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2015
ERP
Practice
Exam 4PM SessionFinancial25 Questions
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ERP Practice Exam 4
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1
ERP Practice Exam 4 Candidate Answer Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3
ERP Practice Exam 4 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5
ERP Practice Exam 4 Answer Sheet/Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .15
ERP Practice Exam 4 Explanations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .17
TABLE OF CONTENTS
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ERP Practice Exam 4
Introduction
The ERP Exam is a practice-oriented examination. Its ques-
tions are derived from a combination of theory, as set forthin the core readings, and real-world work experience.
Candidates are expected to understand energy risk man-
agement concepts and approaches and how they would
apply to an energy risk managers day-to-day activities.
The ERP Exam is also a comprehensive examination,
testing an energy risk professional on a number of risk man-
agement concepts and approaches. It is very rare that an
energy risk manager will be faced with an issue that can
immediately be slotted into just one category. In the real
world, an energy risk manager must be able to identify any
number of risk-related issues and be able to deal with them
effectively.
The ERP Practice Exam 4 has been developed to aid
candidates in their preparation for the ERP Exam. This
practice exam is based on a sample of actual questions
from past ERP Exams and is suggestive of the questions
that will be in the 2015 ERP Exam.
The ERP Practice Exam 4 contains 25 multiple choice
questions. The 2015 ERP Exam will consist of a morning
and afternoon session, each containing 70 multiple choice
questions. The practice exam is designed to be shorter to
allow candidates to calibrate their preparedness for the
exam without being overwhelming.
The ERP Practice Exam 4 does not necessarily cover
all topics to be tested in the 2015 ERP Exam. For a com-
plete list of topics and core readings, candidates should
refer to the 2015 ERP Exam Study Guide. Core readings
were selected in consultation with the Energy Oversight
Committee (EOC) to assist candidates in their review of the
subjects covered by the exam. Questions for the ERP Exam
are derived from these core readings in their entirety. As
such, it is strongly suggested that candidates review all core
readings listed in the 2015 ERP Study Guide in-depth prior
to sitting for the exam.
Suggested Use of Practice Exams
To maximize the effectiveness of the practice exams, candi-
dates are encouraged to follow these recommendations:
1.Plan a date and time to take the practice exam.
Set dates appropriately to give sufficient study/review
time for the practice exam prior to the actual exam.
2.Simulate the test environment as closely as possible.
Take the practice exam in a quiet place.
Have only the practice exam, candidate answer
sheet, calculator, and writing instruments (pencils,
erasers) available.
Minimize possible distractions from other people,
cell phones, televisions, etc.; put away any study
material before beginning the practice exam.
Allocate two minutes per question for the practice
exam and set an alarm to alert you when a total of
50 minutes have passed Complete the entire exam but
note the questions answered after the 50-minute mark.
Follow the ERP calculator policy. Candidates are only
allowed to bring certain types of calculators into the
exam room. The only calculators authorized for use
on the ERP Exam in 2015 are listed below, there will
be no exceptions to this policy. You will not be allowed
into the exam room with a personal calculator other
than the following: Texas Instruments BA II Plus
(including the BA II Plus Professional), Hewlett Packard
12C (including the HP 12C Platinum and the Anniversary
Edition), Hewlett Packard 10B II, Hewlett Packard 10B II+
and Hewlett Packard 20B.
3.After completing The ERP Practice Exam 4
Calculate your score by comparing your answer
sheet with the practice exam answer key. Only
include questions completed within the first 50
minutes in your score.
Use the practice exam Answers and Explanations to
better understand the correct and incorrect answers
and to identify topics that require additional review.
Consult referenced core readings to prepare forthe exam.
Remember: pass/fail status for the actual exam is
based on the distribution of scores from all candi-
dates, so use your scores only to gauge your own
progress and level of preparedness.
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Practice Exam 4
Answer Sheet
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ERP Practice Exam 4
a. b. c. d.
1.
2.
3.
4.
5.
6.
7.
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12.
13.
14.
15.
16.
17.
a. b. c. d.
18.
19.
20.
21.
22.
23.
24.
25.
Correct way to complete
1.
Wrong way to complete
1.
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Questions
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ERP Practice Exam 4
1. An independent refinery has purchased a 3-month cap to hedge its crude oil supply requirement for the next
three months. The cap is written on 180,000 barrels of crude oil per month with a strike price of USD
63.50/bbl and premium of USD 1.80/bbl. The contract requires monthly settlement against the average frontmonth NYMEX WTI contract. Using the average monthly NYMEX WTI closing prices below, calculate the net
profit required to the refinery in settling the cap.
Month 1: USD 65.10
Month 2: USD 62.30
Month 3: USD 69.80
a. USD 450,000
b. USD 510,000
c. USD 720,000
d. USD 1,038,000
2. The economics of forward price formation in which energy commodity market is the least affected by the
concept of convenience yield?
a. Electricity
b. Heating oil
c. Jet fuel
d. Natural gas
3. A Texas based refiner purchases NYMEX WTI futures contracts that lock in a price for its crude oil supply for the
next three months. The refiner executes an Exchange Futures for Physical (EFP) contract to ensure physical delivery
of crude at the Port of Houston. How will the refiner report the EFP transaction under the terms of Dodd-Frank?
a. The refiner is exempt from reporting the EFP under Dodd-Frank.
b. The refiner must report the notional value of the underlying physical crude oil.
c. The refiner must first register as a swap dealer before entering into an EFP contract.
d. The refiner must report the market value of the EFP as a swap at the time it is purchased.
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ERP Practice Exam 4
4. A Texas refinery is negotiating a 2-year OTC crude oil swap with a local crude oil producer in early December
2013, to be cleared through ICE with the following basic terms:
Fixed payer (buyer): Refiner
Floating payer (seller): Producer
Volume: 200,000 barrels
Fixed Price: TBD
Floating Price: Closing ICE Brent Futures Price on February 15, 2014 and 2015
At the time of trade execution, the 1-year and 2-year Brent futures prices are USD 102.65 and USD 104.28, and
the annual zero-coupon bond yields are 1.5% and 2.0% respectively. Consider the following expression:
x y z z
1.02+
1.02752=
1.02=
1.02752 = w
Which variable corresponds to the 2-year swap price?
a. w
b. x
c. y
d. z
5. Acme Plastics is a large manufacturing plant that uses crude oil as a feedstock for their manufacturing
processes. Acme decides to enter into a forward swap transaction to secure the 80,000 barrels of oil they will
need for each of the next two years. The swap has the following terms:
Price of crude oil in year one: USD 91/bbl
Price of crude oil in year two: USD 104/bbl
One-year zero coupon bond yield: 4%
Two-year zero coupon bond yield: 4.5%
Swap payment terms: two equal annual payments
What is the amount per barrel (in USD) Acme will pay on this swap?
a. 91.46
b. 93.51
c. 97.50
d. 101.66
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ERP Practice Exam 4
Questions 6-7 use the information below
In early March 2014 the spot price of Brent crude oil is USD 107.90 and estimated monthly crude oil storagecosts are USD 0.75/bbl. Traders are using the following market data to identify potential market opportunities.
Brent crude oil futures contract prices:
October 2014: USD 112.65
October 2015: USD 104.86
US Treasury zero-coupon bond yields:
March 2014 through September 2014: 2.50%
October 2015: 3.75%
6. The breakeven forward price (is USD) required for a 6-month storage arbitrage to be profitable assuming stor-
age costs are paid at the beginning of each month with no market convenience yield is approximately:
a. 111.09
b. 113.79
c. 115.73
d. 118.53
7. What best approximates (in USD) the zero coupon bond position required to synthetically replicate a long
18-month forward position on 250,000 barrels of Brent crude oil?
a. 24,781,000
b. 25,982,000
c. 26,270,000
d. 27,732,000
8. You hold a large position of deep in-the-money put options on NYMEX Crude Oil Futures. In the past week,
NYMEX Crude Oil Futures have risen sharply, causing the gamma of the position to become more negative.
What action can you take to increase the gamma of the position the most?
a. Sell at-the-money options
b. Buy at-the-money options
c. Sell out-of-the money options
d. Buy out-of-the-money options
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ERP Practice Exam 4
9. Use the temperature data below to calculate Cooling Degree Days (CDD) for a 7-day period:
High Low AverageTemperature Temperature Temperature
71F 62F 66.5F
75F 63F 69.0F
72F 65F 68.5F
69F 67F 68F
64F 61F 62.5F
65F 59F 62F
64F 58F 61F
a. 9.5
b. 12
c. 14.5d. 17
10. A credit analyst is evaluating the liquidity of an integrated petroleum producer to assess its ability to meet
scheduled debt payments. The analyst has the following information from the producers most recent quarterly
financial statement:
USD
Sales and other operating income 9,347,000
Cost of goods sold 1,316,000Depreciation and amortization expense 1,543,000
Capital expenditures and investments 876,000
Pre-tax operating income 781,000
Income tax paid 297,000
Net operating profit after taxes 484,000
Calculate the firms free cash flow for the most recent quarter.
a. USD -392,000
b. USD -95,000
c. USD 1,151,000
d. USD 2,027,000
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ERP Practice Exam 4
11. An airline uses NYMEX Ultra-Low Sulfur Diesel (ULSD) futures contracts to hedge its short jet fuel exposure.
Use the volatility and correlation data below to calculate the minimum variance hedge ratio.
Jet fuel price volatility: 18.73%
ULSD futures price volatility: 16.54%
Correlation between jet fuel and ULSD futures price returns: 0.823
a. 0.727
b. 0.883
c. 0.932
d. 1.132
12. Consider a netting set containing six equal counterparty exposures totaling GBP 3,600,000. The average
correlation between the positions is 0.15 and the future values of the exposures are normally distributed.
What is the best estimate for the expected net exposure?
a. GBP 794,000
b. GBP 1,273,000
c. GBP 1,944,000
d. GBP 3,112,000
13. The following table summarizes the 4-year implied probability of default associated with four midsize oil
exploration and production companies.
Company Year 1 Year 2 Year 3 Year 4
Company A 0.04% 0.17% 0.37% 0.53%
Company B 0.42% 1.05% 1.61% 2.32%
Company C 4.68% 8.41% 11.6% 13.8%
Company D 26.5% 33.1% 39.0% 44.2%
Which company is most likely to have a Moodys/Standard & Poors rating of B1/B+?
a. Company Ab. Company B
c. Company C
d. Company D
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ERP Practice Exam 4
14. A credit analyst is using the following information to assess a bond investment:
Exposure: USD 32,500,000 Recovery rate: 36%
Default probability: 8%
Credit spread: 4.5%
What is the bonds expected loss?
a. USD 787,500
b. USD 1,664,000
c. USD 2,625,000
d. USD 3,375,000
15. A credit risk analyst is evaluating a new one-year bond priced at par that pays an annual coupon. The bond
has a default probability of 12% with an estimated recovery rate of 40%. Assuming the analyst is risk neutral
and the 1-year risk free rate is 2.5%, what is the minimum coupon she would be willing to accept to invest in
the bond?
a. 7.80%
b. 8.18%
c. 10.68%
d. 11.02%
16. Assume an energy commodity position has an average 10-day price return of 0.75% and a daily standard devi-
ation of 1.25%. If daily price returns are independent and normally distributed, what is the portfolios 10-day,
95% VaR?
a. 5.75%
b. 6.27%
c. 6.43%
d. 7.00%
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17. Use data from the credit report below to approximate the original exposure on the underlying bond position.
Obligor: XYZ Energy Recovery rate: 32%
Loss given default: USD 5,850,000
Expected loss: USD 3,910,500
a. USD 4,620,000
b. USD 6,174,000
c. USD 8,603,000
d. USD 11,197,000
18. A crude oil trader holds a long position in 100 call options on Brent Crude oil futures. The trader has identified
a second option on the same underlying contract that can be used to hedge market risk in her position.
What combination of the hedge option and the underlying futures contract will best neutralize the delta and
gamma of the traders position assuming the following market risk characteristics for the positions:
Long Option Hedge Option
Delta 0.613 -0.55
Gamma 0.0723 -0.0950
a. Buy 76 options and sell 19 futures contracts.
b. Sell 76 options and buy 19 futures contracts.
c. Sell 111 options and buy 3 futures contracts.
d. Buy 111 options and buy 3 futures contracts.
19. The following table represents the distribution of operational loss events from a sample of drilling companies
over a 6-month period:
Loss Events Percentage of Observations
0 18%
1 36%
2 29%
3 13%
4 4%
Calculate the standard deviation for the distribution of operational loss events assuming a mean of 1.49.
a. 1.05
b. 1.11
c. 1.22
d. 1.34
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ERP Practice Exam 4
20. A risk analyst has performed a regression analysis on ICE National Balancing Point (NBP) natural gas spot
price returns over the past 500 days in order to estimate the parameters for a simple mean reversion model.
The regression analysis includes the following coefficients for a linear relationship where:
y = 0.0285 x (Log of daily NBP Spot Prices) + 0.0188
Using terms from the linear relationship above, what is the best estimate of the mean reversion rate for NBP
natural gas spot prices?
a. 2
b. 9
c. 14
d. 21
21. Which of the following best describes the relationship between risk-neutral default probabilities and historical
default probabilities?
a. Theoretical default probabilities are typically higher than historical default probabilities due to liquidity
risk premiums
b. Historical default probabilities are typically higher than theoretical default probabilities due to negative
skew in bond returns
c. Theoretical default probabilities are typically higher than historical default probabilities for investment
grade credits and lower than historical default probabilities for non-investment grade credits
d. Historical default probabilities are typically higher than theoretical default probabilities for investment
grade credits and lower than theoretical default probabilities for non-investment grade credits
22. Which of the following mitigation actions, if taken by a central counterparty, will most likely increase risk on
an exchange traded futures contract?
a. Invoke netting agreements on contracts that are in default.
b. Reduce margin requirements on contracts with low volatility and high liquidity.
c. Auction the right to replace contracts that are in default.
d. Increase margin requirements on contracts with large, highly concentrated positions.
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23. To hedge the price exposure to its future production, power generator X is entering into a fixed price forward
sale contract with a load serving entity Y. Which of the following factors is least relevant for the evaluation of
Xs expected loss of its credit risk exposure to Y?
a. Ys credit rating
b. Xs target credit rating
c. Contractual payment term for X and Y to settle electric power delivered
d. Bilateral margining agreement between X and Y
24. The proper application of Key Performance Indicators (KPIs) and Key Risk Indicators (KRIs) in the pursuit of
an organizations risk management objectives is best described as:
a. The use of KPIs exclusively to develop an effective forward looking assessment of trends in operational
risk factors.
b. The integration of KPI objectives and KRI limits to create a single comprehensive risk-weighted metric.
c. The monitoring of KRIs to assess shifts in risk exposure and adjustment of business strategy and
operational procedures to better meet return on risk objectives identified by KPIs.
d. The replacement of KPIs with KRIs and adjustment of company-wide risk capital allocations to account
for the change in risk monitoring procedures.
25. A new exploration company is formed to develop and produce oil in the Arctic. How will the company most
likely implement quantitative and qualitative techniques in its risk management process?
a. Develop an integrated qualitative/quantitative risk strategy from the outset, since each technique is
incomplete when used in isolation
b. Develop a strategy based on the relative qualitative or quantitative experience of the management team
since either can be an effective risk management technique
c. Start with qualitative techniques since they are easier to devise and help provide a depth of information;
adopt quantitative techniques as capabilities develop
d. Start with quantitative techniques since they provide empirical data on degrees of risk exposure; adopt
qualitative techniques as operational experience grows
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a. b. c. d.
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2.
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17.
a. b. c. d.
18.
19.
20.
21.
22.
23.
24.
25.
Correct way to complete
1.
Wrong way to complete
1.
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Explanations
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ERP Practice Exam 4
1. An independent refinery has purchased a 3-month cap to hedge its crude oil supply requirement for the next
three months. The cap is written on 180,000 barrels of crude oil per month with a strike price of USD
63.50/bbl and premium of USD 1.80/bbl. The contract requires monthly settlement against the average frontmonth NYMEX WTI contract. Using the average monthly NYMEX WTI closing prices below, calculate the net
profit required to the refinery in settling the cap.
Month 1: USD 65.10
Month 2: USD 62.30
Month 3: USD 69.80
a. USD 450,000
b. USD 510,000
c. USD 720,000
d. USD 1,038,000
Answer: a
Explanation: The correct answer is a. By selling a cap, if the settlement price of crude oil is above the strike
price in a given month, the difference between the prices must be paid to the refinery. In this case, the first
and third months are above the strike price; the difference for month 1 is USD 1.60, the difference for month 3
is USD 6.30. Multiplied by the contract size of 180,000/bbl per month gives totals of USD 288,000 and USD
1,134,000 respectively for a total of USD 1,422,000, we then must subtract the premium paid for the cap (USD
1.80 x 180,000 bbl x 3 months = 972,000) from the cap total for a net settlement payment of USD 450,000.
Note: no payment is made in month 2 because the settlement price (USD 62.30) is below the strike price
(USD 63.50), though the cap premium is still paid for month 2.
Reading reference (new): IEA, The Mechanics of the Derivatives Markets: What They Are and How They
Function. (Special Supplement to the Oil Market Report, April 2011).
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2. The economics of forward price formation in which energy commodity market is the least affected by the
concept of convenience yield?
a. Electricity
b. Heating oil
c. Jet fuel
d. Natural gas
Answer: a
Explanation: The correct answer is a. Convenience yield is a theoretical framework often used to explain back-
wardation in forward energy commodity prices. While most practitioners argue that convenience yield is irrel-
evant, 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 which cannot be reliably
stored, like electricity, would naturally not exhibit a convenience yield.
Reading reference: Vincent Kaminski. Energy Markets. Chapter 4 The instruments, pg. 134-138.
3. A Texas based refiner purchases NYMEX WTI futures contracts that lock in a price for its crude oil supply for the
next three months. The refiner executes an Exchange Futures for Physical (EFP) contract to ensure physical delivery
of crude at the Port of Houston. How will the refiner report the EFP transaction under the terms of Dodd-Frank?
a. The refiner is exempt from reporting the EFP under Dodd-Frank.
b. The refiner must report the notional value of the underlying physical crude oil.
c. The refiner must first register as a swap dealer before entering into an EFP contract.
d. The refiner must report the market value of the EFP as a swap at the time it is purchased.
Answer: a
Explanation: The correct answer is a. The CFTC determined that a swap of this nature (a physical exchange
transaction) is conducted so that the party engaging in the transaction may take physical delivery of the
contracted commodity. The transaction therefore is considered part of a physical settlement and not a finan-
cial swap transaction therefore it is exempt from D-F reporting requirements.
Reading reference: Gordon Goodman. Swaps: Dodd-Frank Memories.
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4. A Texas refinery is negotiating a 2-year OTC crude oil swap with a local crude oil producer in early December
2013, to be cleared through ICE with the following basic terms:
Fixed payer (buyer): Refiner
Floating payer (seller): Producer
Volume: 200,000 barrels
Fixed Price: TBD
Floating Price: Closing ICE Brent Futures Price on February 15, 2014 and 2015
At the time of trade execution, the 1-year and 2-year Brent futures prices are USD 102.65 and USD 104.28, and
the annual zero-coupon bond yields are 1.5% and 2.0% respectively. Consider the following expression:
x y z z
1.02+
1.02752=
1.02=
1.02752 = w
Which variable corresponds to the 2-year swap price?
a. w
b. x
c. y
d. z
Answer: d
Explanation: The correct answer is d. The swap price is the annual fixed payment required to solve for the value
of a 2-year prepaid swap using the assumed forward Brent prices and 1 and 2-year zero-coupon bond rates.
In this case the total value of the swap, w, is equal to = (115.87/1.02) + (117.05)/(1.0275 2) = 224.47
Using this value, we can then solve for the swap price z which solves the following equation: (z / 1.02) +
( z / 1.02752) = 224.47, which yields 116.45.
Reading reference: IEA, The Mechanics of the Derivatives Markets: What They are and How They Function.
(Special Supplement to the Oil Market Report, April 2011).
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5. Acme Plastics is a large manufacturing plant that uses crude oil as a feedstock for their manufacturing
processes. Acme decides to enter into a forward swap transaction to secure the 80,000 barrels of oil they will
need for each of the next two years. The swap has the following terms:
Price of crude oil in year one: USD 91/bbl
Price of crude oil in year two: USD 104/bbl
One-year zero coupon bond yield: 4%
Two-year zero coupon bond yield: 4.5%
Swap payment terms: two equal annual payments
What is the amount per barrel (in USD) Acme will pay on this swap?
a. 91.46
b. 93.51
c. 97.50
d. 101.66
Answer: a
Explanation: The correct answer is a. To calculate the payment, each year must be factored by the zero
coupon bond yield for the given year:
91/1.04+ 104/1.045^2 =182.91
Dividing this into two equal payments gives an answer of USD 91.46/bbl
Reading reference: IEA, The Mechanics of the Derivatives Markets: What They Are and How They Function.
(Special Supplement to the Oil Market Report, April 2011), pages 26 and 27.
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ERP Practice Exam 4
Questions 6-7 use the information below
In early March 2014 the spot price of Brent crude oil is USD 107.90 and estimated monthly crude oil storagecosts are USD 0.75/bbl. Traders are using the following market data to identify potential market opportunities.
Brent crude oil futures contract prices:
October 2014: USD 112.65
October 2015: USD 104.86
US Treasury zero-coupon bond yields:
March 2014 through September 2014: 2.50%
October 2015: 3.75%
6. The breakeven forward price (is USD) required for a 6-month storage arbitrage to be profitable assuming stor-
age costs are paid at the beginning of each month with no market convenience yield is approximately:
a. 111.09
b. 113.79
c. 115.73
d. 118.53
Answer: b
Explanation: The correct answer is b.
Minimum 6-month forward price = [USD 107.90 * exp (0.025)*(6/12)] + (Future value of storage (USD 4.53) = 113.79
Reading reference: Robert McDonald, Fundamentals of Derivatives Markets 3rd Edition, Chapter 6.
7. What best approximates (in USD) the zero coupon bond position required to synthetically replicate a long
18-month forward position on 250,000 barrels of Brent crude oil?
a. 24,781,000
b. 25,982,000
c. 26,270,000
d. 27,732,000
Answer: a
Explanation: The correct answer is a. The formula to solve is:
S0 = F0e-rT
S0 = 250,000*104.86 * e(-0.0375*1.5) = 24,781,112
Reading reference: Robert McDonald, Derivatives Markets, 3rd Edition, Chapter 6, pages 189-191.
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ERP Practice Exam 4
8. You hold a large position of deep in-the-money put options on NYMEX Crude Oil Futures. In the past week,
NYMEX Crude Oil Futures have risen sharply, causing the gamma of the position to become more negative.
What action can you take to increase the gamma of the position the most?
a. Sell at-the-money options
b. Buy at-the-money options
c. Sell out-of-the money options
d. Buy out-of-the-money options
Answer: b
Explanation: Gamma is defined as the rate of change in an options delta per move in the underlying. Because
delta is defined as the rate of change in an options price per move in the underlying, delta is very low for
deep out-of-the-money options and very high for deep-in the money options. Delta changes most rapidly
when an option is at-the-money, so at-the-money options would have the highest gamma as well.
Reading reference: John c. Hull. Risk Management and Financial Institutions, 3rd Edition, Chapter 7.
9. Use the temperature data below to calculate Cooling Degree Days (CDD) for a 7-day period:
High Low AverageTemperature Temperature Temperature
71F 62F 66.5F
75F 63F 69.0F
72F 65F 68.5F
69F 67F 68F
64F 61F 62.5F
65F 59F 62F
64F 58F 61F
a. 9.5
b. 12
c. 14.5
d. 17
Answer: b
Explanation: The correct answer is b. Cooling Degree Days are the difference between the daily average
temperatures less 65F, if more than 65 degrees. The average temperatures: 66.5, 69, 68.5, 68, 62.5, 62 and 61,
for a total of 12 CDDs for the week.
Reading reference: Robert McDonald, Derivatives Markets, 3rd Edition, Chapter 6.
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ERP Practice Exam 4
10. A credit analyst is evaluating the liquidity of an integrated petroleum producer to assess its ability to meet
scheduled debt payments. The analyst has the following information from the producers most recent quarterly
financial statement:
USD
Sales and other operating income 9,347,000
Cost of goods sold 1,316,000
Depreciation and amortization expense 1,543,000
Capital expenditures and investments 876,000
Pre-tax operating income 781,000
Income tax paid 297,000
Net operating profit after taxes 484,000
Calculate the firms free cash flow for the most recent quarter.
a. USD -392,000
b. USD -95,000
c. USD 1,151,000
d. USD 2,027,000
Answer: c
Explanation: The correct answer is c. Free cash flow is equal to operating cash flow minus capital expendi-
tures and investments. Operating cash flow is equal to net operating profit after taxes plus depreciation and
amortization. So FCF would be 484 + 1,543 876 = 1,151,000.
Answer a subtracts capex from NOPAT but forgets to add D&A
Answer b subtracts capex from pre-tax operating income but forgets to add D&A.
Answer d is operating cash flow and forgets to subtract capex.
Reading reference: Simkins and Simkins, eds. Energy Finance and Economics: Analysis and Valuation, Risk
Management and the Future of Energy. Chapter 9, p. 189-195.
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11. An airline uses NYMEX Ultra-Low Sulfur Diesel (ULSD) futures contracts to hedge its short jet fuel exposure.
Use the volatility and correlation data below to calculate the minimum variance hedge ratio.
Jet fuel price volatility: 18.73%
ULSD futures price volatility: 16.54%
Correlation between jet fuel and ULSD futures price returns: 0.823
a. 0.727
b. 0.883
c. 0.932
d. 1.132
Answer: c
Explanation: The minimum variance hedge ratio is calculated as:
H* = - (a,b) * (a/ b), where is the correlation coefficient between returns of the two commodities, a is
the commodity being hedged, and b is the commodity being used as a hedge.
Hence H = -0.823* (0.1873/0.1654), or -0.932.
The correct answer is c.
Reading reference: Miller, Chapter 3, pp. 46-47.
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12. Consider a netting set containing six equal counterparty exposures totaling GBP 3,600,000. The average
correlation between the positions is 0.15 and the future values of the exposures are normally distributed.
What is the best estimate for the expected net exposure?
a. GBP 794,000
b. GBP 1,273,000
c. GBP 1,944,000
d. GBP 3,112,000
Answer: c
Explanation: The correct answer is c.
Since the future values of the exposures are normally distributed, we can calculate the netting factor using
the following equation:
Netting factor = [ sqrt (n + n (n-1) ] / n
Where n is the number of exposures and is the average correlation between the exposures.
Using n=6 and =0.15, in this case the netting factor is 0.540.
The answer is then 3,600,000 * 0.540 = 1,944,000.
Reading reference: Gregory, chapter 8, p. 140.
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13. The following table summarizes the 4-year implied probability of default associated with four midsize oil
exploration and production companies.
Company Year 1 Year 2 Year 3 Year 4
Company A 0.04% 0.17% 0.37% 0.53%
Company B 0.42% 1.05% 1.61% 2.32%
Company C 4.68% 8.41% 11.6% 13.8%
Company D 26.5% 33.1% 39.0% 44.2%
Which company is most likely to have a Moodys/Standard & Poors rating of B1/B+?
a. Company A
b. Company B
c. Company C
d. Company D
Answer: c
Explanation: The correct answer is c. A B1/B+ rating is a speculative, or junk, credit rating, which would rep-
resent a significant 4-year probability of default. It is not an investment-grade rating, but is also one of the
higher speculative ratings. A 4-year default probability of 0.5% would correspond to an investment-grade rat-
ing (potentially A2/A or A3/A-), a 2.3% probability would fall into the low investment-grade category
(Baa/BBB), and a 44.25% probability would correspond to a much lower speculative grade rating in the
Caa2/CCC range.
Reading reference: Burger, Graeber and Schindlmayr, Managing Energy Risk: A Practical Guide for Risk
Management in Power, Gas, and Other Energy Markets, chapter 3.4.
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ERP Practice Exam 4
14. A credit analyst is using the following information to assess a bond investment:
Exposure: USD 32,500,000 Recovery rate: 36%
Default probability: 8%
Credit spread: 4.5%
What is the bonds expected loss?
a. USD 787,500
b. USD 1,664,000
c. USD 2,625,000
d. USD 3,375,000
Answer: b
Explanation: In order to get the expected loss, first we have to calculate the loss given default. This is equal to
Exposure * (1-Recovery Rate). In this case it is 32,500,000 * (1-36%), or 20,800,000. Then the expected loss is
equal to the loss given default times the probability of default. This is 20,800,000 * 8% = USD 1,664,000.
Reading reference: Malz. Financial Risk Management, Chapter 6, pages 201-203.
15. A credit risk analyst is evaluating a new one-year bond priced at par that pays an annual coupon. The bond
has a default probability of 12% with an estimated recovery rate of 40%. Assuming the analyst is risk neutral
and the 1-year risk free rate is 2.5%, what is the minimum coupon she would be willing to accept to invest in
the bond?
a. 7.80%
b. 8.18%
c. 10.68%
d. 11.02%
Answer: d
Explanation: The correct answer is d.
In order to consider investing in the risky bond, she would demand a coupon spread z which would satisfy the
following equation:
(1-)(1+r+z) + R > 1+r
where is the probability of default, r is the risk free rate, and R is the recovery rate.
1.025 >= 0.12*0.4+0.88*(1+z). minimum z =11.02%
Reading reference: Malz. Financial Risk Management, Chapter 6.
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ERP Practice Exam 4
16. Assume an energy commodity position has an average 10-day price return of 0.75% and a daily standard devi-
ation of 1.25%. If daily price returns are independent and normally distributed, what is the portfolios 10-day,
95% VaR?
a. 5.75%
b. 6.27%
c. 6.43%
d. 7.00%
Answer: a
Explanation: Correct answer is a.
10 day mean return=0.75%
10 day standard deviation =(square root of 10)x1.25%=3.9528%
10-Day, 95% VaR=-(0.75%-1.645x3.9528%)= 5.75%.
B - Incorrect: Assumes daily mean price return multiplied by square root of 10
C - Incorrect: Assumes daily mean price return with no adjustment for time
D - Incorrect: Assumes a two tailed test (confidence interval of 1.96)
Reading reference: Allan Malz, Chapter 3.
17. Use data from the credit report below to approximate the original exposure on the underlying bond position.
Obligor: XYZ Energy
Recovery rate: 32%
Loss given default: USD 5,850,000
Expected loss: USD 3,910,500
a. USD 4,620,000
b. USD 6,174,000
c. USD 8,603,000
d. USD 11,197,000
Answer: c
Explanation: The correct answer is c. Since Loss Given Default = Exposure * (1-recovery rate), then the expo-
sure is equal to the LGD divided by (1-recovery rate). Therefore the original exposure on the position is
5,850,000 / (1-0.32) or approximately USD 8,602,941.
Reading reference: Allan Malz. Financial Risk Management, Models, History and Institutions, Chapter 6, pages
201203.
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ERP Practice Exam 4
18. A crude oil trader holds a long position in 100 call options on Brent Crude oil futures. The trader has identified
a second option on the same underlying contract that can be used to hedge market risk in her position.
What combination of the hedge option and the underlying futures contract will best neutralize the delta and
gamma of the traders position assuming the following market risk characteristics for the positions:
Long Option Hedge Option
Delta 0.613 -0.55
Gamma 0.0723 -0.0950
a. Buy 76 options and sell 19 futures contracts.
b. Sell 76 options and buy 19 futures contracts.
c. Sell 111 options and buy 3 futures contracts.
d. Buy 111 options and buy 3 futures contracts.
Answer: a
Explanation: In order to do a delta - gamma hedge, the gamma must be neutralized first by using the option
provided as a hedge. Since the delta and gamma of the given option are of the opposite side of the portfolio
position, the options must be bought to neutralize the gamma.
The number of contracts needed to neutralize the gamma are: (Gamma of position / Gamma of hedge) *
Number of contracts, i.e. (0.0723/-0.0950) * 100, or 76.1. In other words, 0.76 of an option must be purchased
to hedge the gamma of every existing option in the position.
However, now that the gamma has been neutralized, there remains some residual delta due to the purchase of
the option contracts required to hedge. The delta per contract is now: 0.613 + (-0.55*0.761), or 0.194. Delta
can be hedged with the underlying futures Since the residual delta is positive, then 19 futures contracts must
be sold to hedge the residual delta of the original 100 contract position.
Choices c and d incorrectly neutralize delta first and then solve for residual gamma.
Reading reference: Les Clewlow and Chris Strickland. Energy Derivatives: Pricing and Risk Management, chapter 9,
pp. 967-968.
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ERP Practice Exam 4
19. The following table represents the distribution of operational loss events from a sample of drilling companies
over a 6-month period:
Loss Events Percentage of Observations
0 18%
1 36%
2 29%
3 13%
4 4%
Calculate the standard deviation for the distribution of operational loss events assuming a mean of 1.49.
a. 1.05
b. 1.11
c. 1.22
d. 1.34
Answer: a
Explanation: Correct answer is a.
The first step is to calculate the variance, which is the probability weighted average of the squared difference
between F and its mean. In other words, Variance = (0-1.49)2 * 18% + (1-1.49)2 * 36% + (2-1.49)2 * 29% +
(3-1.49)2 * 13% + (4-1.49)2 * 4% = 1.110.
The standard deviation is the square root of the variance, ie. 1.053.
Reading reference: Michael Miller, Chapter 3.
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20. A risk analyst has performed a regression analysis on ICE National Balancing Point (NBP) natural gas spot
price returns over the past 500 days in order to estimate the parameters for a simple mean reversion model.
The regression analysis includes the following coefficients for a linear relationship where:
y = 0.0285 x (Log of daily NBP Spot Prices) + 0.0188
Using terms from the linear relationship above, what is the best estimate of the mean reversion rate for NBP
natural gas spot prices?
a. 2
b. 9
c. 14
d. 21
Answer: c
Explanation: The mean reversion rate can be estimated from the regression results as follows:
0 = 0.0188 (Coefficient for Intercept)
1 = 0.0285 (Coefficient for Slope)
Assuming 500 data points t = 1/500 = 0.0020
Therefore the mean reversion rate () can be estimated as (1 0.0285/t 0.0020) or 14.25
a is incorrect: 1 = 0.0285/ 0 = 0.0188 = 1.5
b is incorrect: 0 = 0.0188/ t 0.0020 = 9
d is incorrect: fictitiously derived by adding a spread of 7 to answer c.
Reading reference: Les Clewlow and Chris Strickland, Energy Derivatives: Pricing and Risk Management,
Chapter 2, pages 28-29.
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21. Which of the following best describes the relationship between risk-neutral default probabilities and historical
default probabilities?
a. Theoretical default probabilities are typically higher than historical default probabilities due to liquidity
risk premiums
b. Historical default probabilities are typically higher than theoretical default probabilities due to negative
skew in bond returns
c. Theoretical default probabilities are typically higher than historical default probabilities for investment
grade credits and lower than historical default probabilities for non-investment grade credits
d. Historical default probabilities are typically higher than theoretical default probabilities for investment
grade credits and lower than theoretical default probabilities for non-investment grade credits
Answer: a
Explanation: Correct answer is a. By definition, spreadderived PDs include risk and liquidity premia, thus are
higher than historical data-based PDs.
Reading reference: Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global
Financial Markets, Jon Gregory, Chapter 10.
22. Which of the following mitigation actions, if taken by a central counterparty, will most likely increase risk on
an exchange traded futures contract?
a. Invoke netting agreements on contracts that are in default.
b. Reduce margin requirements on contracts with low volatility and high liquidity.
c. Auction the right to replace contracts that are in default.
d. Increase margin requirements on contracts with large, highly concentrated positions.
Answer: d
Explanation: A CCPs increasing of margin requirements could create destabilizing market impacts and there-
fore add systemic risk. An example of this is a contract with large concentrated positions. If the CCP were to
increase the margin requirement, firms holding these positions might be placed into margin calls which could
force them to sell the target security, creating even greater market impact and imposing strains on the fund-
ing system and market liquidity.
Reading reference: Jon Gregory. Counterparty Credit Risk: A Continuing Challenge for Global Financial
Markets, Chapter 7, p. 110.
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ERP Practice Exam 4
23. To hedge the price exposure to its future production, power generator X is entering into a fixed price forward
sale contract with a load serving entity Y. Which of the following factors is least relevant for the evaluation of
Xs expected loss of its credit risk exposure to Y?
a. Ys credit rating
b. Xs target credit rating
c. Contractual payment term for X and Y to settle electric power delivered
d. Bilateral margining agreement between X and Y
Answer: b
Explanation: Answer b is correct. The other answers are incorrect: (a) indicates its credit default probability,
(c) drives Xs settlement credit risk exposure to Y, and (d) would effectively reduce Xs credit risk exposure to
Y. However, (b) mainly affects Xs risk appetite and required risk capital requirement, not a factor to be con-
sidered when evaluating Xs credit risk exposure to Y, therefore, has little impact on the expected credit loss.
Reading reference: Managing Energy Risk: An Integrated View on Power and Other Energy Markets, Markus
Burger, Bernhard Graeber, and Gero Schindlmayr, Chapter 3.4, Pages 139-140.
24. The proper application of Key Performance Indicators (KPIs) and Key Risk Indicators (KRIs) in the pursuit of
an organizations risk management objectives is best described as:
a. The use of KPIs exclusively to develop an effective forward looking assessment of trends in operational
risk factors.
b. The integration of KPI objectives and KRI limits to create a single comprehensive risk-weighted metric.
c. The monitoring of KRIs to assess shifts in risk exposure and adjustment of business strategy and
operational procedures to better meet return on risk objectives identified by KPIs.
d. The replacement of KPIs with KRIs and adjustment of company-wide risk capital allocations to account
for the change in risk monitoring procedures.
Answer: c
Explanation: The correct answer is c. One problem with the use of KPIs for risk management is that they are
backward-looking: they will only show how well the portfolio has met pre-determined goals. KRIs are an
ongoing process of monitoring the portfolio performance to ensure that it stays within pre-determined risk
measurements. Using them together as described in answer c is an effective risk-management strategy.
Adjustments to the portfolio can be made in accordance to the KRIs that can ultimately help the portfolio
reach the KPIs.
Reading reference: John Fraser and Betty Simkins, Enterprise Risk Management: Todays Leading Research
and Best Practices for Tomorrows Executives, Chapter 8, page 128.
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ERP Practice Exam 4
25. A new exploration company is formed to develop and produce oil in the Arctic. How will the company most
likely implement quantitative and qualitative techniques in its risk management process?
a. Develop an integrated qualitative/quantitative risk strategy from the outset, since each technique is
incomplete when used in isolation
b. Develop a strategy based on the relative qualitative or quantitative experience of the management team
since either can be an effective risk management technique
c. Start with qualitative techniques since they are easier to devise and help provide a depth of information;
adopt quantitative techniques as capabilities develop
d. Start with quantitative techniques since they provide empirical data on degrees of risk exposure; adopt
qualitative techniques as operational experience grows
Answer: c
Explanation: The correct answer is c. Enterprises typically begin by using a qualitative approach since it is simpler
to implement, yet gives a full picture of how a risk event may impact operations. Quantitative strategies are often
added to the strategy at a later point.
Reading reference: COSO, Risk Assessment in Practice.
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