. To hedge the exposure it purchases fuel oil futures based on the following historical return data: • Standard deviation of bunker fuel price returns: 8.43% • Standard deviation of fuel oil price returns: 9.98% • Correlation between bunker fuel and fuel oil price returns: 0.863 The minimum variance hedge ratio required to properly size the futures position is closest to: A. 0.616. B. 0.729. C. 1.022. D. 1.210. Correct answer: B Explanation: 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 = -0.863* (0.0843/0.0998), or -0.729. The negative sign indicates that you need to take the opposite position in the hedge as the original position. Reading reference: Michael Miller. Mathematics and Statistics for Financial Risk Management, 2nd Edition, Chapter 3.


62


39.

A petroleum producer is assessing macroeconomic risk associated with its production activity in a small, oil-rich host country. A recent decline in global crude oil prices has weakened the local economy and increased the probability that the government will default on its sovereign debt. Which of the following describes the most likely outcome of a sovereign debt default by the host country? A. Short-term political unrest that triggers a longer-term increase in financing costs. B. Sharp increases in inflation and interest rates that create hyperinflation. C. A deep economic recession that produces multiple years of negative year-over-year GDP growth. D. Cancellation of outstanding sovereign debt obligations that results in a total loss of investor capital. Correct answer: A Explanation: Defaults have often resulted in political unrest including changes of government and coups (often simultaneously), and defaulting countries will typically suffer increases in financing costs lasting up to 10 or 15 years due to the reputational damage from the default. B is incorrect: this would be a likelier outcome if the government chooses to print additional money to avoid default (pp.22-23) C is incorrect: Default does typically result in a recession but the impact has typically been short lived, cf: p. 24, “Default has a negative impact on real GDP growth of between 0.5 and 2%, but the bulk of the decline is in the first year after the default and seems to be short lived.” D is incorrect: cf: p.24 “Default has seldom involved total repudiation of the debt… most defaults are followed by negotiations for either a debt exchange or restructuring, where the defaulting government is given more time…” Reading reference: Aswath Damodaran. Country Risk: Determinants, Measures and Implications – The 2015 Edition.


63


40.

A netting set includes five equal counterparty exposures totaling EUR 4,750,000 with an average correlation between the positions of 0.28. Assuming the future value of the exposures are normally distributed, which of the following amounts (in EUR) represents the best estimate of the expected net exposure? A. 794,000 B. 1,273,000 C. 1,944,000 D. 3,093,000 Correct answer: D Explanation: Since the future value 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 = 5 and ρ = 0.28, in this case the netting factor is 0.651. The answer is then 4,750,000 * 0.651 = 3,092,976. Reading reference: Gregory, Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets, 2nd Edition, Chapter 8. © 2017 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.

64


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 implied default probabilities, a Moody’s/Standard & Poor’s rating of B1/B+ will most likely be assigned to which of the following companies? A. W B. X C. Y D. Z Correct answer: C Explanation: 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, 2ND Edition, Chapter 3.


65


42.

Which of the following market factors will most likely be undetected by an LNG exporter that applies a KPI analysis to its operations? A. Fuel lost due to leakages in the LNG train. B. Delays caused by operational inefficiencies in the LNG tanker loading process. C. A decline in global gas prices due to a current economic downturn in Asia. D. Anticipated natural gas shortages due to more stringent fracking regulations in the US. Correct answer: D Explanation: KPIs monitor performance and as such are lagging indicators – they collect information on events that have already occurred. Anticipated natural gas shortages relate to a potential future event that may affect the distribution network, this is not a risk that would be directly captured by KPIs (it would be better captured by KRIs) Reading reference: John Fraser and Betty Simkins, Enterprise Risk Management: Today’s Leading Research and Best Practices for Tomorrow’s Executives, Chapter 8. © 2017 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.

66


43.

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 the coefficients in the linear relationship, which of the following amounts (in days) is the best estimate of the mean reversion rate for NBP natural gas spot prices? A. B. C. D.

2 9 14 21

Correct answer: C Explanation: 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 days a is incorrect: α1 = 0.0285/ α0 = 0.0188 = 1.5 b is incorrect: α0 = 0.0188/ Δt 0.0020 = 9 d is incorrect: a spread of 7 days was added to the correct answer Reading reference: Les Clewlow and Chris Strickland, Energy Derivatives: Pricing and Risk Management, Chapter 2.


67


44.

Consider an electric utility company that serves a large region in the southeastern United States. The company purchases exchange traded CDD contracts to help manage the economic risk associated with a significant deviation from average temperatures during the summer. The chart below summarizes regional average temperature data for one week during the peak summer cooling season:

High Temperature

Low Average Temperature Temperature

Sunday

86°F

69°F

78°F

Monday

89°F

71°F

80°F

Tuesday

91°F

76°F

84°F

Wednesday

95°F

80°F

88°F

Thursday

101°F

81°F

91°F

Friday

93°F

71°F

82°F

Saturday

82°F

64°F

73°F

Calculate the number of Cooling Degree Days (CDD) for the week. A. 7 B. 65 C. 91 D. 121 Correct answer: D Explanation: 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 = 13 + 15 + 19 + 23 + 26 + 17 + 8 = 121. Reading reference: Robert McDonald. Derivatives Markets, 3rd Edition. Chapter 6


68


45.

A natural gas fired generation plant has a daily fuel requirement of 10,000 MMBtu. The risk management team is using the following NYMEX gas forward curve to price a swap: November December January

Henry Hub USD/MMBtu

WaHa Location USD/MMBtu

Day Count

4.20 4.41 4.63

4.07 4.28 4.77

30 31 31

Ignoring the impact of discounting, which of the following amounts (in USD) most closely approximates the fixed price on a November to January NYMEX Henry Hub strip? A. B. C. D.

4.36 4.38 4.40 4.42

Correct answer: D Explanation: The fixed price on the Henry Hub strip can be approximated using the weighted average monthly NYMEX values (NYMEX price x monthly volume x day count) and the correct day count. A is incorrect: Made up number based on simple average of the WaHa location forward curve for Nov-Jan and does not consider the number of days in the month. B is iIncorrect: Accounts for the weighted average price using monthly WaHa location values (WaHa price x monthly volume x day count) and the correct day count..but is based on WaHa location pricing. C is incorrect: Made up number based on simple average of Nymex forward curve for Nov – Jan and does not consider the number of days in the month. Reading reference: Vince Kaminski, Energy Markets, Chapter 11.


69


46.

A bank has sold an OTC fixed-for-floating RBOB swap to a BB-rated refiner. The swap is subject to a close-out agreement and the bank currently reports a positive MtM on the position. Which of the following steps will the bank most likely take if the refiner declares default on the exposure? A. Reassign the defaulted position to a solvent counterparty. B. Auction off the exposure to other potential counterparties. C. Terminate the position and become a creditor to the refiner’s estate. D. File a claim with the central counterparty equivalent to the MtM value of the defaulted position. Correct answer: C Explanation: A close-out provision immediately terminates the defaulted positions and creates a claim in the amount of the mark-to-market value of the netted positions (i.e. the replacement value of creating identical positions with a solvent counterparty.) If the MtM is negative, the solvent party immediately pays the insolvent party the MtM value. If the MtM is positive, the solvent party becomes a creditor of the insolvent party in the amount of the claim, the payment of which will later be addressed during the bankruptcy proceedings. By immediately terminating the positions and creating a claim in the amount of the current MtM value, it allows the solvent counterparty to immediately hedge the exact defaulted positions. This removes market risk and trading uncertainty as otherwise the solvent party would otherwise have to contend with cashflow mismatches and uncertain timing of potential payments during the bankruptcy process, as well as further market moves in the defaulted positions over time. Reading reference: Jon Gregory. Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets, 2nd Edition, Chapter 3.


70


47.

Which of the following statements best describes the primary objective for structuring a stack-and-roll position? A. B. C. D.

Hedge cross-commodity basis risk Lock in a positive spread when there is an expectation that the forward curve will steepen. Realize the spread on a series of call and put options on the same underlying prompt contract. Manage commodity price risk when the market is perceived to lack liquidity in longer dated futures contracts.

Correct answer: D Explanation: Higher margin requirements could create a destabilizing effect on the market and potentially introduces 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. Reading reference: Robert McDonald, Derivatives Markets, 3rd Edition, Chapter 6 © 2017 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.

71


48.

A crude oil refiner structures a cross-hedge to protect the value of its asphalt production. The refiner consumes 1.5 barrels of crude oil to produce 1 gallon of asphalt. If the hedge ratio is 0.1875, which of the following number of crude oil futures contracts is required to hedge 42,000 gallons of asphalt production? A. 1 B. 5 C. 8 D. 12 Correct answer: D Explanation: Assuming 1.5 barrels of crude oil are required to produce 1 gallon of asphalt, then 63,000 barrels of crude are required to produce 42,000 gallons of asphalt (42,000*1.5 = 63,000). The spec for each WTI contract is 1,000 barrels. Therefore, 12 WTI contracts, based on the hedge ratio (63,000 * 0.1875), are required to hedge the asphalt production. A is incorrect: Assumes 1 contract based on 42,000 gallons of asphalt production and WTI contract spec of 1,000 barrels times 42 gallons per barrel. B is incorrect: Assumes asphalt gallons divided by 1.5 barrels multiplied by the hedge ratio C is incorrect: Assumes 42,000 gallons of asphalt divided by 1,000 barrels per contract multiplied by the hedge ratio. Reading reference: Robert L. McDonald, Derivatives Markets, 3rd Edition. Chapter 4.


72


49.

A risk analyst is developing a probability density function to model price returns associated with a portfolio of electricity futures contracts. The analyst might choose to use a t-distribution as an alternative to a normal distribution because the t-distribution can display: A. Excess kurtosis. B. Higher variance. C. Mean reversion. D. Negative skewness. Correct answer: A Explanation: Electricity price returns generally display high kurtosis which makes the Student’s t distribution a more appropriate choice. B is incorrect: Both distributions can be chosen to have high variances. C is incorrect: the t-distribution and normal distribution are symmetric with a mean of zero. D is incorrect: The t-distribution and normal distribution are symmetric. Reading reference: Michael Miller, Mathematics and Statistics for Financial Risk Management, 2nd Edition, Chapter 4. © 2017 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.

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50.

Which of the following statements is a correct assumption to make when estimating the recovery rate for an individual counterparty exposure? A. The recovery rate is negatively correlated with default rates. B. The recovery rate is positively correlated with counterparty credit spreads. C. The recovery rate associated with subordinated debt is higher than senior unsecured debt. D. The recovery rate associate with OTC derivative transactions is lower than subordinated debt. Correct Answer: A Explanation: Recovery rates are negatively correlated with overall default rates (cf: Gregory, chapter 10, p. 210.) They also tend to vary over time so in years with more defaults the recovery rates are lower. OTC derivatives typically rank pari passu with senior debt in terms of priority for payoff, and the settled recovery takes place after the actual recovery but is often lower. Reading reference: Jon Gregory, Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets, 2nd Edition, Chapter 3.


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51.

An energy futures portfolio consists of contracts covering 40,000 gallons of RBOB and 60,000 gallons of ULSD. The current pricing for each prompt month contract is summarized below: RBOB ULSD

Bid (USD/gal) 1.235 1.108

Offer (USD/gal) 1.257 1.129

Calculate the expected cost of liquidating the portfolio (in USD) under normal market conditions with sufficient market liquidity. A. 1,070 B. 1,250 C. 2,140 D. 2,510 Correct answer: A Explanation: Cost of liquidation (normal market) is derived from the parameters below as follows: • • • •

The proportional bid-offer spread for RBOB is: 0.022/1.246 = 0.018 The proportional bid-offer spread for HO is: 0.021/1.119 = 0.019 The mid-market value of RBOB is: 1.246 * 40,000 = 49,840 The mid-market value of HO is: 1.119 * 60,000 = 67,110

The Cost of liquidation under normal market conditions = ((49,840 x 0.018)/2) + ((67,110 x 0.019)/2) = USD 1,070 An alternative method for calculating the expected cost is summarized below: • RBOB mid = 1.246 • RBOB mid – RBOB bid = 0.011 • ULSD mid = 1.1185 • ULSD mid – ULSD bid = 0.0105 • (0.011 * 40,000) + (0.0105 * 60,000) = 440 + 630 = USD 1,070 Reading reference: John Hull, Risk Management and Financial Institutions, 4th Edition, Chapter 24.


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52.

A refinery processes 6,000,000 barrels of crude oil per month. It creates a financial position that replicates a 3:2:1 refining spread to hedge its monthly production of gasoline and heating oil. To hedge the gasoline portion of the 3:2:1 spread, the refinery will: A. Buy 2,000 NYMEX RBOB futures contracts. B. Buy 4,000 NYMEX RBOB futures contracts. C. Sell 2,000 NYMEX RBOB futures contracts. D. Sell 4,000 NYMEX RBOB futures contracts. Correct answer: D Explanation: The “3-2-1” crack spread represents the profit made per barrel of oil from selling refined products such as gasoline and heating oil. The 3-2-1 indicates that 3 barrels of oil are used to produce 2 barrels worth of gasoline and 1 barrel worth of heating oil. Since gasoline futures and heating oil futures are quoted in gallons, this has to be adjusted by 42 gallons per barrel. The 3-2-1 crack spread per barrel is therefore equal to: (2* RBOB Futures Price * 42) + (Heating Oil Futures * 42) / (3* Crude Oil Futures). Since the refinery processes 6,000,000 barrels, this implies that the equivalent of 4,000,000 barrels of gasoline would be covered by the crack spread. Since the refinery is hedging the crack spread, it should sell the futures on the refined product (locking in a fixed sale price on its production) and buy the crude oil futures, locking in a fixed purchase price on its input. The proper amount of RBOB futures contracts to sell is: 4,000,000 bbl * * 42 gallons per barrel / 42,000 gallons per contract = 4000. Reading reference: Vincent Kaminski. Energy Markets, Chapter 18. © 2017 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.

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53.

Management at a refinery strategically shifts production away from gasoline to increase its production of distillates. Which of the following spread positions will best hedge production if distillates account for 50% of the refiner’s new product mix? A. 2:1:1 crack spread hedge B. 4:3:1 crack spread hedge C. 5:3:2 crack spread hedge D. 6:2:1 crack spread hedge Correct answer: A Explanation: Heating oil and diesel are middle distillates of the crude oil refining process. Since their operation configuration will change so that middle distillates will represent almost 50% of their output they should change their hedge to map their new operational configuration. Middle distillates and gasoline (light distillate) will represent almost equal portions of their output therefore they should place a 2:1:1 crack spread hedge. Reading reference: Vincent Kaminski. Energy Markets, Chapter 18.


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54.

Assume two 100 MW generators supply power to the grid at a cost of USD 45.00/MWh and USD 85.00/MWh, respectively. Peak hourly demand is assumed to be uniformly distributed between 65 MWh and 185 MWh. Calculate the probability that the market clearing price during a peak hour is less than USD 55.00/MWh. A. 25.0% B. 29.2% C. 32.2% D. 35.0% Correct answer: B Explanation: The price can only be set below USD55/MWh if demand is less than or equal to 100 MW. Thus P(D<=100) = (100-65)/(185-65) = 0.292. Reading reference: Michael Miller, Mathematics and Statistics for Financial Risk Management, 2nd Edition Chapter 2. © 2017 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.

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55.

A crude oil producer maintains a long put option position consisting of 500 contracts on crude oil futures with a strike price of USD 35/bbl. The position is currently delta neutral with a gamma of 0.038 and a vega of 5.7. The producer is required to neutralize gamma while keeping the position delta neutral. An option with the following delta and gamma has been identified: • Delta: 0.52 • Gamma: 0.048 Which of the following sets of transactions will the producer execute to neutralize the option position’s gamma and delta, respectively? A. Sell 206 options; buy 396 futures. B. Sell 328 options; buy 632 futures. C. Sell 396 options; buy 206 futures. D. Sell 632 options; buy 328 futures Correct answer: C Explanation: To hedge market risk in the position, the producer must first neutralize the positive gamma by selling an appropriate number of option contracts based on the following: (Gamma of position / Gamma of hedge) * Number of contracts, i.e. (0.038/0.048) * 500, or 396 contracts. In other words, 0.792 of an option must be sold to immunize gamma in each option contract. Once gamma is neutralized, the producer must purchase 206 Brent Crude oil futures contracts to neutralize the residual delta as follows: 0 - (0.792*0.52) = 0.411 futures per option contract or 163 futures contracts. Choices a and b incorrectly calculate the ratio (gamma of hedge/gamma of position) required to size the number of option contracts required to immunize gamma. Reading reference: John C. Hull. Risk Management and Financial Institutions, 4th Edition, Chapter 8.


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56.

A GARCH (1,1) 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 remain balanced and plausible? A. α + β ≤ 1 B. α + β ≥ 1 C. α ≤ 1 and β ≤ 1 D. α ≥ 1 and β ≥ 1 Correct answer: A Explanation: 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. Reference: John C. Hull. Risk Management and Financial Institutions, Chapter 10 © 2017 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.

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57.

The following natural gas pricing data is available for the month of February: • Published AECO hub price: USD 2.03/MMBtu • Henry Hub settlement price: USD 1.96/MMBtu The current pipeline capacity charge for gas shipments between Henry Hub and AECO is USD 0.08/MMBtu. Calculate the realized AECO basis (in USD/MMBtu) for the month. A. -0.15 B. -0.07 C. 0.01 D. 0.07 Correct answer: D Explanation: The “realized” basis represents the monthly cash price (index/posting) less the NYMEX Final Settlement for that same month. This would be 2.03 – 1.96 or 0.07. Since AECO is more expensive than Henry Hub, this actually results in a positive basis. Reading reference: Vincent Kaminski. Energy Markets, Chapter 11.


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58.

A crude oil producer typically sells forward contracts to hedge price risk on its expected future production. As an alternative to selling a forward contract at USD 35.00/bbl, the producer buys a 2-year put option on crude oil futures. The put option has a USD 35.00/bbl strike and a premium of USD 3.25/bbl. If the annualized risk-free rate is 1.50%, the economic return on the put option will outperform the economic return on the forward contract when the price (in USD/bbl) of crude oil at option expiration is: A. Below 31.65. B. Above 31.65. C. Below 38.35. D. Above 38.35. Correct answer: A Explanation: Since the put premium is paid two years prior to the option payoff, the foregone interest cost on the premium needs to be considered in calculating the profit in year two. The future value of the premium in two years is USD 3.25 x (1.0150)^2 = 3.3482. Therefore, the put option will outperform the forward strategy below a price of USD 35 - USD 3.35 or USD 31.65/bbl of crude oil. B is incorrect: 35 – 3.25 C is incorrect: 35 + 3.25 D is incorrect: 35 + (3.25*1.0150)^2 Reading reference: Robert McDonald, Fundamentals of Derivatives Markets, 3rd Edition, Chapter 4. © 2017 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.

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59.

Which of the following corporate stakeholders will typically serve as the first line of defense within an effective ERM framework? A. Chief Risk Officer B. Chief Compliance Officer C. Individual business line managers D. Functionally independent corporate risk department Correct answer: C Explanation: In an effectively implemented ERM framework, Managers of individual business lines are the first line of defense. The second line of defense lies with the functionally independent corporate risk function, followed by an independent review/audit with credible challenge knowledge. The Chief Data Officer (CDO) establishes data policies/standards and serves as a champion for firm-wide data quality. Reading reference: Management Solutions. Operational Risk Management in the Energy Industry.


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60.

A risk analyst at a refinery is calculating the 10-day, 95% VaR on a 100,000 barrel Brent crude oil position currently valued at USD 3,250,000. Using a daily returns for Brent crude oil prices over the past 12 months, the analyst applies a simple moving average to estimate the volatility factor used in the VaR model. Noticing higher crude oil price volatility over the past month, the analyst applies an EWMA with a lambda of 0.99 to adjust the volatility factor used in the VaR model. Applying the new volatility estimate will most likely cause the new VaR amount to: A. Increase slightly relative to the original VaR. B. Increase sharply relative to the original VaR. C. Decrease slightly relative to the original VaR. D. Decrease sharply relative to the original VaR. Correct answer: A Explanation: Applying a decay factor of 0.99 will place a slightly greater weight on more recent observations. Therefore, the standard deviation and VaR should increase only slightly. Reading reference: John C. Hull. Risk Management and Financial Institutions, 4th Edition, Chapter 12.


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