2018 Erp Practice Exam 2

2018

ERP

®

PRACTICE EXAM PART II

ENERGY RISK PROFESSIONAL

garp.org/erp

2018 Energy Risk Professional Examination (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 to understand understand energy risk management concepts 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 comprehensive examination, testing an energy risk professional professional on a number of risk management concepts 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. 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 2018 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 2018. 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 2018 ERP Exam. The 2018 ERP Part I Practice Exam Exam contains 80 multiple choice questions and the 2018 ERP Part II Practice Exam contains 60 multiple-choice questions, the same number of questions that appear on the actual 2018 ERP Exam Part I and 2018 ERP Exam Part II. As such, the Practice Exams were designed designed to allow candidates to calibrate their preparedness both in terms of material and time. The 2018 ERP Practice Exams do not necessarily cover all topics to be tested in the 2018 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 2018 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 2018 ERP Exam Study Guide and 2018 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.

© 2018 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 yourself sufficient study and review before taking the practice exam prior to the actual exam.

2. Simulate the exam day environment as closely as possible. •

Take the practice exam(s) in a quiet place where you will not be interrupted.

•

Have only the practice exam, candidate answer sheet, calculator, and pencils available.

•

Minimize any possible distractions from other people, cell phones, televisions, etc.; put away any study materials before beginning the practice exam.

•

Allocate four hours to complete the ERP Part I Practice Exam and four hours to complete the ERP Part II Practice Exam and keep track of your time while taking the exam. The actual ERP Exam Part I and ERP Exam Part II are four 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 2018 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 checking your answer sheet against the practice exam answer key included in this document.

•

Use the practice exam answers and explanations to better understand your correct and incorrect answers and to identify topics where you require additional review. Consult the core readings referenced with each question to prepare for the exam.

•

Remember, the pass/fail status for the actual exam is based on the distribution of scores from all candidates, so use your scores only to to gauge your own progress and level of preparedness .


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Common Abbreviations and Acronyms The following is a list of commonly used abbreviations and acronyms that appear in the LOBs and that may appear on the exam: • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • •

Bbl: Barrel of _________ BOE: Barrel of oil equivalent BTU: British Thermal Unit CCP: Central counterparty CDD: Cooling degree days Cf: Cubic feet CFD: Contract for Differences CFR: Cost and freight CIF: Cargo, insurance, and freight CIP: Cargo and insurance paid CPT: Carriage paid to all transport CRO: Chief Risk Officer CSA: Credit Support Annex CVA: Credit value adjustment DA: Day-ahead DAP: Delivered at place DAT: Delivered at terminal DDP: Delivered duty paid DES: Delivered ex ship EFP: Exchange for physicals EIA: (US) Energy Information Agency ERM: Enterprise risk management ETS: Emissions trading system EWMA: Exponentially weighted moving average EXW: Ex-works FAS: Free alongside ship FOB: Free on board FTR: Financial transmission right GARCH: Generalized auto-regressive conditional heteroskedasticity HDD: Heating degree days ICE: Intercontinental Exchange IEA: International Energy Agency IOC: Independent oil company IRR: Internal rate of return ISDA: International Swaps and Derivatives Association ISO: Independent System Operator JCC: Japan customs cleared (oil price)

• • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • •

KPI: Key performance indicators KRI: Key risk indicators kW: Kilowatt kWh: kilowatt-hour LMP: Locational marginal pricing LNG: Liquefied natural gas LSE: Load serving entity Mcf: Million cubic feet MMBtu: Million British thermal units MT: Metric ton MtM: Mark-to-market MW: Megawatt MWh: Megawatt-hour NGL: Natural gas liquid NOC: National oil company NPV: Net present value NYMEX: New York Mercantile Exchange OPEC: Organization of the Petroleum Exporting Countries OTC: Over-the-counter PFE: Potential future exposure PPA: Power purchase agreement PSA: Production sharing agreement PTR: Physical transmission right PV: Photovoltaic installation (solar) PSC: Production services contract RAROC: Risk-adjusted return on capital RBOB: Reformulated gasoline blendstock for oxygen blending RCSA: Risk control self-assessment RTO: Regional Transmission Organization SMP: System marginal price ULSD: Ultra-low sulfur diesel VaR: Value-at-risk VOLL: Value of lost load VPP: Volumetric production payment WACC: Weighted average cost of capital WTI: West Texas intermediate crude oil


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2018 ERP Practice Exam, Part II – Candidate Answer Sheet •

1. ___________

31. __________

2. ________ 2. ___________ ___ 3. ________ 3. ___________ ___ 4. ________ 4. ___________ ___ 5. ________ 5. ___________ ___ 6. ________ ___________ ___ 7. ________ ___________ ___ 8. ________ ___________ ___ 9. ________ ___________ ___ 10. __________ 11. __________ 12. __________ 13. __________ 14. __________ 14. __________ 15. __________ 15. __________ 16. __________ 16. __________ 17. __________ 17. __________ 18. __________ 18. __________ 19. __________ 19. __________ 20. __________ 20. __________ 21. __________ 21. __________ 22. __________ 23. __________ 24. __________ 25. __________ 26. __________ 27. __________ 28. __________ 28. __________ 29. __________ 29. __________ 30. __________ 30. __________

32. __________ 33. __________ 34. __________ 35. __________ 36. __________ 37. __________ 38. __________ 39. __________ 40. __________ 41. __________ 42. __________ 43. __________ 44. __________ 45. __________ 46. __________ 47. __________ 48. __________ 49. __________ 50. __________ 51. __________ 52. __________ 53. __________ 54. __________ 55. __________ 56. __________ 57. __________ 58. __________ 59. __________ 60. __________


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1.

An analyst at an ISO reviews a multivariate regression model used by the firm to project average day-ahead electricity demand. The model includes variables that might be rejected at higher thresholds of statistical significance. Which of the following independent variables will likely have the lowest statistical significance significance in forecasting day-ahead electricity demand on a grid? a. b. c. d.

Average temperature Day of the week Distributed generation Available utility-scale storage


5


2.

An investment analyst is completing a due diligence report on an exchange traded fund (ETF) whose returns are largely derived from rolling investments in front-month Henry Hub natural gas a nd WTI crude oil futures contracts. The following statistics on the fund’s monthly returns between 2014 and 2017 are included in the analyst’s report: Year

Mean (µ)

Standard Deviation (σ)

Skewness

Kurtosis

2014

0.02

0.01

-0.42

1.64

2015

-0.01

0.03

0.33

1.61

2016

0.03

0.02

-0.11

4.20

2017

0.04

0.01

0.13

4.14

The following table summarizes the number of monthly occurrences when the return varied more than three standard deviations from the mean between 2014 and 2017. Year

Monthly return < µ – 3σ

Monthly return > µ + 3σ

A B C D

1 2 4 1

1 0 2 3

Which year (A, B, C or D) most likely corresponds to the statistical data on the fund’s monthly returns for 2017, as cited in the analyst’s due diligence report? a. b. c. d.

Year A Year B Year C Year D


6


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: Three-month NYMEX ULSD call option with a strike price of USD 1.75/gal at a premium of USD 0.05/gal Three-month NYMEX ULSD put option with a strike price of USD 1.75/gal at a premium of USD 0.11/gal

● ●

One week after establishing the position, the closing NYMEX ULSD prompt-month futures price is USD 1.90/gallon. Calculate the current net MtM value (in USD) per contract of the straddle position. a. b. c. d.

4.

-4,200 -420 42 420

A bank holds a portfolio of derivative transactions with a single counterparty that declares default. The markto-market 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) +5,500,000

Collateral value (in EUR) 1,000,000

+12,000,000 -5,000,000 +3,000,000

4,000,000 0 1,500,000

The transactions are covered by an ISDA CSA with a closeout netting agreement. Assuming a 30% recovery rate and that any recovered amounts are received immediately at the time of default, calculate the bank’s total net exposure (in EUR) to the counterparty. a. b. c. d.

2,850,000 4,350,000 6,300,000 7,850,000


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5.

A heating oil trader for a large financial institution observes weather forecasts predicting unusually volatile weather patterns for the coming winter months and therefore initiates a long straddle position. One-month NYMEX ULSD call and put options with a strike price of USD 3.20 per gallon trade at premiums of USD 0.15 and USD 0.17 per gallon, respectively. What would be the net profit (or loss) per contract if the price of heating oil is USD 2.80 per gallon at the time of expiration? a. b. c. d.

6.

USD 2,520 per contract USD 3,360 per contract USD 4,200 per contract USD 5,040 per contract

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 95% of sites that are commercially viable, and a negative test result for 80% of sites that are not viable. If 5 out of 100 drilling sites are commercially viable, calculate the probability that best approximates the viability of a site, given a positive test result. a. b. c. d.

5% 10% 20% 25%


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7.

A primary economic objective at a refinery is to minimize the v olatility of its operating margins while managing price risk. To help achieve this objective, 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)

1.55

0.123

0.102

1.60

0.104

0.122

If the prompt-month NYMEX RBOB futures price is currently USD 1.575/gal, which of the following sets of transactions will most effectively achieve the refiner’s economic objectives? a. b. c. d.

8.

Buy USD 1.60 put options and sell USD 1.55 call options. Buy USD 1.55 put options and sell USD 1.60 call options. Sell USD 1.55 put options and buy USD 1.60 call options. Sell USD 1.60 put options and buy USD 1.55 call options.

At the start of the winter heating season, a natural gas trader initiates a position expecting a bullish market (inelastic demand curve). The trader wants to benefit from expected volatility of natural gas prices as well as a positive price trend during the winter season, but also believes that other market participants might overpay for insurance against extreme weather events during the season. Which of the following transactions will the trader mostly likely structure? a. b. c. d.

Buy at-the-money calls and sell out of-the-money calls. Buy out-of-the money calls and sell at-the-money calls. Buy at-the-money puts and sell out-of-the-money puts. Buy out-of-the money puts and sell at-the-money puts.


9


9.

A commodity trader observes that the volatility of daily futures price returns typically increases as futures contracts approach maturity. Which of the following choices best explains this increase in volatility? a. b. c. d.

10.

Seasonality of supply and demand of energy futures contracts Market contango creates an incentive to roll expiring prompt-month futures contracts Hedging of deep OTM options on futures contracts increases demand for implied volatility Higher trading volumes in response to new market information as contracts approach maturity

A factor-push model is applied to stress test the mark-to-market value of several combinations of option positions on the April 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, the volatility of the April NYMEX WTI futures price is 10%, and the current settlement price for the April WTI contract is USD 60.00/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.

A long 55.00 call and a long 65.00 call A long 60.00 call and a long 60.00 put A long 57.50 call and a short 52.50 call A long 55.00 call and a short 55.00 put


10


11.

The variance of historical monthly price returns on the SP-15 peak power futures contract is 0.1050 over a 5-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 5-year period? a. b. c. d.

12.

36.4% 38.8% 112.3% 126.6%

A Canadian refinery pays USD 6.20 per contract to buy 1,000 European-style call options on the promptmonth Brent Crude futures contract. The call options have a strike price of USD 54.25/bbl and expire in six months. If the prompt-month Brent futures contract is trading at USD 58.75/bbl and the current 1-year riskfree rate is 1.50%, which of the following amounts (in USD) will the refinery expect to pay for 1000 Europeanstyle put options with the same maturity and strike price? a. b. c. d.

1,634 1,700 1,734 1,767


11


13.

A US-based producer is building an LNG terminal in Australia which is scheduled to be completed in five years. To help reduce exposure to foreign currency fluctuations, the producer has structured a seven-year, fixed-for-floating swap on the Australian dollar (AUD) with a BBB-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. b. c. d.

14.

CVA Netting Reset Take-or-pay

Three months ago, a shipping company entered into a 1-year forward contract to purchase 100,000 MT of bunker fuel from a counterparty at a price of USD 165/MT. Current market pricing for bunker fuel is summarized below: ● ● ● ●

Spot price: USD 185/MT 6-month forward price: USD 189/MT 9-month forward price: USD 195/MT 1-year forward price: USD 208/MT

Calculate the shipping company’s credit exposure (in USD) if the counterparty defaults today (assume no impact from discounting). a. b. c. d.

1,300,000 2,000,000 3,000,000 4,300,000


12


15.

A credit analyst is assessing the default profile for several counterparty exposures. The following chart illustrates the estimated annual default probability for a specific counterparty over the next 7 years (i.e. the probability the exposure will default in that year alone):

t l u a f e D f o y t i l i b a b o r P l a u n n A

20.0% 18.0% 16.0% 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% 1

2

3

4

5

6

7

Year

Using the S&P rating standards as a guideline, what is the most likely rating for this counterparty exposure? a. b. c. d.

16.

A BB CCC D

A commercial natural gas end-user in the US state of Virginia hedges 100% of its expected February 2019 gas consumption totaling 100,000 MMBtu. Which of the following sets of transactions should the end-user execute in order to best minimize basis risk in its operation? a. b. c. d.

Buy 10 February 2019 NYMEX Henry Hub natural gas futures contracts and sell a Transco Zone 5 natural gas basis swap for February 2019 covering 100,000 MMBtu. Buy 100 February 2019 NYMEX Henry Hub natural gas futures contracts and buy a Transco Zone 5 natural gas basis swap for February 2019 covering 100,000 MMBtu. Sell 10 February 2019 NYMEX Henry Hub natural gas futures contracts and buy a Transco Zone 5 natural gas basis swap for February 2019 covering 100,000 MMBtu. Sell 100 February 2019 NYMEX Henry Hub natural gas futures contracts and sell a Transco Zone 5 natural gas basis swap for February 2019 covering 100,000 MMBtu.


13


17.

What VaR methodology, requiring limited calculation time, will most effectively capture the non-linear payoff structure associated with a diversified portfolio of option contracts on crude oil and natural gas futures? a. b. c. d.

18.

Delta-gamma VaR Monte Carlo simulation VaR Historical simulation VaR Variance-covariance VaR

A credit analyst is assessing a USD 10,500,000 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 10,000,000, an estimated recovery rate of 70%, and an expected loss of USD 500,000 in the event of default. Calculate the implied default probability on the bond? a. b. c. d.

6.80% 10.50% 15.87% 20.91%


14


19.

A renewable investor is using the RAROC approach to evaluate the terms of a PPA offered by a utility for a proposed 100MW solar installation. The investor makes the following estimates for the first year of operation under the terms of the PPA: • • •

Pre-tax net income from operations: USD 15 million Economic capital required to support the project: USD 110 million Tax rate for the project: 30%

The estimated pre-tax net income includes an adjustment for expected losses that the investor would incur if the utility defaults. Additionally, the investor assumes that it can invest its economic capital risk-free at 2.0%. Calculate the expected RAROC for this project. a. b. c. d.

20.

9.5% 10.9% 13.6% 15.6%

An energy consultant is researching the effectiveness of netting agreements in mitigating counterparty risk for the consulting firm’s clients. For which of the following OTC derivative transactions would a bilateral netting agreement provide the greatest economic benefit to the counterparty identified in the transaction? a. b. c. d.

A refinery long a straddle on gasoline futures A natural gas producer long a floor on natural gas A crude oil producer long a put option on WTI futures A coal-fired electric power generator long a coal swap


15


21.

A refined products trader has structured a 1-year fixed-for-floating swap on 50,000 barrels of gasoil with a Ba1/BB+ rated counterparty. The trader applies the following information to price counterparty risk into the transaction: ● ● ●

Expected exposure: 4.00% Loss given default: 85% 1-year probability of default: 0.90%

Assuming annual settlements and ignoring the impact of discounting, the best approximation of the CVA (as a %) for the swap is: a. b. c. d.

22.

0.03% 0.50% 0.61% 2.45%

A refinery purchases an 80,000 barrel allotment of light sweet crude oil from a Norwegian producer. Pricing has been confirmed at bill of lading (B/L) plus 2 days, with equal delivery each day. If B/L is received on March 3, which of the following market-on-close orders will the trader submit to hedge price risk on March 4? a. b. c. d.

Sell 40 lots of March Brent futures. Sell 80 lots of March Brent futures. Sell 40 lots of April Brent futures. Sell 80 lots of April Brent futures.


16


23.

The market risk team at a retail power distributor has been asked to explain why off-peak real-time electricity prices spiked in the ERCOT market during the previous day. Which of the following market factors most likely explains the off-peak price spike? a. b. c. d.

24.

The unplanned outage of a 1 GW nuclear generator occurred in ERCOT. The planned retirement of a 1GW coal-fired generator in ERCOT was announced. The average hourly cooling degree days were two standard deviations below the 5-year historical average for that date. The neighboring SPP market experienced price spikes that converged with prices in ERCOT.

The 1-day, 99% VaR for a Brent crude oil futures position is USD 3,500,000, based on 5,000 simulated 1 -day returns. Which of the following statements best describes the 1 -day, 99% expected shortfall? a. b. c. d.

The maximum 1-day simulated loss The average simulated 1-day loss that exceeds USD 3,500,000 The difference between the 1-day, 95% VaR and the 1-day, 99% VaR The difference between the 1-day, 95% VaR and the average simulated 1-day return for the position


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25.

The following call and put option contracts are available on the prompt-month Henry Hub Natural Gas futures contract: Contract

Option

Strike (USD)

Expiration

W

Call Call Put Put

3.00 3.50 3.50 4.00

June 30, 2018 June 30, 2018 June 30, 2018 June 30, 2018

X Y Z

Assume the underlying futures contract is trading at USD 3.50. Which of the following combinations of the option contracts is required to estimate implied volatility? a. b. c. d.

26.

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

A market risk analyst at an energy trading company has identified eleven 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. b. c. d.

The VaR model i s in the “green zone” and is acceptable to use with no further revision. The VaR model is in the “yellow zone” and requires further adjustment such as increasing the safety multiplier to set aside more risk capital when using the model. The VaR model is i n the “red zone” and must be revised substantially before it can be considered usable. The VaR model is in the “orange zone” and must be replaced.


18


27.

Consider the following information related to bonds issued by two different large regional energy producers: Bond A

Bond B

USD 100,000

USD 50,000

Probability of default

6%

7%

Expected recovery rate

30%

40%

Position size

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 70,000 100,000

A trader is holding a 500,000 gallon position in fuel oil. Due to an unexpected slump in oil prices, the position decreases in value by 15% which exceeds the trader’s allowable loss for the position. The CRO instructs the trader to liquidate the position when the current bid and offer prices are USD 3.10/gal and 3.30/gal respectively. Assuming normal market conditions, the expected cost (in USD) of liquidation is closest to: a. b. c. d.

50,000 85,000 100,000 1,600,000


19


29.

A natural gas forward contract has three months until expiration. As the contract approaches the expiry date, volatility will most likely: a. b. c. d.

30.

Remain stable Decrease steadily Increase steadily Be unpredictable due to market seasonality

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

Day 1

Henry Hub Nat Gas Daily Price return (%) 2.06%

WTI Crude Oil Daily Price return (%) 1.83%

Day 2

1.65%

2.01%

Day 3

-2.65%

1.14%

Day 4

1.75%

0.56%

Day 5

-1.77%

1.23%

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 -0.24 0.28 0.46


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31.

An energy trader sells a 3-month floor to manage price volatility requirements for the next three months. The floor is written on 250,000 barrels of crude oil per month at a strike price of USD 70.00/bbl and a monthly premium of USD 1.75/bbl. Settlement occurs on a monthly basis against the average daily promptmonth NYMEX WTI contract closing prices summarized below: ● ● ●

Month 1: USD 75.10/bbl Month 2: USD 62.30/bbl Month 3: USD 71.80/bbl

Which of the following amounts (in USD) represents the cumulative net profit/loss earned by the trader on this contract for the 3-month period? a. b. c. d.

32.

-1,112,500 -612,500 720,000 1,487,500

The economics of forward price formation would be least affected by the convenience yield of which energy commodity? a. b. c. d.

Electricity Heating oil Jet fuel Natural gas


21


33.

An analyst has been asked to estimate the volatility for Brent crude oil using the EWMA model with a decay factor (λ) of 0.95. The estimated volatility yesterday was 1.73% per day. The market price of Brent crude oil was USD 60.99 yesterday and USD 60.45 the day before yesterday. Which of the following volatilities is the best estimate of Brent crude oil volatility today? a. b. c. d.

34.

1.58% 1.63% 1.70% 1.73%

The spot price of Brent crude on the ICE exchange is USD 70. The annual risk-free interest rate is 4%, and monthly storage cost is USD 0.50 per barrel. If the crude can be stored for three months but cannot be sold out of storage before the three month storage term ends, what is the breakeven forward price per barrel supporting a storage strategy (in USD)? a. b. c. d.

71.50 72.19 72.21 72.30


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35.

A commodity trader manages a portfolio of oil futures positions. The portfolio currently contains only two futures assets with the following individual 1-day, 95% VaR amounts: ● ●

June 2018 Brent futures contracts: USD 2,400,000 June 2018 WTI futures contracts: USD 3,000,000

If the correlation between the two oil price returns is 0.9, assuming a zero-mean normal distribution, which of the following amounts (in USD) best approximates the 1-day, 95% VaR of the portfolio? a. b. c. d.

36.

3,100,000 3,200,000 5,300,000 3,800,000

The head of the counterparty risk team is explaining to a colleague the magnitude and frequency of counterparty settlement risk events that the team monitors. The group head explains that compared to settlement risk, losses due to pre-settlement risk are typically: a. b. c. d.

Larger and occur more frequently Larger but occur less frequently Smaller but occur more frequently Smaller and occur less frequently


23


37.

Which of the following transactions would reduce the gamma the most on a portfolio of long options on NYMEX WTI crude oil futures contracts? a. b. c. d.

38.

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

A global transport and logistics provider has entered into a contract to purchase gasoline at the wholesale price. To hedge the exposure it purchases RBOB gasoil futures based on the following historical return data: • • •

Standard deviation of wholesale gasoline price returns: 16.49% Standard deviation of RBOB gasoil futures: 20.90% Correlation between wholesale gasoline and RBOB gasoil futures: 0.95

The minimum variance hedge ratio required to properly size the futures position is closest to: a. b. c. d.

0.75 0.79 1.20 1.27


24


39.

A power generator has sold a 1-year, 50 MW CFD to a large wholesale industrial customer that covers the 2018 calendar year. The CFD has a strike price of USD 50/MWh and the contract was executed under an ISDA Credit Support Annex containing the following terms: • • •

Threshold amount: USD 500,000 Independent amount: 5% of outstanding face value Minimum transfer amount: USD 100,000

If the market price of a calendar year 2018 CFD is currently USD 45/MWh, how much collateral (in USD) will the generator be required to post, assuming a 365-day year (8,760 hours covered by the contract)? a. b. c. d.

40.

0 2,190,000 2,800,000 3,300,000

A netting set includes seven equal counterparty exposures totaling EUR 8,000,000 with an average correlation between the positions of 0.15. Assuming the future value of the exposures follows a multivariate normal distribution, which of the following amounts (in EUR) represents the best estimate of the expected net exposure? a. b. c. d.

794,000 1,273,000 3,093,000 4,167,000


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41.

A counterparty credit analyst at an IOC is evaluating the creditworthiness of a new counterparty with which the firm is planning to initiate a sizable multi-year contract equipment supply contract. The cumulative implied default probabilities for each of the next four years associated with several midsize oil exploration and production companies are summarized below: Company

Year 1

Year 2

Year 3

Year 4

W

0.02%

0.03%

0.05%

0.1%

X

0.22%

0.41%

0.93%

1.25%

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 A2/A will most likely be assigned to which of the following companies? a. b. c. d.

42.

W X Y Z

A Japanese power company owns a network of five gas-fired generating plants that are fueled with imported LNG that is purchased at an oil-linked price. As part of its contingency funding plan, risk managers at the company are preparing a list of Early Warning Indicators (EWI’s) which the company can use to trigger its liquidity exception reporting. Which of the following market observations would most likely trigger a liquidity exception report at the company? a. b. c. d.

A reduction in the collateral haircuts applied to bonds of several competitors A significant appreciation in the Japanese yen against the US dollar and euro An increase in credit spreads for investment-grade Japanese utility bonds A decrease in global crude oil and natural gas market volatility


26


43.

A risk analyst has performed a regression analysis on Henry Hub (HH) natural gas spot price returns over the past 1,000 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 = 0.029 x (Log of daily HH Spot Prices) + 0.017 Using the coefficients in the linear relationship, which of the following amounts (in days) is the best estimate of the mean reversion rate for HH natural gas spot prices? a. b. c. d.

44.

2 9 15 30

An independent power producer has purchased an OTC wea ther option covering the peak summer load months. The option has a strike of 775 that pays USD 36,750 per CDD. Calculate the payout on the CDD contract (in USD) using the following average daily temperature data reported for the months of July and August.

July August

a. b. c. d.

Average Daily Temperature

Actual Day Count

78°F 80°F

31 31

1,139,250 3,417,750 5,696,250 14,810,250


27


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

Day Count

3.90 4.10 4.20

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.

46.

3.99 4.07 4.12 4.18

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. b. c. d.

Reassign the defaulted position to a solvent counterparty. Auction off the exposure to other potential counterparties. Terminate the position and become a creditor to the refiner’s estate. File a claim with the central counterparty equivalent to the MtM value of the defaulted position.


28


47.

The primary objective of a stack-and-roll position is to: a. b. c. d.

48.

Realize the spread on a call and put option with different maturities on the same underlying commodity position. Lock in a profit on a commodity trade when there is an expectation that the forward curve will steepen. Manage price risk on a commodity position when there is a perceived lack of liquidity in longer dated futures contracts. Hedge cross-commodity basis risk.

A refiner consumes 1.40 barrels of crude oil to produce 1 gallon of naphtha. If the hedge ratio is 0.5825, the number of crude oil futures contracts required to hedge 42,000 gallons of naphtha is closest to: a. b. c. d.

17 24 28 34


29


49.

A petroleum company is planning to drill ten exploratory oil wells across ten separate fields over a one-year period. Geological engineers estimate that the probability of finding oil at each field is 30%. Assuming all probabilities are independent of each other, which type of distribution should the engineers use to model the number of successful wells? a. b. c. d.

50.

Binomial Chi-squared Lognormal Poisson

A consultant has just been assigned to a new project advising an energy company on implementing an ERM program. In preparation for the project, the consultant reviews several case studies that involved the successful implementation of ERM at energy companies. Among these cases is Statoil, which applies a concept called “total risk optimization”. Which of the following statements describes the process Statoil used to achieve this objective? a. b. c. d.

Centralize the core risk function to prevent some value-destroying decisions made by individual business units Build a firm-wide distribution of risk exposures by summing together all risk exposures faced by the individual units Place the CRO in charge of all risk management decisions which impact operations at the business unit level Encourage business units to hedge their own risk exposures aggressively in order to reduce firm-wide risk exposure


30


51.

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 heightened the probability that the government could default on its sovereign debt. Which of the following describes the most likely outcome of a sovereign debt default by the host country? a. b. c. d.

52.

Short-term political unrest that triggers a longer-term increase in financing costs Sharp increases in inflation and interest rates that create hyperinflation A deep economic recession that produces multiple years of negative year-over-year GDP growth Cancellation of outstanding sovereign debt obligations that results in a total loss of investor capital

A refinery processes 8,000,000 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. b. c. d.

Buy 4,000 NYMEX RBOB futures contracts. Buy 5,333 NYMEX RBOB futures contracts. Sell 4,000 NYMEX RBOB futures contracts. Sell 5333 NYMEX RBOB futures contracts.


31


53.

The evolving economics of refined products has led management at a refinery to strategically shift production away from gasoline to increase its production of distillates. Which of the following spread positions will best hedge production if distillates account for 40% of the refiner’s new product mix? a. b. c. d.

54.

2:1:1 crack spread hedge 4:3:1 crack spread hedge 5:3:2 crack spread hedge 6:2:1 crack spread hedge

Assume two 100 MW generators supply power to the grid, in an energy at a cost of USD 50.00/MWh and USD 90.00/MWh, respectively. Peak hourly demand is assumed to be uniformly distributed between 70 MWh and 190 MWh. Calculate the probability that the market clearing price during a peak hour is less than USD 55.00/MWh. a. b. c. d.

25.0% 29.2% 32.2% 35.0%


32


55.

A crude oil producer has purchased 750 put options on Brent Crude oil futures at a strike price of USD 65/barrel. The position is currently delta neutral with a gamma of 0.0745 and a vega of 0.0265. The producer has identified an option contract with the following delta and gamma to hedge her position: • •

Delta: -0.045 Gamma: -0.0925

Which of the following combinations of transactions will most effectively neutralize gamma and delta? a. b. c. d.

56.

Buy 604 options to neutralize gamma; Buy 604 options to neutralize gamma; Buy 931 options to neutralize gamma; Buy 931 options to neutralize gamma;

buy 27 futures to neutralize delta. sell 27 futures to neutralize delta. buy 42 futures to neutralize delta. sell 42 futures to neutralize delta.

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 a ssumption 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


33


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. b. c. d.

58.

-0.15 -0.07 0.01 0.07

The following market prices for NYMEX Henry Hub futures are quoted at the close of trading on September 1 and November 1 respectively:

December January

Henry Hub Futures Price September 1 (USD/MMBtu)

Henry Hub Futures Price November 1 (USD/MMBtu)

4.235 4.365

4.579 4.279

On September 1 a natural gas trader expects the spread between the December and January Henry Hub futures closing price to widen over the next two months. How would the trader structure a calendar spread on September 1 to benefit from this view and what is the realized net profit or loss per contract on the position based on the November 1 closing prices? a. b. c. d.

Long December and short January futures; USD -7,140 Long January and short December futures; USD -4,300 Long December and short January futures; USD 4,300 Long January and short December futures; USD 7,140


34


59.

A risk analyst at a refinery is calculating the 10-day, 99% VaR on a natural gas position currently valued at USD 3,250,000. Using daily returns for natural gas prices over the past 12 months, the analyst’s current model applies an EWMA model with a lamda of 0.99 to estimate the VaR. Over the latest month, natural gas prices have fallen substantial and volatility has increased significantly. As result, the analyst changes the model’s lambda to 0.8 to recalibrate the volatility factor used in the VaR model. Applying the new volatility estimate will most likely cause the new VaR amount to: a. b. c. d.

60.

Increase slightly relative to the original V aR. Increase sharply relative to the original VaR. Decrease slightly relative to the original VaR. Decrease sharply relative to the original VaR.

The risk committee of a global exploration and production company is evaluating an opportunity to expand its production business into the Canadian oil sands market. The project requires a large capital investment for bidding on several concessions and establishing local operations. When assessing strategic risk related to this expansion from an ERM perspective, which of the following actions would be most appropriate? a. b. c. d.

Estimate the most likely outcome and decide to expand if the return on investment in this case exceeds the firm’s cost of capital Compare the probability weighted distribution of potential returns from the new project to the firm’s hurdle rate Add the VaR of the proposed expansion to the VaR of the company’s existing operations to project the overall firm-wide VaR Decide to expand if the RAROC for the proposed expansion is greater than the project’s economic capital requirement


35


2018 ERP Practice Exam, Part II – Candidate Answer Sheet 1. _____d______

31. _____b_____

2. _____d______ 3. _____b______ 4. _____a______ 5. _____b______ 6. _____c______ 7. _____b______ 8. _____a______ 9. _____d______ 10. ____b______ 11. ____c______ 12. ____c______ 13. ____c______ 14. ____c______ 15. ____c______ 16. ____a______ 17. ____a______ 18. ____c______ 19. ____b______ 20. ____d______ 21. ____a______ 22. ____c______ 23. ____a______ 24. ____b______ 25. ____b______ 26. ____c______ 27. ____c______ 28. ____a______ 29. ____c______ 30. ____c______

32. _____a_____ 33. _____c_____ 34. _____c_____ 35. _____c_____ 36. _____c_____ 37. _____c_____ 38. _____a_____ 39. _____c_____ 40. _____d_____ 41. _____b_____ 42. _____c_____ 43. _____d_____ 44. _____b_____ 45. _____b_____ 46. _____c_____ 47. _____c_____ 48. _____d_____ 49. _____a_____ 50. _____a_____ 51. _____a_____ 52. _____d_____ 53. _____c_____ 54. _____a_____ 55. _____a_____ 56. _____a_____ 57. _____d_____ 58. _____b_____ 59. _____b_____ 60. _____b_____


36


1.

An analyst at an ISO reviews a multivariate regression model used by the firm to project average day-ahead electricity demand. The model includes variables that might be rejected at higher thresholds of statistical significance. Which of the following independent variables will likely have the lowest statistical significance in forecasting day-ahead electricity demand on a grid? a. b. c. d.

Average temperature Day of the week Distributed generation Available utility-scale storage

Answer: d Explanation: Utility-scale storage is a supply factor. Furthermore, capacity does not imply usage which might be correlated with levels of power demand. Incorrect answers: A) The time factors influencing the system load include the time of the year, the day of the week and the hour of the day; B) Time factor, weather conditions, and social factors are k ey factors in the short- and medium-term load forecasting; C) Distributed generation refers to generating capacity that can satisfy consumption at the point of production. Therefore, consumers with access to distributed generation will reduce their demand for the grid. Reference: Rafal Weron, Modeling and Forecasting Electricity Loads and Prices, Chapter 3.2


37


2.

An investment analyst is completing a due diligence report on an exchange traded fund (ETF) whose returns are largely derived from rolling investments in front-month Henry Hub natural gas a nd WTI crude oil futures contracts. The following statistics on t he fund’s monthly returns between 2014 and 2017 are included in the analyst’s report: Year

Mean (µ)

Standard Deviation (σ)

Skewness

Kurtosis

2014

0.02

0.01

-0.42

1.64

2015

-0.01

0.03

0.33

1.61

2016

0.03

0.02

-0.11

4.20

2017

0.04

0.01

0.13

4.14

The following table summarizes the number of monthly occurrences when the return varied more than three standard deviations from the mean between 2014 and 2017. Year

Monthly return < µ – 3σ

Monthly return > µ + 3σ

A B C D

1 2 4 1

1 0 2 3

Which year (A, B, C or D) most likely corresponds to the statistical data on the fund’s monthly returns for 2017, as cited in the analyst’s due diligence report? a. b. c. d.

Year A Year B Year C Year D

Answer: d Explanation: Both 2016 and 2017 have relatively large kurtosis, implying a relatively larger number of extreme return observations, making C and D potential candidates. The positive skew of 2017 would imply that the extreme days on the upside should outnumber the extreme days on the downside, making D the correct choice. Reference: Michael Miller, Mathematics and Statistics for Financial Risk Management, 2nd Edition, Chapter 3: Basic Statistics


38


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: ● ●

Three-month NYMEX ULSD call option with a strike price of USD 1.75/gal at a premium of USD 0.05/gal Three-month NYMEX ULSD put option with a strike price of USD 1.75/gal at a premium of USD 0.11/gal

One week after establishing the position, the closing NYMEX ULSD prompt-month futures price is USD 1.90/gallon. Calculate the current net MtM value (in USD) per contract of the straddle position. a. b. c. d.

-4,200 -420 42 420

Answer: b Explanation: Based on the closing NYMEX ULSD prompt-month futures price of USD 1.90/gal, the current net MtM value of the straddle is calculated as follows: 1.90 - 1.75 - 0.05 - 0.11 = -0.01 multiplied by 42,000 gallons per contract resulting in a net MtM value of USD -420. In this scenario, the call option generates a loss which since the change in the value of the underlying spot price has not offset the premium paid for both options. Reference: S. Mohamed Dafir and Vishnun N. Gajjala. Fuel Hedging and Risk Management , Chapter 4.


39


4.

A bank holds a portfolio of derivative transactions with a single counterparty that declares declares default. The markto-market 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) +5,500,000

Collateral value (in EUR) 1,000,000

+12,000,000 -5,000,000 +3,000,000

4,000,000 0 1,500,000

The transactions are covered by an ISDA CSA with a closeout netting agreement. Assuming a 30% recovery rate and that any recovered amounts are received immediately at the time of default, calculate the bank’s total net exposure (in EUR) to the counterparty. a. b. c. d.

2,850,000 4,350,000 6,300,000 7,850,000

Answer: a Explanation: Exposure is reduced by both the netting agreement and the collateral. The bank has EUR 20,500,000 of exposures at the time of default. default. Since 30% of this amount is immediately immediately recovered, that leaves it with EUR 14,350,000 of exposures exposures outstanding. During the closeout, this is netted against the negative exposure of 5,000,000 leaving it with a balance of EUR 9,350,000. Since EUR 6,500,000 in pledged collateral collateral is available, that leaves a total net exposure of EUR 2,850,000. 2,850,000. Note that the negative exposure is is not adjusted by the recovery rate because the solvent party (the bank) still owes the counterparty this amount in full. Reference: Jon Gregory, Jon Gregory, The xVA Challenge: Counterparty Credit Risk, Funding, Collateral and Capital, 3rd Edition, Chapter 5.


40


5.

A heating oil trader for a large financial institution observes weather forecasts predicting unusually volatile weather patterns for the coming winter months and therefore initiates a long straddle position. One-month NYMEX ULSD call and put options with a strike price of USD 3.20 per gallon trade at premiums of USD 0.15 and USD 0.17 per gallon, respectively. What would be the net profit (or loss) per contract if the price of heating oil is USD 2.80 per gallon at the time of expiration? a. b. c. d.

USD 2,520 per contract USD 3,360 per contract USD 4,200 per contract USD 5,040 per contract

Answer: b Explanation: At a spot price of USD 2.80, the net profit is 3.20 - 2.80 -.15 -.17 or .08 times 42,000 gallons per contract. In this situation the “long put” provided the profit, while the premium payments reduced the profit. Reference: S. Mohamed Dafir and Vishnun N. Gajjala, Fuel Hedging and Risk Management. Chapter 4: Shipping and Airlines – Basics for Fuel Hedging


41


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 95% of sites that are commercially viable, and a negative test result for 80% of sites that are not viable. If 5 out of 100 drilling sites are commercially viable, calculate the probability that best approximates the viability of a site, given a positive test result. a. b. c. d.

5% 10% 20% 25%

Answer: c Explanation: Assume P(V) is the probability that a reservoir is commercially viable and P(T) probability that the test is positive. P(NV) and P(NT) are the probabilities of the opposite events.

From the text we understand that: P(T|V)=95%, P(T|NV)=20%,P(V)=5/100. We can therefore derive: P(T) = P(T|V) * P(V) + P(T|NV) * P(NV) =95%*5/100 + 20%*95/100=23.75% P(V|T) = P (V and T) / P (T) =P (T|V) * P(V) / P(T) = (95%*5/100) / 23.75% = 20.00% Reference: Michael Miller, Mathematics and Statistics for Financial Risk Management , 2nd Edition, Chapter 2


42


7.

A primary economic objective at a refinery is to minimize the volatility of its operating margins while managing price risk. To help achieve this objective, 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)

1.55

0.123

0.102

1.60

0.104

0.122

If the prompt-month NYMEX RBOB futures price is currently USD 1.575/gal, which of the following sets of transactions will most effectively achieve the refiner’s economic objectives? a. b. c. d.

Buy USD 1.60 put options and sell USD 1.55 call options. Buy USD 1.55 put options and sell USD 1.60 call options. Sell USD 1.55 put options and buy USD 1.60 call options. Sell USD 1.60 put options and buy USD 1.55 call options.

Answer: b Explanation: The collar will help the refiner to hedge price risk and, by extension, margins on its refining operation. In this case, the refiner will lock in a range of selling prices between 1.55 and 1.60 (less any cost of implementing the trade). If the RBOB price rallies over 1.60, the short call will be assigned to the refiner so the refiner will realize an effective price of 1.60. If the price falls below 1.55, the refiner can exercise the put option to lock in the price at that level. Reference: Vincent Kaminski, Energy Markets, Chapter 18.


43


8.

At the start of the winter heating season, a natural gas trader initiates a position expecting a bullish market (inelastic demand curve). The trader wants to benefit from expected volatility of natural gas prices as well as a positive price trend during the winter season, but also believes that other market participants might overpay for insurance against extreme weather events during the season. Which of the following transactions will the trader mostly likely structure? a. b. c. d.

Buy at-the-money calls and sell out of-the-money calls. Buy out-of-the money calls and sell at-the-money calls. Buy at-the-money puts and sell out-of-the-money puts. Buy out-of-the money puts and sell at-the-money puts.

Answer: a Explanation: The behavior of traders is driven by the belief that buyers (suppliers) will overpay for insurance against tail events offered by the purchase of options with a high strike price. Meanwhile, a long position in the calls benefits from short-term variations of prices around current levels, often induced by excessive trading. Reference: Vincent Kaminski. Energy Markets, Chapter 11


44


9.

A commodity trader observes that the volatility of daily futures price returns typically increases as futures contracts approach maturity. Which of the following choices best explains this increase in volatility? a. b. c. d.

Seasonality of supply and demand of energy futures contracts Market contango creates an incentive to roll expiring prompt-month futures contracts Hedging of deep OTM options on futures contracts increases demand for implied volatility Higher trading volumes in response to new market information as contracts approach maturity

Answer: d Explanation: As the time remaining to the physical delivery (settlement) date of an energy forward contract approaches zero, the 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 that, in turn, increases price volatility. Reference: S. Mohamed Dafir and Vishnun N. Gajjala, Fuel Hedging and Risk Management , Chapter 4


45


10.

A factor-push model is applied to stress test the mark-to-market value of several combinations of option positions on the April 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, the volatility of the April NYMEX WTI futures price is 10%, and the current settlement price for the April WTI contract is USD 60.00/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.

A long 55 call and a long 65 call A long 60 call and a long 60 put A long 57.50 call and a short 52.50 call A long 55 call and a short 55 put

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 60 call and a long 60 put would create the greatest loss if the underlying remained at USD 60.00/bbl. The position would actually increase in value if the factor was pushed in either direction. Reference: Kevin Dowd, Managing Market Risk , Chapter 13.


46


11.

The variance of historical monthly price returns on the SP-15 peak power futures contract is 0.1050 over a 5-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 5-year period? a. b. c. d.

36.4% 38.8% 112.3% 126.6%

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. 1050)*(sqrt 12) = 0.3240 * 3.46410 = 112.3% Reference: Les Clewlow and Chris Strickland, Energy Derivatives: Pricing and Risk Management , Chapter 3.


47


12.

A Canadian refinery pays USD 6.20 per contract to buy 1,000 European-style call options on the promptmonth Brent Crude futures contract. The call options have a strike price of USD 54.25/bbl and expire in six months. If the prompt-month Brent futures contract is trading at USD 58.75/bbl and the current 1-year riskfree rate is 1.50%, which of the following amounts (in USD) will the refinery expect to pay for 1,000 European-style put options with the same maturity and strike price? a. b. c. d.

1,634 1,700 1,734 1,767

Answer: c Explanation: The prices of put and call options are related via an algebraic equation, which states that holding a stock and a put option on the stock is equivalent to purchasing a call option and investing in a bond that pays out the strike price at maturity. This re lationship is known as “put–call” parity. In the case of commodities, options are generally written on futures contracts and not spot prices. Investors hold forward or futures positions and not spot positions and, therefore, the put –call parity relationship is written as: F0e−rT + P = C + K e −rT or C − P = (F0 − K) e−rT , where:

F0e−rT is equal to the discounted value of the Futures price K e−rT is equal to the discounted value of the Option Strike price C is equal to the Option Call Premium P is equal to the Option Call Premium By valuing only one of either a call or a put option, we can calculate the value of the other option using this parity relationship. Rearranging and applying the market data from the question stem: C = 6.20 K = 54.25 F = 58.75 T=0.50 r = 1.50%

 = 6.20  (−.1 ∙ .) (58.7554.25) P = 1.734 The amount the refinery pays for 1000 Put options is: USD 1,734 (USD 1000* USD 1.734).

Reference: S. Mohamed Dafir and Vishnun N. Gajjala. Fuel Hedging and Risk Management , Chapter 4.


48


13.

A US-based producer is building an LNG terminal in Australia which is scheduled to be completed in five years. To help reduce exposure to foreign currency fluctuations, the producer has structured a seven-year, fixed-for-floating swap on the Australian dollar (AUD) with a BBB-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. b. c. d.

CVA Netting Reset Take-or-pay

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 r educes 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. Reference: Jon Gregory, The xVA Challenge: Counterparty Credit Risk, Funding, Collateral and Capital, 3rd Edition, Chapter 5.


49


14.

Three months ago, a shipping company entered into a 1-year forward contract to purchase 100,000 MT of bunker fuel from a counterparty at a price of USD 165/MT. Current market pricing for bunker fuel is summarized below: ● ● ● ●

Spot price: USD 185/MT 6-month forward price: USD 189/MT 9-month forward price: USD 195/MT 1-year forward price: USD 208/MT

Calculate the shipping company’s credit exposure (in USD) if the counterparty defaults today (assume no impact from discounting). a. b. c. d.

1,300,000 2,000,000 3,000,000 4,300,000

Answer: c 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 nine months to maturity, the shipper is essentially holding a nine-month forward contract. The replacement risk is therefore: (195-165) * 100,000 = 3,000,000. Since the shipping company has not paid the counterparty yet, there is zero settlement risk. 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).


50


15.

A credit analyst is assessing the default profile for several counterparty exposures. The following chart illustrates the estimated annual default probability for a specific counterparty over the next 7 years (i.e. the probability the exposure will default in that year alone):

t l u a f e D f o y t i l i b a b o r P l a u n n A

20.0% 18.0% 16.0% 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% 1

2

3

4

5

6

7

Year

Using the S&P rating standards as a guideline, what is the most likely rating for this counterparty exposure? a. b. c. d.

A BB CCC D

Answer: C Explanation: This default probability profile would most closely correspond to a Caa/CCC rating. This can be implied by the charts on p. 201 and especially in p. 203. For a lower speculative grade rating, the probability of default is highest in the first couple of years. For an investment grade rating, the probability of default is very low in the first couple of years and increases modestly over time. The reasoning is that low-graded exposures are most likely to suffer a default event early on; if they survive the near term, they have likely improved their financials to escape the problems and the likelihood of default decreases as you get farther out. A D-rated security is already defaulted. 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).


51


16.

A commercial natural gas end-user in the US state of Virginia hedges 100% of its expected February 2019 gas consumption totaling 100,000 MMBtu. Which of the following sets of transactions should the end-user execute in order to best minimize basis risk in its operation? a. b. c. d.

Buy 10 February 2019 NYMEX Henry Hub natural gas futures contracts and sell a Transco Zone 5 natural gas basis swap for February 2019 covering 100,000 MMBtu. Buy 100 February 2019 NYMEX Henry Hub natural gas futures contracts and buy a Transco Zone 5 natural gas basis swap for February 2019 covering 100,000 MMBtu. Sell 10 February 2019 NYMEX Henry Hub natural gas futures contracts and buy a Transco Zone 5 natural gas basis swap for February 2019 covering 100,000 MMBtu. Sell 100 February 2019 NYMEX Henry Hub natural gas futures contracts and sell a Transco Zone 5 natural gas basis swap for February 2019 covering 100,000 MMBtu.

Answer: a Explanation: Basis refers to the difference in price between a forward (futures) market and a cash (spot) market. The end – user is seeking to eliminate the basis price r isk associated with gas price in February 2019 vs today’s s pot price. Therefore, the company should buy February 2019 futures contract. In the natural gas markets, basis risk is also locational. A locational basis swap can help mitigate the r isk exposure between the natural gas price at Henry Hub and Virginia’s Transco zone 5. In sizing the transaction, one NYMEX natural gas future contract represents 10,000 MMBtu. Reference: Vincent Kaminski. Energy Markets, Chapter 11


52


17.

What VaR methodology, requiring limited calculation time, will most effectively capture the non-linear payoff structure associated with a diversified portfolio of option contracts on crude oil and natural gas futures? a. b. c. d.

Delta-gamma VaR Monte Carlo simulation VaR Historical simulation VaR Variance-covariance VaR

Answer: a Explanation: Delta-gamma VaR is the best method to use in this case. It incorporates the non-linear payoff structure and dependence of options on their underlying assets and is calculated much faster than full Monte Carlo simulations or historical simulations. Clewlow estimates that full Monte Carlo simulations can take 100 to 1,000 times the duration to calculate as that of delta-gamma VaR due to computational difficulty in repricing the options using an option model. Similarly, historical simulation is computationally demanding because it needs to reprice the whole portfolio. Reference: Clewlow and Strickland, Energy Derivatives: Pricing and Risk Management, Chapter 10


53


18.

A credit analyst is assessing a USD 10,500,000 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 10,000,000, an estimated recovery rate of 70%, and an expected loss of USD 500,000 in the event of default. Calculate the implied default probability on the bond? a. b. c. d.

6.80% 10.50% 15.87% 20.91%

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 3,150,000. The implied default probability is then the EL of USD 500,000 divided by the LGD USD 3,150,000 or 15.87%. Note: The par value of the bonds is not used in the calculation. 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).


54


19.

A renewable investor is using the RAROC approach to evaluate the terms of a PPA offered by a utility for a proposed 100MW solar installation. The investor makes the following estimates for the first year of operation under the terms of the PPA: • • •

Pre-tax net income from operations: USD 15 million Economic capital required to support the project: USD 110 million Tax rate for the project: 30%

The estimated pre-tax net income includes an adjustment for expected losses that the investor would incur if the utility defaults. Additionally, the investor assumes that it can invest its economic capital risk-free at 2.0%. Calculate the expected RAROC for this project. a. b. c. d.

9.5% 10.9% 13.6% 15.6%

Answer: b Explanation: RAROC is equal to: After-tax risk-adjusted net income / Economic capital. This can also be expressed as: (Revenues – costs – expected losses + return on risk capital) / Economic capital. Because the pre-tax net income from operations already includes the adjustments for costs and expected losses, the RAROC is:

[(15 + (110 million * 2.0%) ) * (1-0.3)] / 110 = 10.94%. A forgets to add in the return on risk capital. C forgets to add in the return on risk capital and forgets to correct for taxes. D forgets to correct for taxes. Reference: Michel Crouhy, Dan Galai, and Robert Mark, The Essentials of Risk Management, 2nd Edition , chapter 17


55


20.

An energy consultant is researching the effectiveness of netting agreements in mitigating counterparty risk for the consulting firm’s clients. For which of the following OTC derivative transactions would a bilateral netting agreement provide the greatest economic benefit to the counterparty identified in the transaction? a. b. c. d.

A refinery long a straddle on gasoline futures A natural gas producer long a floor on natural gas A crude oil producer long a put option on WTI futures A coal-fired electric power generator long a coal swap

Answer: d 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 coal swap would have the greatest likelihood of creating a negative mark-to-market and therefore the greatest economic benefit in a netting arrangement. Reference: Jon Gregory. Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets, 2 nd Edition, Chapter 4.


56


21.

A refined products trader has structured a 1-year fixed-for-floating swap on 50,000 barrels of gasoil with a Ba1/BB+ rated counterparty. The trader applies the following information to price counterparty risk into the transaction: ● ● ●

Expected exposure: 4.00% Loss given default: 85% 1-year probability of default: 0.90%

Assuming annual settlements and ignoring the impact of discounting, the best approximation of the CVA (as a %) for the swap is: a. b. c. d.

0.03% 0.50% 0.61% 2.45%

Answer: a 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 CVA ≈ 4.00% * 85% * 0.90% = 0.0003060 or 0.03060%

Reference: Jon Gregory. The xVA Challenge: Counterparty Credit Risk, Funding, Collateral and Capital, 3rd Edition, Chapter 14.


57


22.

A refinery purchases an 80,000 barrel allotment of light sweet crude oil from a Norwegian producer. Pricing has been confirmed at bill of lading (B/L) plus 2 days, with equal delivery each day. If B/L is received on March 3, which of the following market-on-close orders will the trader submit to hedge price risk on March 4? a. b. c. d.

Sell 40 lots of March Brent futures. Sell 80 lots of March Brent futures. Sell 40 lots of April Brent futures. Sell 80 lots of April Brent futures.

Answer: c Explanation: Most energy commodities have a standard notional quantity for one contract, referred to as a “lot”. For example, one lot of WTI crude oil is 1,000 bbls. The refinery is hedging Day 1 pricing and will sell 40 lots of Brent, which is equivalent to 40,000 bbls (40 x 1,000).

As with all futures, trading for a given contract month ceases at a defined futures expiration date prior to the contract month. In the case of the Brent contract, this is roughly two-thirds (2/3) of the way through the previous contract month. Therefore, only April futures would be available for trading. Reference: Glen Swindle. Valuation and Risk Management in Energy Markets . Chapter 2.


58


23.

The market risk team at a retail power distributor has been asked to explain why off-peak real-time electricity prices spiked in the ERCOT market during the previous day. Which of the following market factors most likely explains the off-peak price spike? a. b. c. d.

The unplanned outage of a 1 GW nuclear generator occurred in ERCOT. The planned retirement of a 1GW coal-fired generator in ERCOT was announced. The average hourly cooling degree days were two standard deviations below the 5-year historical average for that date. The neighboring SPP market experienced price spikes that converged with prices in ERCOT.

Answer: a Explanation: Price spikes may appear in a stable demand environment when a considerable amount of base load is removed from the market.

B is incorrect: The removal of future capacity on the grid is unlikely to affect real time prices; however, it may increase the price level of the forward curve. C is incorrect: An average hourly cooling degree day (CDD) below the 5-year historical average will most likely create a load requirement that is lower than forecasted. D is incorrect: One of the stylized facts about electricity markets identified by the text is that they are regional. One market has little to no impact on other markets. Reference: Rafal Weron, Modeling and Forecasting Electricity Loads and Prices , Chapter 2.


59


24.

The 1-day, 99% VaR for a Brent crude oil futures position is USD 3,500,000, based on 5,000 simulated 1 -day returns. Which of the following statements best describes the 1-day, 99% expected shortfall? a. b. c. d.

The maximum 1-day simulated loss The average simulated 1-day loss that exceeds USD 3,500,000 The difference between the 1-day, 95% VaR and the 1-day, 99% VaR The difference between the 1-day, 95% VaR and the average simulated 1-day return for the position

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. Therefore, since the 99% VaR is equal to USD 3,500,000 the expected shortfall would be the average of all simulated 1-day losses which exceed this amount Reference: John C. Hull. Risk Management and Financial Institutions, 4th Edition , Chapter 12.


60


25.

The following call and put option contracts are available on the prompt-month Henry Hub Natural Gas futures contract: Contract

Option

Strike (USD)

Expiration

W

Call Call Put Put

3.00 3.50 3.50 4.00

June 30, 2018 June 30, 2018 June 30, 2018 June 30, 2018

X Y Z

Assume the underlying futures contract is trading at USD 3.50. 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

Answer: b Explanation: As described in Clewlow and Strickland, 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). Reference: Les Clewlow and Chris Strickland. Energy Derivatives: Pricing and Risk Management , Chapter 3.


61


26.

A market risk analyst at an energy trading company has identified eleven 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 requires further adjustment such as increasing the safety multiplier to set aside more risk capital when using the model. c. The VaR model is in the “red zone” and must be revised substantially before it can be considered usable. d. The VaR model is in the “orange zone” and must be replaced.

Answer: c Explanation: Ten or more exceedances puts the model into the “red zone” where it must be substantially rev ised before being considered usable. 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. Potential solutions for yellow zones is increasing 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) Reference: Les Clewlow and Chris Strickland. Energy Derivatives: Pricing and Risk Management , Chapter 10.


62


27.

Consider the following information related to bonds issued by two different large regional energy producers: Bond A

Bond B

USD 100,000

USD 50,000

Probability of default

6%

7%

Expected recovery rate

30%

40%

Position size

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 70,000 100,000

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, since we are using a 95% Credit VaR the confidence level is 5%. Given the recovery rate estimates, if bond A defaults the loss is USD 70,000, and if bond B defaults the loss is USD 30,000. We can then construct a table with the four possible outcomes: Outcome Neither bond defaults Only Bond B defaults Only Bond A defaults Both bonds default

Probability 87.42% 6.58% 5.58% 0.42%

Loss (USD) 0 30,000 70,000 100,000

In this case it would be a default of Bond A which would incur a loss USD 70,000. Since the probability of this loss is above the 5% confidence level, the 95% credit VaR is 70,000. The probability of both bonds defaulting is 0.42% (6% * 7%), which is below the confidence level, so 100,000 is not the 95% credit VaR. 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).


63


28.

A trader is holding a 500,000 gallon position in fuel oil. Due to an unexpected slump in oil prices, the position decreases in value by 15% which exceeds the trader’s allowable loss for the position. The CRO instructs the trader to liquidate the position when the current bid and offer prices are USD 3.10/gal and 3.30/gal respectively. Assuming normal market conditions, the expected cost (in USD) of liquidation is closest to: a. b. c. d.

50,000 85,000 100,000 1,600,000

Answer: a Explanation: In order to determine the liquidation cost in a normal market condition, the firm should use the formula: Liquidation cost = ( s * α) / 2

Where s is the spread expressed as a percentage of midpoint: (3.30-3.10)/3.20 = 0.625 and α is the current portfolio value calculate d at the midpoint, 500,000 * 3.20 = 1,600,000. Hence the liquidation cost is equal to (1,600,000 * .0625)/2 = 50,000. More simply, half the bid-offer spread is 0.10, so 500,000 * 0.10 = 50,000 Answer B Incorrectly assumes the liquidation cost is equal to midpoint of the market value of the position after 15% drop in value (1,360,000 * 0.0625) = 85,000 Answer C incorrectly assumes the bid-ask spread times the position (0.20 * 500,000) Answer D incorrectly assumes the market va lue of the position. (3.20 * 500,000) Reference: John C. Hull. Risk Management and Financial Institutions , Chapter 24


64


29.

A natural gas forward contract has three months until expiration. As the contract approaches the expiry date, volatility will most likely: a. b. c. d.

Remain stable Decrease steadily Increase steadily Be unpredictable due to market seasonality

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 maturity approaches causing a rise in number trades of that forward contract that, in turn, increases price volatility. Reference: Les Clewlow and Chris Strickland. Energy Derivatives: Pricing and Risk Management, Chapter 3


65


30.

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

Day 1

Henry Hub Nat Gas Daily Price return (%) 2.06%

WTI Crude Oil Daily Price return (%) 1.83%

Day 2

1.65%

2.01%

Day 3

-2.65%

1.14%

Day 4

1.75%

0.56%

Day 5

-1.77%

1.23%

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 -0.24 0.28 0.46

Answer: c Explanation:

The correlation can be calculated as follows: Correlation

 =   

is equal to

∑(−̅ )(−̅ ) . See the steps below for calculating the latter √ ∑(−̅ ) ∑(−̅ )

equation. Step 1 Calculate the correlation function numerator,

 , which is the covariance (x,y), ∑(̅ )(̅ ).

Commodity A

Commodity B

(HH)

(WTI)

(̅ )

(̅ )

(̅ ) ( ̅ )

Day 1

2.06%

1.83%

0.01852

0.00476

0.00009

Day 2

1.65%

2.01%

0.01442

0.00656

0.00009

Day 3

-2.65%

1.14%

-0.02858

-0.00214

0.00006

Day 4

1.75%

0.56%

0.01542

-0.00794

-0.00012

Day 5

-1.77%

1.23%

-0.01978

-0.00124

0.00002

Sample mean

0.00208

0.01354

0.02234

0.00581

(̅ )(  ̅ )

Sample standard deviation


0.00015

66


Step 2 Calculate correlation’s denominator, i.e., the standard deviation of x and y,

(̅ )

(̅ )

Day 1

0.00034

0.00002

Day 2

0.00021

0.00004

Day 3

0.00082

0.00000

Day 4

0.00024

0.00006

Day 5

0.00039

0.00000

sum above

sum above

0.00200

0.00013

2

  and .

2

Step 3 Divide the numerator by the denominator. Explanation Numerator

0.00012

Denominator

0.00051

Correlation

0.2814

Reference: Michael Miller. Mathematics and Statistics for Financial Risk Management, 2nd Edition , Chapter 3.


67


31.

An energy trader sells a 3-month floor to manage price volatility requirements for the next three months. The floor is written on 250,000 barrels of crude oil per month at a strike price o f USD 70.00/bbl and a monthly premium of USD 1.75/bbl. Settlement occurs on a monthly basis against the average daily promptmonth NYMEX WTI contract closing prices summarized below: ● ● ●

Month 1: USD 75.10/bbl Month 2: USD 62.30/bbl Month 3: USD 71.80/bbl

Which of the following amounts (in USD) represents the cumulative net profit/loss earned by the trader on this contract for the 3-month period? a. b. c. d.

-1,112,500 -612,500 720,000 1,487,500

Answer: b Explanation: By selling a floor, if the settlement price of crude oil is below the strike price in a given month, the difference between the prices must be paid by the trader. In this case, the second month is below the strike price; the difference for month 2 is USD 7.70. Multiplying this price differential by the contract size of 250,000/bbl price yields the amount the trader must pay: USD 1,925,000. Subtract the premium received for the floor (USD 1.75 x 250,000 bbl x 3 months = 1,312,000) for a net settlement payment of USD 612,500. Note: No payment is made in month 1 and 3 because the settlement prices (USD 75.10 and 71.80) are above

the strike price (USD 70.00), though the floor premium is still received in each of these months. Reference: Vincent Kaminski, Energy Markets, Chapter 18.


68


32.

The economics of forward price formation would be least affected by the convenience yield of which energy commodity? a. b. c. d.

Electricity Heating oil Jet fuel Natural gas

Answer: a Explanation: Convenience yield is a theoretical framework often used to explain backwardation in forward energy commodity prices. While most practitioners argue that convenience yield is irrelevant, storable commodities that exhibit seasonal demand patterns do have a positive economic benefit that accrues to the owner of the underlying physical energy commodity. Commodities, like electricity, without deep storage markets would by definition not exhibit a material convenience yield. References: S. Mohamed Dafir and Vishnun N. Gajjala. Fuel Hedging and Risk Management , Chapter 4; Glen Swindle, Valuation and Risk Management in Energy Markets , Chapter 2.


69


33.

An analyst has been asked to estimate the volatility for Brent crude oil using the EWMA model with a decay factor (λ) of 0.95. The estimated volatility yesterday was 1.73% per day. The market price of Brent crude oil was USD 60.99 yesterday and USD 60.45 the day before yesterday. Which of the following volatilities is the best estimate of Brent crude oil volatility today? a. b. c. d.

1.58% 1.63% 1.70% 1.73%

Answer: c Explanation: The correct application of the EWMA formula is:

Daily return = 60.99 / 60.45 -1= 0.00893. Volatility = sqrt(0.95*0.01732+(1-0.95)*0.00893 2) or 1.70%. 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. Reference: John C. Hull. Risk Management and Financial Institutions, 4th Edition , Chapter 10.


70


34.

The spot price of Brent crude on the ICE exchange is USD 70. The annual risk-free interest rate is 4%, and monthly storage cost is USD 0.50 per barrel. If the crude can be stored for three months but cannot be sold out of storage before the three month storage term ends, what is the breakeven forward price per barrel supporting a storage strategy (in USD)? a. b. c. d.

71.50 72.19 72.21 72.30

Answer: c Explanation: The breakeven future’s price is the sum of the future va lue of the commodity (1 + 0. 04/12) 3, = 1.01003) x current spot price of USD 70 = USD 70.70) and the future value of 3 months storage, USD 1.51. Therefore breakeven forward price is USD 72.21 = 70.702 + 1.508).

Reference: Robert McDonald, Derivatives Markets, 3rd Edition. Chapter 4


71


35.

A commodity trader manages a portfolio of oil futures positions. The portfolio currently contains only two futures assets with the following individual 1-day, 95% VaR amounts: ● ●

June 2018 Brent futures contracts: USD 2,400,000 June 2018 WTI futures contracts: USD 3,000,000

If the correlation between the two oil price returns is 0.9, assuming a zero-mean normal distribution, which of the following amounts (in USD) best approximates the 1-day, 95% VaR of the portfolio? a. b. c. d.

3,100,000 3,200,000 5,300,000 3,800,000

Answer: c

Explanation: Multi-asset VaR can be generalized:

However, two asset VaR can be reduced to:

, =    2∗ ∗ ∗, Using the information portfolio information above, the 1-day, 95% portfolio VaR for this two-item portfolio is:

5,264,979 = √ 2,400,000  3,000,000  2∗ 2,400,000 ∗ 3,000,000∗0.9 Reference: John C. Hull. Risk Management and Financial Institutions, 4th Edition , Chapter 12.


72


36.

The head of the counterparty risk team is explaining to a colleague the magnitude and frequency of counterparty settlement risk events that the team monitors. The group head explains that compared to settlement risk, losses due to pre-settlement risk are typically: a. b. c. d.

Larger and occur more frequently Larger but occur less frequently Smaller but occur more frequently Smaller and occur less frequently

Answer: c Explanation: Pre-settlement risk occurs prior to the maturity and/or settlement, while settlement risk is the risk of counterparty default during the settlement of the transaction.

Magnitude of pre-settlement risk is just the mark-to-market (i.e. profit/loss) of the position and thus smaller when compared to settlement risk exposures since settlement risk entails the full value of the underlying contract. Settlement risk is limited to an extremely short period of time (in most cases) relative to the length of the contract and thus events occur infrequently. Conversely, pre-settlement risk events much more often since pre-settlement exists for substantially the entire duration of the transaction. Reference: Jon Gregory, The xVA Challenge: Counterparty Credit Risk, Funding, Collateral and Capital, 3 rd Edition, Chapter 4.


73


37.

Which of the following transactions would reduce the gamma the most on a portfolio of long options on NYMEX WTI crude oil futures contracts? a. b. c. d.

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

Answer: c Explanation: Gamma is defined as the rate of change in an option’s delta per move in the underlying. Delta is defined as the rate of change in an option’s price per move in the underlying. Delta very high, converging to one, for deepest-in the money options. Delta changes most rapidly when an option is at-the-money. Therefore, a tthe-money options have the highest gamma as displayed in the diagram depicting gamma’s value versus the asset price. Therefore, reducing the portfolio’s gamma would r equire selling options, and since gamma is highest when options are at-the-money, selling at-the- money options reduces the portfolio’s gamma the most.

Reference: John C. Hull. Risk Management and Financial Institutions, 4 th Edition, Chapter 8.


74


38.

A global transport and logistics provider has entered into a contract to purchase gasoline at the wholesale price. To hedge the exposure it purchases RBOB gasoil futures based on the following historical return data: • • •

Standard deviation of wholesale gasoline price returns: 16.49% Standard deviation of RBOB gasoil futures: 20.90% Correlation between wholesale gasoline and RBOB gasoil futures: 0.95

The minimum variance hedge ratio required to properly size the futures position is closest to: a. b. c. d.

0.75 0.79 1.20 1.27

Answer: a Explanation: The minimum variance hedge ratio is calculated as: H* = -ρ (a,b) * (σ a / σb), where ρ is the correlation coefficient between returns of the two commodities, a is the commodity being hedged (wholesale gasoline), and b is the commodity being used as a hedge (RBOB gasoil futures). Hence H =-0.95* (0.1649/0.2090), or -0.75. The negative sign indicates that you need to take the opposite position in the hedge as the original position. Reference: Michael Miller. Mathematics and Statistics for Financial Risk Management , 2nd Edition, Chapter 3.


75


39.

A power generator has sold a 1-year, 50 MW CFD to a large wholesale industrial customer that covers the 2018 calendar year. The CFD has a strike price of USD 50/MWh and the contract was executed under an ISDA Credit Support Annex containing the following terms: • • •

Threshold amount: USD 500,000 Independent amount: 5% of outstanding face value Minimum transfer amount: USD 100,000

If the market price of a calendar year 2018 CFD is currently USD 45/MWh, how much collateral (in USD) will the generator be required to post, assuming a 365-day year (8,760 hours covered by the contract)? a. b. c. d.

0 2,190,000 2,800,000 3,300,000

Answer: c Explanation: MtM=50MW*24h/d*365d/y*(50-45) FV = 50MW*24h/d*365d/y*50 Collateral = MtM + FV*5% - $500,000 (rounded up to nearest $100,000)

Other answers relate to incorrect calculations that could be performed. a – MtM is calculated as in favor of the counterparty b – MtM without threshold or independent amount d – missing application of threshold Reference: Jon Gregory. Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets, 3 rd Edition, Chapter 5, pages TBD Chapter 5


76


40.

A netting set includes seven equal counterparty exposures totaling EUR 8,000,000 with an average correlation between the positions of 0.15. Assuming the future value of the exposures follows a multivariate normal distribution, which of the following amounts (in EUR) represents the best estimate of the expected net exposure? a. b. c. d.

794,000 1,273,000 3,093,000 4,167,000

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 =

√  +  (−1)  

Where n is the number of exposures and ρ is the average co rrelation between the exposures. Using n = 7 and ρ = 0.15, in this case the netting factor is

The answer is then 8,000,000 * 0.521= 4,167,905.

√  +  (−1).1 

= 0.521.

Reference: Jon Gregory, The xVA Challenge: Counterparty Credit Risk, Funding, Collateral and Capital, 3 rd Edition, Chapter 7


77


41.

A counterparty credit analyst at an IOC is evaluating the creditworthiness of a new counterparty with which the firm is planning to initiate a sizable multi-year contract equipment supply contract. The cumulative implied default probabilities for each of the next four years associated with several midsize oil exploration and production companies are summarized below: Company

Year 1

Year 2

Year 3

Year 4

W

0.02%

0.03%

0.05%

0.1%

X

0.22%

0.41%

0.93%

1.25%

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 A2/A will most likely be assigned to which of the following companies? a. b. c. d.

W X Y Z

Answer: b Explanation: An A2/A rating is a medium investment grade rating which implies a small amount of credit risk but overall a solid investment profile. A 4-year cumulative default probability of 1.25% would correspond most closely to this rating class. An Aa2/AA rating is a high investment-grade credit rating which would represent a fairly insignificant 4-year probability of default. It is a high quality grade subject to low credit risk. Company W would most likely fall into this rating category. A 13.8% probability would most likely fall into the non-investment grade or high-yield category, with perhaps a single-B rating. A 44.2% probability would correspond to a much lower speculative grade rating in the Caa2/CCC range. 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.


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42.

A Japanese power company owns a network of five gas-fired generating plants that are fueled with imported LNG that is purchased at an oil-linked price. As part of its contingency funding plan, risk managers at the company are preparing a list of Early Warning Indicators (EWI’s) which the company can use to trigger its liquidity exception reporting. Which of the following market observations would most likely trigger a liquidity exception report at the company? a. b. c. d.

A reduction in the collateral haircuts applied to bonds of several competitors A significant appreciation in the Japanese yen against the US dollar and euro An increase in credit spreads for investment-grade Japanese utility bonds A decrease in global crude oil and natural gas market volatility

Answer: c Explanation: An increase in credit spreads of investment-grade Japanese bonds would serve as an Early Wa rning Indicator since this would indicate that the credit outlook for firms in its industry could be deteriorating. This may make it more difficult or expensive for the firm to receive funding in the future.

A is incorrect as a reduction in collateral haircuts is an indicator of better credit quality. B is incorrect as appreciating Yen would put the utility at an advantage in purchasing LNG and would often be an indicator of a stronger Japanese economy D is incorrect as decreasing volatility is a sign of stability in the financial markets or its peer group. Reference: Venkat and Baird, Liquidity Risk Management – A Practitioner’s Perspective . Chapter 7


79


43.

A risk analyst has performed a regression analysis on Henry Hub (HH) natural gas spot price returns over the past 1,000 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 = 0.029 x (Log of daily HH Spot Prices) + 0.017 Using the coefficients in the linear relationship, which of the following amounts (in days) is the best estimate of the mean reversion rate for HH natural gas spot prices? a. b. c. d.

2 9 15 30

Answer: d Explanation: The mean reversion rate can be estimated from the regression results as follows: α0 = 0.017 (Coefficient for Intercept) α1 = 0.029 (Coefficient for Slope) Assuming 1,000 data points Δt = 1/1,000 = 0.001 Therefore, the mean reversion rate (α) can be estimated as (α 1/Δt), .029/.001, or 29 days

Reference: Les Clewlow and Chris Strickland, Energy Derivatives: Pricing and Risk Management, Chapter 2.


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44.

An independent power producer has purchased an OTC weather option covering the peak summer load months. The option has a strike of 775 that pays USD 36,750 per CDD. Calculate the payout on the CDD contract (in USD) using the following average daily temperature data reported for the months of July and August. Average Daily Temperature

Actual Day Count

78°F 80°F

31 31

July August

a. b. c. d.

1,139,250 3,417,750 5,696,250 14,810,250

Answer: b Explanation:

Cooling Degree Days (CDDs) for the period are 868 calculated as follows: July: (78-65)*31 = 403 August: (80-65)*31 = 465 The formula for the payout on the CDD contract is: Payout = V x (CDD Jul-Aug - KCDDJul-Aug)+ x (PG Aug) Therefore: Payout = 36,750 x (868 - 775) = USD 3,417,750 Reference: Vincent Kaminski. Energy Markets, Chapter 11


81


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

Day Count

3.90 4.10 4.20

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.

3.99 4.07 4.12 4.18

Answer: b 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)/ the correct day count.

4.07 = (3.90*30 + 4.10*31+ 4.20*31) / (30 + 31+ 31) Reference: Vincent Kaminski, Energy Markets, Chapter 11.


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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. b. c. d.

Reassign the defaulted position to a solvent counterparty. Auction off the exposure to other potential counterparties. Terminate the position and become a creditor to the refiner’s estate. File a claim with the central counterparty equivalent to the MtM value of the defaulted position.

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.) Reference: Jon Gregory, The xVA Challenge: Counterparty Credit Risk, Funding, Collateral and Capital, 3rd Edition, Chapter 5.


83


47.

The primary objective of a stack-and-roll position is to: a. b. c. d.

Realize the spread on a call and put option with different maturities on the same underlying commodity position. Lock in a profit on a commodity trade when there is an expectation that the forward curve will steepen. Manage price risk on a commodity position when there is a perceived lack of liquidity in longer dated futures contracts. Hedge cross-commodity basis risk.

Answer: c Explanation: Stack and roll is the process of stacking futures contracts in the near-term contract and rolling over into the new near-term contract. There is often more market liquidity in the near-term contracts, and the traders may speculate on the shape of the forward curve and deploy this strategy to make gains. If the new nearterm futures price is lower than the expiring near-term price (in backwardation), this strategy is profitable. Reference: Robert McDonald, Derivatives Markets, 3rd Edition , Chapter 6.


84


48.

A refiner consumes 1.40 barrels of crude oil to produce 1 gallon of naphtha. If the hedge ratio is 0.5825, the number of crude oil futures contracts required to hedge 42,000 gallons of naphtha is closest to: a. b. c. d.

17 24 28 34

Answer: d Explanation: Assuming 1.40 barrels of crude oil are required to produce 1 gallon of naphtha (a gasoline blendstock), then 58,800 barrels of crude are required for 42,000 gallons of naphtha (42,000*1.40 = 58,800).

Each WTI contract represents 1,000 barrels. Therefore, (58,800 bbls x 0.5825 hedge ratio) / (1,000 barrels per contract) = 34 WTI crude oil futures contracts are required to hedge 42,000 gallons of naphtha. Reference: Robert McDonald, Derivatives Markets, 3rd Edition , Chapter 4


85


49.

A petroleum company is planning to drill ten exploratory oil wells across ten separate fields over a one-year period. Geological engineers estimate that the probability of finding oil at each field is 30%. Assuming all probabilities are independent of each other, which type of distribution should the engineers use to model the number of successful wells? a. b. c. d.

Binomial Chi-squared Lognormal Poisson

Answer: a Explanation: A binomial distribution would be used here. A single well could be modeled as a Bernoulli variable with p=0.30, with two outcomes, “oil” and “no oil”. Since a Binomial distribution measures a group of independent and identically distributed Bernoulli variables, these ten wells can therefore be modeled using a binomial distribution. A Poisson process is not the best distribution to use since it measures the frequency of events occurring which have no theoretical maximum, such as the number of unexplained shutdowns. Since the max number of wells finding oil is 10 the binomial distribution is better. Reference: Michael Miller, Mathematics and Statistics for Financial Risk Management, 2nd Edition , Chapter 4


86


50.

A consultant has just been assigned to a new project advising an energy company on implementing an ERM program. In preparation for the project, the consultant reviews several case studies that involved the successful implementation of ERM at energy companies. Among these cases is Statoil, which applies a concept called “total risk optimization”. Which of the following statements describes the process Statoil used to achieve this objective? a. b. c. d.

Centralize the core risk function to prevent some value-destroying decisions made by individual business units Build a firm-wide distribution of risk exposures by summing together all risk exposures faced by the individual units Place the CRO in charge of all risk management decisions which impact operations at the business unit level Encourage business units to hedge their own risk exposures aggressively in order to reduce firm-wide risk exposure

Answer: a Explanation: As described in the Statoil case study, a key goal of the company’s risk management is to avoid suboptimal decisions, which is also known as “optimizing total risk.” The value metric that underpins ERM in Statoil implies that it is the perspective of the company as a whole that should prevail in practical situations where different individuals and business units may have differing views on how to proceed. One such example is hedging decisions, where central management of core risk functions prevents (for example) a situation in which two units with offsetting risk exposures to individually hedge their exposures and destroy value for the firm.

B is incorrect, this is bad practice as it ignores diversification benefits, which would be realized through ERM. C is incorrect, as the company does not centralize all risk management functions, most of which continue to rest with the business units. Only “core” functions are coordinated centrally and owned by the CEO. D is incorrect, Statoil did the opposite by removing the ability of individual units to set FX derivative policies. Rather, the firm centralized management of FX and other core hedging decisions rather than letting these decisions be made on the unit level. Reference: John Fraser, Betty Simkins, and Kristina Narvaez, Implementing Enterprise Risk Management: Case Studies and Best Practices , Chapter 4


87


51.

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 heightened the probability that the government could default on its sovereign debt. Which of the following describes the most likely outcome of a sovereign debt default by the host country? a. b. c. d.

Short-term political unrest that triggers a longer-term increase in financing costs Sharp increases in inflation and interest rates that create hyperinflation A deep economic recession that produces multiple years of negative year-over-year GDP growth Cancellation of outstanding sovereign debt obligations that results in a total loss of investor capital

Answer: a Explanation: A is correct: 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…” Reference: Aswath Damodaran. Country Risk: Determinants, Measures and Implications – The 2017 Edition


88


52.

A refinery processes 8,000,000 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. b. c. d.

Buy 4,000 NYMEX RBOB futures contracts. Buy 5,333 NYMEX RBOB futures contracts. Sell 4,000 NYMEX RBOB futures contracts. Sell 5,333 NYMEX RBOB futures contracts.

Answer: d Explanation: The 3:2:1 crack spread represents the profit m ade 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 a factor of 42 (for 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). If the refinery processes 8,000,000 barrels per month, this implies that the equivalent of 5,333,333 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 required number of RBOB futures contracts to sell is: 5,333,333 bbl * 42 gallons per barrel / 42,000 gallons per contract, or 5,333 contracts. Reference: Vincent Kaminski. Energy Markets, Chapter 18.


89


53.

The evolving economics of refined products has led management at a refinery to strategically shift production away from gasoline to increase its production of distillates. Which of the following spread positions will best hedge production if distillates account for 40% of the refiner’s new product mix? a. b. c. d.

2:1:1 crack spread hedge 4:3:1 crack spread hedge 5:3:2 crack spread hedge 6:2:1 crack spread hedge

Answer: c 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 40% of their output they should change their hedge to map their new operational configuration. Middle distillates and gasoline (light distillate) will represent 40% and 60% of their output, respectively, therefore they should hedge their exposure by using a 5:3:2 crack spread hedge. Reference: Vincent Kaminski. Energy Markets, Chapter 18.


90


54.

Assume two 100 MW generators supply power to the grid, in an energy at a cost of USD 50.00/MWh and USD 90.00/MWh, respectively. Peak hourly demand is assumed to be uniformly distributed between 70 MWh and 190 MWh. Calculate the probability that the market clearing price during a peak hour is less than USD 55.00/MWh. a. b. c. d.

25.0% 29.2% 32.2% 35.0%

Answer: a Explanation: The electricity price is determined by the cost of power for highest cost generator providing electricity to the grid. Thus, the price can only be set below USD55/MWh when electricity demand is less than or equal to 100 MW, i.e. when the 50/MWh is the only one of the two generators providing energy to meet demand. Since demand is uniformly distributed P (Price < $55/MWh) = P(D <=100 MWh) = (100 MW - 70 MW) / (190 MW – 70 MW ) = 0.25. Reference: Michael Miller, Mathematics and Statistics for Financial Risk Management , 2nd Edition Chapter 2


91


55.

A crude oil producer has purchased 750 put options on Brent Crude oil futures at a strike price of USD 65/barrel. The position is currently delta neutral with a gamma of 0.0745 and a vega of 0.0265. The producer has identified an option contract with the following delta and gamma to hedge her position: • •

Delta: -0.045 Gamma: -0.0925

Which of the following combinations of transactions will most effectively neutralize gamma and delta? a. b. c. d.

Buy 604 options to neutralize gamma; buy 27 futures to neutralize delta. Buy 604 options to neutralize gamma; sell 27 futures to neutralize delta. Buy 931 options to neutralize gamma; buy 42 futures to neutralize delta. Buy 931 options to neutralize gamma; sell 42 futures to neutralize delta.

Answer: a Explanation: To hedge market risk in the position, the producer must first neutralize gamma by purchasing an appropriate number of put option contracts based on the following:

(Gamma of position / G amma of hedge) * Number of contracts, i.e. (-0.0745/0.0925) * 750, or 604 contracts. In other words, 0.805 of an option must be purchased to immunize gamma in each option contract. Once gamma is neutralized, the producer must purchase 27 Brent Crude oil futures contracts to neutralize the residual delta as follows: 0 - (0.805*-0.045) =+ 0.036 futures per option contract or buy 27 futures contracts. Reference: John C. Hull. Risk Management and Financial Institutions, 4th Edition , Chapter 8.


92


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 a ssumption 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

Answer: a Explanation: In order to keep this a stationary process and assure that the volatility s tays 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


93


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. b. c. d.

-0.15 -0.07 0.01 0.07

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 results in a positive basis. Reference: Vincent Kaminski. Energy Markets, Chapter 11.


94


58.

The following market prices for NYMEX Henry Hub futures are quoted at the close of trading on September 1 and November 1 respectively:

December January

Henry Hub Futures Price September 1 (USD/MMBtu)

Henry Hub Futures Price November 1 (USD/MMBtu)

4.235 4.365

4.579 4.279

On September 1 a natural gas trader expects the spread between the December and January Henry Hub futures closing price to widen over the next two months. How would the trader structure a calendar spread on September 1 to benefit from this view and what is the realized net profit or loss per contract on the position based on the November 1 closing prices? a. b. c. d.

Long December and short January futures; USD -7,140 Long January and short December futures; USD -4,300 Long December and short January futures; USD 4,300 Long January and short December futures; USD 7,140

Answer: b Explanation: Correct answer is b. A futures position taken with the expectation that the spread will widen assumes a purchase of the higher priced January contract at USD 4.365 and the sale of the lower priced December contract at USD 4.235. By November 1 the spread between the two contracts had actually narrowed by 0.43/MMBtu (so much that the spread is now negative), creating a loss of (0.43*10,000) or USD 4,300 per contract. Reference: Vincent Kaminski. Energy Markets, Chapter 4


95


59.

A risk analyst at a refinery is calculating the 10-day, 99% VaR on a natural gas position currently valued at USD 3,250,000. Using daily returns for natural gas prices over the past 12 months, the analyst’s current model applies an EWMA model with a lamda of 0.99 to estimate the VaR. Over the latest month, natural gas prices have fallen substantial and volatility has increased significantly. As result, the analyst changes the model’s lambda to 0.8 to recalibrate the volatility factor used in the VaR model. Applying the new volatility estimate will most likely cause the new VaR amount to: a. b. c. d.

Increase slightly relative to the original V aR. Increase sharply relative to the original VaR. Decrease slightly relative to the original VaR. Decrease sharply relative to the original VaR.

Answer: b Explanation: Decreasing the decay factor from 0.99 to 0.80 will place a substantially greater weight on more recent observations. Therefore, all else being equal, the standard deviation and VaR will increase too. Reference: John C. Hull. Risk Management and Financial Institutions, 4th Edition, Chapter 12.


96


60.

The risk committee of a global exploration and production company is evaluating an opportunity to expand its production business into the Canadian oil sands market. The project requires a large capital investment for bidding on several concessions and establishing local operations. When assessing strategic risk related to this expansion from an ERM perspective, which of the following actions would be most appropriate? a. b. c. d.

Estimate the most likely outcome and decide to expand if the return on investment in this case exceeds the firm’s cost of capital Compare the probability weighted distribution of potential returns from the new project to the firm’s hurdle rate Add the VaR of the proposed expansion to the VaR of the company’s existing operations to project the overall firm-wide VaR Decide to expand if the RAROC for the proposed expansion is greater than the project’s economic capital requirement

Answer: b Explanation: The most appropriate step in assessing strategic risk is to develop a distribution of the potential outcomes of the expansion and assess the probability of each outcome occurring. That way the firm will be able to assess the probability of “windfalls” (i.e. high profit outcomes) and extreme losses to better assess whether the proposed expansion would add value to the firm. This can be done by assessing whether the probability weighted outcome is greater than the firm’s hurdle rate. The firm would then have to assess whether the proposed investment is also allowable given its risk appetite and tolerance limits.

A is incorrect. This ignores the shape of the distribution of outcomes and the potential for extreme losses or profits. Even if the most likely outcome adds value, if there is a significant potential for extreme losses the project could still end up destroying value. C is incorrect. This option does not account for any diversification benefits from the proposed expansion. Since one of the main goals of ERM is to capture diversification benefits and assess risk from a firm-wide perspective, this choice is not correct. D is incorrect. RAROC is used to compare the expected return on the project to the company’s hurdle rate. Since economic capital is the denominator of RAROC, this would imply that a return of at least 100% is needed to accept the project, which is far too high. Reference: James Lam, Implementing Enterprise Risk Management – From Methods to Application , Chapter 15


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2018 Erp Practice Exam 2

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