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GLOBAL ASSOCIATION OF RISK PROFESS IONALS

Energy RiskProfessional (ERP)SampleQuestions

2010



© GARP, Global Association of Risk Professionals, Inc., 2010It is illegal to reproduce this material in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc. 1

ENERGY RISK PROFESSIONAL SAMPLE QUESTIONS

This document contains twenty (20) sample questions that model the

temperament of those that will be presented on the October 2010 Energy

Risk Professional (ERPTM) examination.

All candidates are advised to closely review the 2010 ERP Study Guide for

the primary and subtopics that will be covered in the October 2010 ERP

examination. As described in the 2010 ERP Study Guide, the examination

will cover physical operations and physical and financial markets for energy,

as well as risk management techniques in both areas. The topics selected by

the Energy Oversight Committee (EOC) reflect those that energy risk profes-

sionals working in practice today must master. The topics are reviewed

yearly to ensure the ERP Examination is kept timely and relevant.

ERP Examination Approach

The ERP is a practice-oriented examination. Its questions are derived from

a combination of science, industry practice, and theory, as well as “real-

world” work experience. Candidates are expected to understand both

physical and financial energy sectors, general and specific risk management

concepts and approaches, and how they are applied in an energy risk

professional’s day-to-day activities.

The ERP Examination is a comprehensive assessment, testing risk profes-

sionals on a number of energy-related risk management concepts and

approaches. One should note that it is very rare that an energy risk

professional will be faced with an issue that can immediately be slotted

into one category; in the real world, an energy risk professional must be

able to identify any number of risk-related issues and be able to manage

them effectively.

Readings

Questions for the ERP Examination are derived from the readings listed

under each topic, which are outlined in greater detail with the 2010

ERP Study Guide. These readings were selected by the ERP EOC to assist

candidates in their review of the subjects covered by the examination.

It is strongly suggested that candidates review these readings in depth

prior to sitting for the examination.

Sample Questions

This document contains a total of twenty (20) sample questions.

• 40% physical (8 questions total)

- Two representative questions from each section

• 60% financial (12 questions total)

- Two representative questions from each section




Energy RiskProfessional (ERP)SampleQuestions

2010



2010 ERP SAMPLE QUESTIONS: CANDIDATE ANSWER SHEET

a. b. c. d.

1.

2.

3.

4.

5.

6.

7.

8.

9.

10.

a. b. c. d.

11.

12.

13.

14.

15.

16.

17.

18.

19.

20.





© GARP, Global Association of Risk Professionals, Inc., 2010It is illegal to reproduce this material in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc4


1. Which of these elements is an example of operational risk mitigation in oil drilling?

a. Regular testing for quality control

b. Soliciting public opinion on proposed drilling sites

c. Installation of a blowout preventer system

d. Ensuring the counter party in the lease agreement has sound credit

2. Which of the following statements regarding Value-at-Risk is false?

a. VaR assumes the portfolio does not change over time.

b. VaR is a single number measure of risk.

c. VaR does not estimate the absolute worst-case scenario.

d. VaR models are best used to predict future market behavior.

3. On July 20, Merg Refining knows it will need to purchase 20,000 barrels of crude in November. On NYMEX, oil futures

contracts are traded for delivery every month. Thus, Merg decides to hedge using a mid-December contract. The futures price

on July 20 is $60.00/bbl. On November 12, Merg is ready to purchase their needed crude and closes out its futures contract

on that day; at this time the spot price is $62.00/bbl and the futures price is $61.10/bbl.

In this scenario, the effective price paid per barrel is

a. $61.10

b. $60.90

c. $62.10

d. $62.90

4. _____ risk in the natural gas market can be hedged with a _____.

a. Operational / futures contract

b. Counter-party / plain vanilla swap

c. Regulatory / letter of credit

d. Market price / forward contract





5. Which of the following are true for futures contracts?

I. As prices fluctuate, margin calls can be made any time.

II. Futures contracts are exchange traded derivatives.

III. To exit the commitment of a futures contract, a holder of a futures contract must sell the futures contract prior to the

settlement date.

IV. A holder of an option has the right, but not the obligation, to exercise that option, but the holder of a futures contract

has an obligation to fulfill the terms of the futures contract.

a. II, IV

b. II only

c. II, III, IV

d. I, III, IV

6. Given the following, simplified table of U.S. Gulf Coast refining margins at a given time, which is NOT true:

Refining Margins—$/bbl

Crude Price $/bbl Simple Complex Very Complex

Light Crude 21.00 .10 .30 .35

Medium Crude 20.00 (0.35) 0.65 1.52

Heavy Crude 15.00 (3.16) 3.60 4.60

a. Simple refineries break even more or less on light crude, but lose money handling heavier crudes.

b. Medium crudes are profitable in complex refineries but not in simple ones.

c. Complex refineries are highly profitable running heavy crude, but they may have difficulty competing for space against

very complex refineries running the same crude.

d. Heavy crude is too expensive and may have to come down in price to compete with medium and light crudes.

7. For the development of an off-shore drilling project, the _____ is the main determinant of cost.

a. basic engineering survey

b. reservoir type

c. cost associated with transporting equipment and bulk material

d. water depth





8. What measure of hedge effectiveness did FASB 133 recommend?

a. 60/40 offset ratio

b. 90/10 offset ratio

c. “highly effective” offset ratio

d. None of these

9. Taking into account a snapshot from the table below, one can calculate that the probability of a B2 rated bond defaulting in

the fourth year as _____, and survive until the end of year three is _____.

Default probability in %

Moody’s Rating Year

1 2 3 4 5

B1 4.680 8.3800 11.5800 13.8500 16.1200

B2 7.1600 11.6700 15.5500 18.1300 20.7100

B3 11.6200 16.6100 21.0300 24.0400 27.0500

Caa1 17.3816 23.2341 28.6386 32.4788 36.3137

a. 2.58%; 84.45%

b. 4.28%; 78.97%

c. 5.91%; 71.36%

d. 7.54%; 65.30%

10. Pipeline rates can be determined in a number of ways. The cost of alternative transportation method involves understanding

the rates charged by competing forms of transportation, including setting rates against costs of alternative forms of trans-

portation such as ship, barge, rail, and truck. Considering the above mentioned method, if the cost of shipping 1,000 bbl of

crude from Tuscon, AZ to St. Louis, MO via truck is $25/bbl, and by rail is $21/bbl, all things being equal, an ideal charge on

a pipeline with existing capacity to transport 1,000 bbl should be:

a. $23.00 - $25.00/bbl

b. $19.50 - $21.00/bbl

c. $24.50 - $25.50/bbl

d. $21.00 - $22.50/bbl





11. Rank, in order of increasing costs, single investments of the liquefied natural gas chain.

a. Natural gas exploration; Receiving terminal; LNG ship; Liquefaction plant

b. LNG ship; Natural gas exploration; Liquefaction plant; Receiving terminal

c. Natural gas exploration; Liquefaction plant; LNG ship; Receiving terminal

d. Receiving terminal; LNG ship; Natural gas exploration; Liquefaction plant

12. Development of coal-to-liquid production plants in the United States is risky because

a. Technology to deal with concomitant carbon dioxide emissions have yet to be developed.

b. Coal is a relatively scarce resource in the U.S. and would require major transportation infrastructure investments.

c. U.S. operators have limited experience with gasifying American coal.

d. Coal-to-liquid technology is virtually non-existent in the U.S. and worldwide.

13. Which of the following is NOT a method for managing credit-risk exposure within energy markets?

a. Clearing OTC energy derivatives

b. Obtaining credit risk insurance

c. Purchasing commodity futures

d. Securing a financial guarantee via an Irrevocable Standby Letter of Credit

14. On January 1, a European-type call option for WTI crude with a strike price of $60/bbl and an expiration date of July 1 is

priced at $3.90 per barrel. At the same time, July WTI futures are priced $55/bbl. The risk free interest is 8% per annum.

The price of a WTI European Put option with a strike of $60/bbl and matures in 6 months is closest to:

a. $5.50

b. $6.50c. $7.50

d. $8.50





15. You are trading in an electricity market, where the volatility of electricity generated by peak-period, gas fired plants is 28%and increasing. What volatility would you then expect from electricity generated from baseload coal?

a. Greater than 28%

b. Less than 28%

c. Unknowable

d. Equal to 28%

16. Emily Smith, ERP, manages the cost of jet fuel for a small charter airline company in the Northeastern United States. The

company is struggling, and a significant consideration for the company is to hedge against anticipated increases in fuel

costs in the coming six months. Due to the company’s poor financial standing—it has limited ability to raise cash and its

credit lines are very close to being completely drawn down; Emily’s ability to reduce the impact of adverse price movements

is largely limited. Given these constraints, which of the following alternatives could best mitigate the adverse effect of a

significant increase in jet fuel prices?

a. Buy out of money call options on jet fuel

b. Buy at the money call options on jet fuel

c. Enter into a long jet fuel futures position

d. Enter into a long jet fuel forward position

17. Which of the following is NOT a main driver behind investments in alternative energy projects?

a. Labor disputes

b. Oil and natural gas prices

c. Tax incentives

d. Public sentiment

18. The spot price volatility of WTI crude is 0.3, or 30%, and the spot price is $71.21. Assuming the return of WTI is normally

distributed with zero drift, over the next year one can roughly expect the price of WTI to be _____ 66% of the time.

a. $45.57 - $96.85

b. $49.85 - $94.18

c. $49.85 - $92.57

d. $45.57 - $94.96





19. You are estimating VaR for an energy portfolio that includes derivative positions. Due to a recent political event, you expectunprecedented volatility in energy markets in the coming days. Given this situation, which method would be preferred to

determine VaR?

a. Delta Normal

b. Historical simulation

c. Monte Carlo simulation

d. Deterministic model

20. The FERC and EPA Act of 2005 reasserts the Federal Energy Regulatory Commission’s roles in all of the following EXCEPT:

a. Supervising financial practices and corporate governance in energy markets

b. Supporting the principle of competition in wholesale power markets

c. Strengthening regulatory powers to ensure fair competition and avoid consumer exploitation

d. Developing a stronger energy infrastructure




Energy RiskProfessional (ERP)SampleQuestionsAnswers andExplanations

2010





1. Which of these elements is an example of operational risk mitigation in oil drilling?

a. Regular testing for quality control

b. Soliciting public opinion on proposed drilling sites

c. Installation of a blowout preventer system

d. Ensuring the counter party in the lease agreement has sound credit

Correct answer: c.

Reason: Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems, or

from external events. As another precaution against unusual and even catastrophic surges in wellbore pressure, every well

is fitted with a blowout preventer system, hence 3 is correct.

Reference: Leffler: Chapter 4, p. 59

a. is an example of quality control, hence incorrect.

b. is an example of mitigating legal or reputational risk, hence incorrect.

d. is an example of credit/counter party risk mitigation, hence incorrect.

2. Which of the following statements regarding Value-at-Risk is false?

a. VaR assumes the portfolio does not change over time.

b. VaR is a single number measure of risk.

c. VaR does not estimate the absolute worst-case scenario.

d. VaR models are best used to predict future market behavior.

Correct answer: d.

Reason: VaR uses some model of what constitutes normal market behavior. Since the future cannot be known (or there

would be no need to VaR) the model must be based on statistical assumptions for how the market will behave.

Reference: Leppard: Chapter 8, p. 195





3. On July 20, Merg Refining knows it will need to purchase 20,000 barrels of crude in November. On NYMEX, oil futurescontracts are traded for delivery every month. Thus, Merg decides to hedge using a mid-December contract. The futures price

on July 20 is $60.00/bbl. On November 12, Merg is ready to purchase their needed crude and closes out its futures contract

on that day; at this time the spot price is $62.00/bbl and the futures price is $61.10/bbl.

In this scenario, the effective price paid per barrel is

a. $61.10

b. $60.90

c. $62.10

d. $62.90

Correct answer: b.

Reason: The effective price paid (in dollars per barrel) is the final spot price less the gain on the futures, or

62.00 – 1.10 = 60.90

This can also be calculated as the initial futures price plus the final basis,

60.00 + 0.90 = 60.90

Reference: James: Chapter 13, p. 263

4. _____ risk in the natural gas market can be hedged with a _____.

a. Operational / futures contract

b. Counter-party / plain vanilla swap

c. Regulatory / letter of credit

d. Market price / forward contract

Correct answer: d.

Reason: If a forward contract is used to make or take delivery of the underlying commodity, then it has eliminated market

risk by locking in the price of the physical commodity. A long forward contract can effectively be “closed out” by selling a

contract for the same physical specification, location, volume and month before physical delivery commences; the mark-to-

market value of a forward contract tells us the value of doing so at the current market level.

Reference: Leppard: Chapter 4, p. 43





5. Which of the following are true for futures contracts?

I. As prices fluctuate, margin calls can be made any time.

II. Futures contracts are exchange traded derivatives.

III. To exit the commitment of a futures contract, a holder of a futures contract must sell the futures contract prior to the

settlement date.

IV. A holder of an option has the right, but not the obligation, to exercise that option, but the holder of a futures contract

has an obligation to fulfill the terms of the futures contract.

a. II, IV

b. II only

c. II, III, IV

d. I, III, IV

Correct answer: c.

Reason: II, III, and IV are true.

An energy derivative is a contract that is derived from an underlying energy related commodity. Such a contract may be an

agreement to trade a commodity at some future date, a futures contract being one example.

A futures contract is an obligation to either take or make delivery of a specified number of units (gallons, barrels, bushels,

ounces, etc.) of a given commodity at a specified time and location in the future.

Every contract is interchangeable, which is one of the preexisting conditions needed for a successful futures contract. The

existing contract is canceled out by an opposite transaction. If one sells it, one needs to buy to offset it. If one buys it, and

gets long, one needs to sell to offset it.

In any discussion of futures it is important to be aware that there are margin calls that need to be made immediately

and daily.

Reference: Beutel: Chapter 5, p. 48-50; Burger, Graeber and Schindlmayr: Chapter 2, p. 47, 51-2





6. Given the following, simplified table of U.S. Gulf Coast refining margins at a given time, which is NOT true:

Refining Margins—$/bbl

Crude Price $/bbl Simple Complex Very Complex

Light Crude 21.00 .10 .30 .35

Medium Crude 20.00 (0.35) 0.65 1.52

Heavy Crude 15.00 (3.16) 3.60 4.60

a. Simple refineries break even more or less on light crude, but lose money handling heavier crudes.

b. Medium crudes are profitable in complex refineries but not in simple ones.

c. Complex refineries are highly profitable running heavy crude, but they may have difficulty competing for space against

very complex refineries running the same crude.

d. Heavy crude is too expensive and may have to come down in price to compete with medium and light crudes.

Correct answer: d.

Reason: All of the above are true except for number four. In fact, the light crude may be too expensive and may have to

come down in price in order to compete with heavy crude.

Reference: Leffler: Chapter 20, p. 222

7. For the development of an off-shore drilling project, the _____ is the main determinant of cost.

a. basic engineering survey

b. reservoir type

c. cost associated with transporting equipment and bulk material

d. water depth

Correct answer: d.

Reason: The capital cost of developing an oil or gasfield may amount to several billion dollars. It is crucial that the key

parameters are identified and evaluated so that the project can be properly defined and its viability assessed, because some

of these parameters strongly influence the costs. Onshore, the nature of the terrain is the main determinant of costs.Offshore it is the water depth, which may be conventional (to 300 m), deep (to 1500 m) or ultra-deep (over 1500 m).

A basic engineering survey represents about 2% of the technical costs of an off-shore drilling project, while transporting

equipment and bulk material represents about 7.5% of the total cost. Reservoir parameters determine the number of wells

required, and whether water or gas injection will be needed during the lifetime of the field.

Reference: Editions Technip: Chapter 4, p. 135-7





8. What measure of hedge effectiveness did FASB 133 recommend?

a. 60/40 offset ratio

b. 90/10 offset ratio

c. “highly effective” offset ratio

d. None of these

Correct answer: c.

Reason: FASB has chosen to use a “highly effective” offset ratio as a measure of hedge effectiveness, rather than

specifying a numeric ratio.

If the fair value hedge is fully effective, the gain or loss on the hedging instrument, adjusted for the component, if any, of

that gain or loss that is excluded from the assessment of effectiveness under the entity’s defined risk management strategy

for that particular hedging relationship (as discussed in paragraph 63 in Section 2 of Appendix A), would exactly offset the

loss or gain on the hedged item attributable to the hedged risk. Any difference that does arise would be the effect of hedge

ineffectiveness, which consequently is recognized currently in earnings. The measurement of hedge ineffectiveness for a

particular hedging relationship shall be consistent with the entity’s risk management strategy and the method of assessing

hedge effectiveness that was documented at the inception of the hedging relationship, as discussed in paragraph 20(a).

Nevertheless, the amount of hedge ineffectiveness recognized in earnings is based on the extent to which exact offset is

not achieved. Although a hedging relationship must comply with an entity’s established policy range of what is considered

“highly effective” pursuant to paragraph 20(b) in order for that relationship to qualify for hedge accounting, that compli-

ance does not assure zero ineffectiveness. Section 2 of Appendix A illustrates assessing hedge effectiveness and measuring

hedge ineffectiveness. Any hedge ineffectiveness directly affects earnings because there will be no offsetting adjustment of

a hedged item’s carrying amount for the ineffective aspect of the gain or loss on the related hedging instrument.

Reference: FASB 133, p.18-19





9. Taking into account a snapshot from the table below, one can calculate that the probability of a B2 rated bond defaulting inthe fourth year as _____, and survive until the end of year three is _____.

Default probability in %

Moody’s Rating Year

1 2 3 4 5

B1 4.680 8.3800 11.5800 13.8500 16.1200

B2 7.1600 11.6700 15.5500 18.1300 20.7100

B3 11.6200 16.6100 21.0300 24.0400 27.0500

Caa1 17.3816 23.2341 28.6386 32.4788 36.3137

a. 2.58%; 84.45%

b. 4.28%; 78.97%

c. 5.91%; 71.36%

d. 7.54%; 65.30%

Correct answer: a.

Reason: The unconditional default probability of a B2 rated bond in year four is calculated as 18.13 – 15.55 = 2.58%.

The probability the bond will survive to end of year three is calculated as 100 – 15.55 = 84.45%. Each probability

represents a cumulative default probability or the probability of default by that year.

Reference: Burger: Chapter 6, p. 269-70





10. Pipeline rates can be determined in a number of ways. The cost of alternative transportation method involves understandingthe rates charged by competing forms of transportation, including setting rates against costs of alternative forms of trans-

portation such as ship, barge, rail, and truck. Considering the above mentioned method, if the cost of shipping 1,000 bbl of

crude from Tuscon, AZ to St. Louis, MO via truck is $25/bbl, and by rail is $21/bbl, all things being equal, an ideal charge on

a pipeline with existing capacity to transport 1,000 bbl should be:

a. $23.00 - $25.00/bbl

b. $19.50 - $21.00/bbl

c. $24.50 - $25.50/bbl

d. $21.00 - $22.50/bbl

Correct answer: b.

Reason: The cost of alternative transportation method involves understanding the rates charged by the competing forms

of transportation—ship, barge, rail, truck. The pipeline charge will be set equal to or slightly below those rates. Calculating

rates using this method can be very favorable for the pipeline owner, especially for long-distance transportation.

EOG Resources has paid as much as $25/bbl to ship crude by truck, but have switched to rail because this cost is just

uneconomical (Reuters: March 12, 2009).

Reference: Miesner and Leffler: Chapter 10, p. 221

11. Rank, in order of increasing costs, single investments of the liquefied natural gas chain.

a. Natural gas exploration; Receiving terminal; LNG ship; Liquefaction plant

b. LNG ship; Natural gas exploration; Liquefaction plant; Receiving terminal

c. Natural gas exploration; Liquefaction plant; LNG ship; Receiving terminal

d. Receiving terminal; LNG ship; Natural gas exploration; Liquefaction plant

Correct answer: a.

Reason: The heart of an LNG project and the largest single investment in the chain is the liquefaction plant. Figure 3-2 on

page 84 illustrates break-even costs for a greenfield LNG project off the U.S. east coast.

Reference: Tusiani: Chapter 3, p. 67-86





12. Development of coal-to-liquid production plants in the United States is risky because

a. Technology to deal with concomitant carbon dioxide emissions have yet to be developed.

b. Coal is a relatively scarce resource in the U.S. and would require major transportation infrastructure investments.

c. U.S. operators have limited experience with gasifying American coal.

d. Coal-to-liquid technology is virtually non-existent in the U.S. and worldwide.

Correct answer: c.

Reason: CTL production based on FT or MTG synthesis is ready for commercial development in the United States. There

is, however, some risk that first-of-a-kind FT or MTG CTL plants could experience severe performance shortfalls or other

operational problems, especially during their initial operating years. This risk stems from the limited commercial experience

in gasifying U.S. coals and the challenges associated with building a plant that is very large, highly integrated, and

technically complex.

Reference: Bartis, et al: Chapter 3, p. 41

13. Which of the following is NOT a method for managing credit-risk exposure within energy markets?

a. Clearing OTC energy derivatives

b. Obtaining credit risk insurance

c. Purchasing commodity futures

d. Securing a financial guarantee via an Irrevocable Standby Letter of Credit

Correct answer: c.

Reason: Methods for managing credit-risk exposure include: master netting; collateralization; financial guarantees; credit

insurance; credit derivatives; assignment; and clearing OTC energy derivatives. The purchase of commodity futures is a

hedging strategy.

Reference: James: Chapter 16, p. 319-21





14. On January 1, a European-type call option for WTI crude with a strike price of $60/bbl and an expiration date of July 1 ispriced at $3.90 per barrel. At the same time, July WTI futures are priced $55/bbl. The risk free interest is 8% per annum. The

price of a WTI European Put option with a strike of $60/bbl and matures in 6 months is closest to:

a. $5.50

b. $6.50

c. $7.50

d. $8.50

Correct answer: d.

Reason: This question relates two concepts—the put call parity and the relationship between the price of the physical

commodity and its representation as a commodity futures contract. The spot price of a commodity, S(t), is widely considered

as the most important indicator of future spot prices and such acts as the chief factor determining the shape of the futures

price curve. At maturity, the price of the physical, underlying, commodity and the financial commodity future, F(t,T) should

be equal to preclude arbitrage. Because of the equilibrium assumption, the convergence of physical and financial prices

holds true, which at expiration at time (T) can be expressed as

F(T, T) = S(T)

Up to expiration, i.e., where t<T, the equilibrium relationship between the spot price and the price of the futures contract

can be expressed by the well-known cost-of-carry relationship:

F(t, T) = S(t)e[ r ( t )+c(t ) -y (t ) ] (T- t ),

where, r(t) is the risk-free rate at t, c(t) are the general storage, warehousing and other, similar, costs associated with

holding the physical commodity in storage, and y(t) is the convenience yield earned from having the physical commodity

in possession. The above relationship implies that the current price of the commodity is $52.84, 55 * exp(-0.04) = $52.84,

assuming that storage costs are zero and there is no convenience yield.

The traditional put-call parity can be expanded to include the futures contract as the underlying, and reads:

C(t,T) – P(t,T) = S(t) – K(T) e- r ( t ) (T- t ),

K(T) the strike price, S(t) the current price of the underlying, and C(t,T) and P(t,T) the prices of call and put option

respectively, at t with a strike price of K(T). The current price of the underlying, S(t), WTI, is not given. Substituting in theput-call parity relation yields

3.90 – P(t,T) = 55 e ( -0 .08 x 0 .5 ) – 60 e( -0 .08 x 0 .5 )

Which when solved for P gives $8.70.

Reference: Geman: Chapter 2, p. 10-11, 15-16





15. You are trading in an electricity market, where the volatility of electricity generated by peak-period,gas fired plants is 28% and increasing. What volatility would you then expect from electricity

generated from baseload coal?

a. Greater than 28%

b. Less than 28%

c. Unknowable

d. Equal to 28%

Correct answer: b.

Reason: The question implies the reader understands that in all likelihood the baseload material used for electricity

generation is coal (see below), and that natural gas trades higher than coal. In this case, baseload coal is being used to

provide a constant energy and natural gas is being used to supplement peak load energy demands.

Of all the fossil fuels, coal is the most widely used. According to the EIA, during 2004, 50% of the nation’s electric power

was generated at coal-fired plants. Based upon 2004 net generation shares by energy source, nuclear and natural gas are

next in popularity after coal.

While base load is constant and fairly predictable, electric utilities must be prepared at all times for the sometimes unpre-

dictable demand seasonal weather changes cause. An increase in demand is referred to as peak load and intermediate load.

Reference: Warkentin-Glenn: chapter 1, p. 10, 17





16. Emily Smith, ERP, manages the cost of jet fuel for a small charter airline company in the Northeastern United States.The company is struggling, and a significant consideration for the company is to hedge against anticipated increases in

fuel costs in the coming six months. Due to the company’s poor financial standing—it has limited ability to raise cash and

its credit lines are very close to being completely drawn down; Emily’s ability to reduce the impact of adverse price move-

ments is largely limited. Given these constraints, which of the following alternatives could best mitigate the adverse effect

of a significant increase in jet fuel prices?

a. Buy out of money call options on jet fuel

b. Buy at the money call options on jet fuel

c. Enter into a long jet fuel futures position

d. Enter into a long jet fuel forward position

Correct answer: a.

Reason: There are some companies whose credit risk is such that it is much easier for them to buy options rather than sell

options. This is because the option buyer normally pays the upfront premium one or two business days after transacting,

and thus poses a far lower credit risk than an option seller, who does not settle his obligations until maturity (or upon early

exercise). Given smaller credit exposure, companies of lesser credit-standing can normally transact on equal terms with top

credits when they are pure options buyers. With limited credit lines, futures and forwards (assuming they are margined)

pose a potential collateral requirement in the future which would be a problem for the company in the example.

Typical examples of companies using this kind of option strategy might be a privately owned shipping company which buys

an OTC fuel oil cap as a hedge against an increase in bunker fuel prices, or a small charter airline that buys a jet fuel cap.

Typically, these would settle in cash against the monthly average price of an appropriate index.

In this scenario, an out-of-the-money call should be cheaper than an at-the-money call. On the other hand, it only protects

against significant price movements, and even then only a small portion of the adverse movement's negative effects will be

offset.

For a futures position, the cash outlay would be smaller for the option than the futures margin position

To trade forward, you should need to post collateral or reduce counterparty credit risk for the other party.

Reference: Kaminski: Chapter 2, p. 67





17. Which of the following is NOT a main driver behind investments in alternative energy projects?

a. Labor disputes

b. Oil and natural gas prices

c. Tax incentives

d. Public sentiment

Correct answer: a.

Reason: The following items, while not comprehensive, serve as a good starting point for understanding alternative energy

drivers: oil and natural gas prices; taxes, politics, and regulations; geopolitical environment; technological advancements;

supply chain costs; and sentiment.

Reference: Fisher Investments: Chapter 6, p. 167-8

18. The spot price volatility of WTI crude is 0.3, or 30%, and the spot price is $71.21. Assuming the return of WTI is normally

distributed with zero drift, over the next year one can roughly expect the price of WTI to be _____ 66% of the time.

b. $45.57 - $96.85

b. $49.85 - $94.18

c. $49.85 - $92.57

d. $45.57 - $94.96

Correct answer: c.

Reason: Volatility roughly represents the percentage of the price range within which we can expect to see the prices 66%

of the time. For example, if the spot price volatility is 0.1, or 10%, and if the spot price is currently $20, then over the next

year we can—very roughly—expect the price to be within the $18 to $22 range 66% of the time.

For this problem, $49.85 and $92.57 represent the plus/minus 30% volatility range off of $71.21.

Reference: Pilopovic: Chapter 8, p. 217





19. You are estimating VaR for an energy portfolio that includes derivative positions. Due to a recent political event, you expectunprecedented volatility in energy markets in the coming days. Given this situation, which method would be preferred to

determine VaR?

a. Delta Normal

b. Historical simulation

c. Monte Carlo simulation

d. Deterministic model

Correct answer: c.

Reason:

a. Delta Normal would not work because there are assets with non-linear payoff functions, hence I incorrect.

b. Historical simulation would not work because unprecedented volatility is expected, hence incorrect.

c. Monte Carlo simulation is the only justifiable answer. Monte Carlo simulations can also be used in option price

valuation. This technique simulates either the underlying market prices or the option underlying prices at the time of

option expiration—it is an excellent pricing technique, as all the complexities of multivariable markets can be

factored in.

d. Deterministic model is invented, hence incorrect.

Reference: Pilopovic: Chapter 9, p. 265

20. The FERC and EPA Act of 2005 reasserts the Federal Energy Regulatory Commission’s roles in all of the following EXCEPT:

a. Supervising financial practices and corporate governance in energy markets

b. Supporting the principle of competition in wholesale power markets

c. Strengthening regulatory powers to ensure fair competition and avoid consumer exploitation

d. Developing a stronger energy infrastructure

Correct answer: a.

Reason: Supervising financial practices and corporate governance are powers granted under the Sarbanes-Oxley Act of

2002 and applies to all corporations and industries, not just those in energy markets.

Reference: FERP & EPA Act 2005



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