erp practice exam3 7115

2015

ERPPractice Exam 3PM SessionFinancial—25 Questions

© 2015 Global Association of Risk Professionals. All rights reserved. It is illegal to reproduce this material iin any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

ERP® Practice Exam 3

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1

ERP Practice Exam 3 Candidate Answer Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3

ERP Practice Exam 3 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5

ERP Practice Exam 3 Answer Sheet/Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .15

ERP Practice Exam 3 Explanations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .17

TABLE OF CONTENTS

© 2015 Global Association of Risk Professionals. All rights reserved. It is illegal to reproduce this material 1in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.


IntroductionThe ERP Exam is a practice-oriented examination. Its ques-

tions are derived from a combination of theory, as set forth

in the core readings, and “real-world” work experience.

Candidates are expected to understand energy risk man-

agement concepts and approaches and how they would

apply to an energy risk manager’s day-to-day activities.

The ERP Exam is also a comprehensive examination,

testing an energy risk professional on a number of risk 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 3 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 3 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 3 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 ExamsTo 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 3 • 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 for

the 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.

Energy RiskProfessional(ERP®) ExamPractice Exam 3

Answer Sheet



a. b. c. d.

1. � � � �

2. � � � �

3. � � � �

4. � � � �

5. � � � �

6. � � � �

7. � � � �

8. � � � �

9. � � � �

10. � � � �

11. � � � �

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. � � � ��


Questions



1. The middle office trade support group at a crude oil trading firm is evaluating the margin requirements for along position in 400 April WTI futures contracts. The position includes the following terms:

• Trade date: January 25• Purchase price: USD 107.81 • Initial margin requirement: USD 3,900,000 • Required maintenance threshold: USD 3,120,000

Below what price (in USD) will a margin call be triggered on the April WTI futures position, assuming theexchange requires the account balance for all futures positions to be “topped-up” to their initial required margin level in the event of a margin call?

a. 102.68b. 104.99c. 105.86d. 107.61

2. A refinery purchases NYMEX WTI futures contracts to hedge the purchase of 40,000 barrels of WTI crude oilin two months. The contracts are purchased at USD 97.00/bbl. Two months later, the refiner closes the futuresposition and purchases 40,000 barrels at spot. What is the effective price paid per barrel if the futures con-tract is now trading at USD 98.50/bbl and the spot price is USD 100.10/bbl?

a. USD 98.50b. USD 98.60c. USD 100.10d. USD 100.40

3. Calculate the net profit on the following straddle position assuming the NYMEX ULSD closing futures price isUSD 2.73/gallon at expiration?

• 2-month NYMEX USLD call option with a strike price of USD 2.91/gallon and premium of USD 0.05/gallon• 2-month NYMEX USLD put option with a strike price of USD 2.91/gallon and premium of USD 0.09/gallon

a. USD 1,680 per contractb. USD 2,100 per contractc. USD 3,780 per contractd. USD 5,400 per contract

sbalakrish010

Highlight

sbalakrish010

Highlight

sbalakrish010

Highlight

6 © 2015 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.


4. The market risk manager for a refinery plans to structure a collar for margin protection. She has the followingprice data available for options on NYMEX RBOB futures to assess the economics of the transaction:

RBOB Strike Price Call Premium Put Premium(USD/gal) (USD) (USD)

3.21 0.156 0.1373.29 0.129 0.146

Assuming the NYMEX RBOB futures contract is currently trading at USD 3.24/gal, how would the risk managerstructure the transaction to best manage earnings volatility in the refinery’s operations?

a. Buy put options @ USD 3.21 strike and sell call options @ USD 3.29 strikeb. Sell put options @ USD 3.21 strike and buy call options @ USD 3.29 strikec. Buy put options @ USD 3.29 strike and sell call options @ USD 3.21 striked. Sell put options @ USD 3.29 strike and buy call options @ USD 3.21 strike

5. A petroleum commodities trader observes the following NYMEX price quotes. He believes the spread is toowide and executes a ten-contract position to benefit from a narrowing of the spread:

• August RBOB: USD 2.58/gal • December RBOB: USD 2.74/gal

On June 30, the contracts close at the following prices:

• August RBOB: USD 2.63/gal• December RBOB: USD 2.68/gal

What is the trader’s profit (ignoring broker costs, margin requirements and other expenses) on the positionbased on the June 30 closing prices?

a. USD 5,040b. USD 29,400c. USD 46,200d. USD 67,200

sbalakrish010

Highlight

sbalakrish010

Highlight



Questions 6-7 use the information below:

A risk manager at a large international bank, has compiled the following closing price data on the Brent CrudeOil futures contract for the past 31 trading days:

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

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

7. While backtesting a 1-year, 99% VaR model, the risk manager finds six exceptions to the VaR model. Howshould he interpret this result relative to Basel requirements?

a. The model is in the “green zone” and is acceptable to use with no further revisionb. The model is in the “yellow zone” and further adjustments must be made such as increasing the safety

multiplier used with the modelc. The model is in the “red zone” and must be dramatically revised before it can be used furtherd. The model is in the “red zone” and the model must be discarded

10/1/2013 10/16/2013 10/31/2013Time

120

115

110

105

100

Fut

ures

Pri

ce (

US

D)

sbalakrish010

Highlight

sbalakrish010

Highlight



8. The 10-day, 95% VaR for a USD 10,000,000 energy commodity portfolio is USD 2,000,000. Based on the VaRcalculation, what is the correct interpretation of market risk for the portfolio?

a. Portfolio losses over a ten day period are expected to exceed USD 2 million once in every five, ten-day periodsb. Portfolio losses over a ten day period are expected to exceed USD 2 million once in every twenty, ten-day periodsc. There is a 5% chance that portfolio losses will exceed USD 2 million during the next ten trading daysd. There is a 95% chance that portfolio losses will exceed USD 2 million during the next ten trading days

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

• Cap: USD 125/bbl• Floor: USD 115/bbl• Tenor: Six months (June to November)• Valuation Index: Mean of Platts Singapore (MOPS)

The monthly MOPs Index per barrel are as follows:

• June: USD 132 • September: USD 128• July: USD 120 • October: USD 122• August: USD 111 • November: USD 115

Calculate the net payment owed to/from the airline at settlement on November 30?

a. The airline receives USD 300,000b. The airline pays USD 300,000c. The airline receives USD 500,000d. The airline pays USD 500,000

10. A market risk analyst has applied a factor-push model to stress test the MtM value of several combinations ofoption positions on the April 2015 NYMEX WTI futures contract. The model applies a four standard deviationdecrease in the price of the underlying futures contract. Each option has the same expiration date and thecurrent settlement price for the April 2015 WTI contract is USD 105.

What combination of options will be least impacted by the factor-push model?

a. A long 95 call and a long 115 callb. A long 100 call and a short 110 callc. A long 105 call and a long 105 putd. A short 100 put and a long 100 call

sbalakrish010

Highlight

sbalakrish010

Highlight

sbalakrish010

Highlight




A credit analyst at a regional commercial bank has been asked to assess the credit fundamentals related tofour different energy companies. To complete the analysis the analyst has assembled the following data fromthe most recently published balance sheet for each entity:

Balance Sheet(in Millions USD) Company A Company B Company C Company DCash 1,675 5,643 7,610 15,376Short-term investments 1,767 8,259 5,659 5,297Accounts receivable 888 1,337 4,296 6,489Inventory 4,467 21,785 2,145 45,832Total current assets 8,797 37,024 19,710 72,994

Property, plant and equipment 13,370 17,812 3,899 27,432Total assets 22,167 54,836 23,609 100,426

Total current liabilities 5,770 12,893 4,252 48,659Long term debt 10,000 15,555 3,210 0Total liabilities 16,770 28,448 7,462 48,659Total shareholder equity 6,397 26,388 16,147 51,767

11. Which of the following relationships will provide the best measure of financial leverage used by each company?

a. (Total Liabilities)(Total Shareholder Equity)

b (Long Term Debt)(Total Current Assets)

c. (Long Term Assets)(Total Current Liabilities)

d. (Total Liabilities-Long Term Debt)(Total Assets)

12. Using the Quick Ratio as a guideline, which company has the highest relative short-term liquidity risk?

a. Company Ab. Company Bc. Company Cd. Company D



13. The variance of historical weekly price returns on the SP-15 on-peak power futures contract is .0323 over a 5-yearperiod. What is the best estimate of annual volatility on the SP15 contract.

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

14. Which VaR methodology provides the greatest flexibility and best approximation for a portfolio of powergenerating assets?

a. Deltab. Delta-Gammac. Historical Simulation using information from the last 90 trading daysd. Monte Carlo Simulation

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

The producer is concerned about migration of the counterparty’s credit rating in the later years of the swap.Which of the following structures will help reduce the producer’s potential long-term counterparty exposure?

a. A CVA adjustment b. A reset agreement c. A take-or-pay provision d. A netting agreement




On September 1, 2014, a regional airline contracts to purchase 60,000 gallons of jet fuel from a local refineryfor forward delivery in one-year at a fixed-price of USD 3.88/gallon. Terms of the purchase require the airline totake delivery of the jet fuel on September 1, 2015, after making payment in full. The continuously compoundedrisk-free interest rate is 4% per year.

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

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

17. Assume that by the end of April 2015, the price for jet fuel has risen to USD 4.14/gallon. What is the refinery’sreplacement risk on April 30, 2015 (four months from the delivery date)?


18. Assume the daily change in Brent Crude Oil prices and Newcastle Coal prices are independent. What is theprobability that the price of Brent Crude Oil and Newcastle Coal will both increase by more than 2% on agiven day based on the following:

• 40% probability that Brent Crude Oil price will increase more than 2%• 15% probability that Newcastle Coal price will increase more than 2%

a. 6%b. 9%c. 11%d. 55%



19. Consider a USD 7,200,000 credit exposure related to a 10-year fixed-rate bond issued by a Baa3/BBB- ratedmidstream oil and gas company. Assuming a USD 8,000,000 par value and an estimated recovery rate of43%, what is the bond’s implied default probability if the expected loss is USD 291,500?

a. 6.19%b. 6.40%c. 6.83%d. 7.10%

20. When executed, which of the following long option positions has the greatest potential for wrong-way riskwith the referenced counterparty?

a. At-the-money call option on an oil future with a BBB rated oil producerb. At-the-money put option on an oil future with an AA rated shipping company c. Out-of-the-money put option on an oil future with a BBB rated shipping company d. Out-of-the-money put option on an oil future with an AA rated oil producer

21. What OTC derivative transaction provides the greatest economic benefit (to the counterparty identified) in abilateral netting arrangement?

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

22. Which statement best explains the difference between risk appetite and risk tolerance?

a. Risk appetite is a measure of how much risk an organization is willing to take on, while risk tolerance is used to communicate a level of acceptable risk

b. Risk appetite expresses a range of risk levels an organization is willing to endure, while risk tolerance is a single definitive figure

c. Risk appetite is a willingness to embrace risk, while risk tolerance is an aversion to enduring riskd. Risk appetite cannot be derived empirically, while risk tolerance can



23. A refined products trader has structured a 1-year fixed-for-floating swap on 150,000 barrels of gasoil with aBa1/BB+ rated counterparty. The trader has been given the following information from various risk groupswithin the organization:

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

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

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

24. What best describes the approach senior management should take to develop an effective risk appetite state-ment for an energy company according to the COSO framework?

a. Develop a consistent appetite across all risk classes to ensure the policy can be communicated clearly and powerfully across the company

b. Focus on establishing a financial risk appetite benchmark that can ensure the profitability of each operating unit c. Delegate decisions on risk appetite to individual operational units to ensure fitness for purpose and ownership

at the operating leveld. Consider each major risk class separately and set independent risk appetites for each one

25. Risk managers at a nuclear power facility are working with plant engineers to develop an engineering-basedmodel assessment of the potential for a catastrophic operational failure. What best describes the weakness inusing this approach to forecast the probability of such an event?

a. It relies on reactive analyses when estimating projectionsb. It does not properly account for the interaction between parts of a complex mechanical systemc. It tends to overweight the potential for a plant meltdown while underweighting the potential for less serious

operational failuresd. It fails to account for the reaction of plant managers to a crisis situation, likely underestimating the probability

of an operational failure


Answers



a. b. c. d.

1. � � � �

2. � � � �

3. � � � �

4. � � � �

5. � � � �

6. � � � �

7. � � � �

8. � � � �

9. � � � �

10. � � � �

11. � � � �

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. � � � ��


Explanations



1. The middle office trade support group at a crude oil trading firm is evaluating the margin requirements for along position in 400 April WTI futures contracts. The position includes the following terms:

• Trade date: January 25• Purchase price: USD 107.81 • Initial margin requirement: USD 3,900,000 • Required maintenance threshold: USD 3,120,000

Below what price (in USD) will a margin call be triggered on the April WTI futures position, assuming theexchange requires the account balance for all futures positions to be “topped-up” to their initial required margin level in the event of a margin call?

a. 102.68b. 104.99c. 105.86d. 107.61

Answer: c

Explanation: The correct answer is c. The trader can lose no more than (3,900,000-3,120,000), or 780,000, on thistrade without receiving a call. In order to find the correct price, we must first find the gain or loss on the trade perdollar change in the WTI futures contracts, which is 400 contracts * 1,000 barrels per contract, or USD 400,000.Therefore, the contract can trade no lower than 107.81-(780,000/400,000), or 105.86, before the trader gets a call.

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

2. A refinery purchases NYMEX WTI futures contracts to hedge the purchase of 40,000 barrels of WTI crude oilin two months. The contracts are purchased at USD 97.00/bbl. Two months later, the refiner closes the futuresposition and purchases 40,000 barrels at spot. What is the effective price paid per barrel if the futures con-tract is now trading at USD 98.50/bbl and the spot price is USD 100.10/bbl?

a. USD 98.50b. USD 98.60c. USD 100.10d. USD 100.40

Answer: b

Explanation: The effective price paid (in dollars per barrel) is the final spot price less the gain on the futures, or100.10 – 1.50 = 98.60. This can also be calculated as the initial futures price plus the final basis, 97.00 + 1.60 = 98.60.

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



3. Calculate the net profit on the following straddle position assuming the NYMEX ULSD closing futures price isUSD 2.73/gallon at expiration?

• 2-month NYMEX USLD call option with a strike price of USD 2.91/gallon and premium of USD 0.05/gallon• 2-month NYMEX USLD put option with a strike price of USD 2.91/gallon and premium of USD 0.09/gallon

a. USD 1,680 per contractb. USD 2,100 per contractc. USD 3,780 per contractd. USD 5,400 per contract

Answer: a

Explanation: Answer “a” is correct because at a closing price of 2.73, the profit is 2.91 - 2.73 - 0.05 - 0.09 =0.04 multiplied by 42,000 gallons per contract. In this situation the “long put” provided the profit, while thepremium payments reduced the profit.

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).

4. The market risk manager for a refinery plans to structure a collar for margin protection. She has the followingprice data available for options on NYMEX RBOB futures to assess the economics of the transaction:

RBOB Strike Price Call Premium Put Premium(USD/gal) (USD) (USD)

3.21 0.156 0.1373.29 0.129 0.146

Assuming the NYMEX RBOB futures contract is currently trading at USD 3.24/gal, how would the risk managerstructure the transaction to best manage earnings volatility in the refinery’s operations?

a. Buy put options @ USD 3.21 strike and sell call options @ USD 3.29 strikeb. Sell put options @ USD 3.21 strike and buy call options @ USD 3.29 strikec. Buy put options @ USD 3.29 strike and sell call options @ USD 3.21 striked. Sell put options @ USD 3.29 strike and buy call options @ USD 3.21 strike

Answer: a

Explanation: The correct answer is a. The collar will help the refiner to hedge price risk and, by extension,margins on its refining operation for the month of October. In this case, the refiner will lock in a range of sell-ing prices between 3.21 and 3.29 (less any cost of implementing the trade). If the RBOB price rallies over 3.29,the sold call will be assigned to the refiner so the refiner will realize an effective price of 3.29. If the price fallsbelow 3.21, the refiner can exercise the put option to lock in the price at that level.

Reading reference (new): Vincent Kaminski, Energy Markets, Chapter 18.



5. A petroleum commodities trader observes the following NYMEX price quotes. He believes the spread is toowide and executes a ten-contract position to benefit from a narrowing of the spread:

• August RBOB: USD 2.58/gal • December RBOB: USD 2.74/gal

On June 30, the contracts close at the following prices:

• August RBOB: USD 2.63/gal• December RBOB: USD 2.68/gal

What is the trader’s profit (ignoring broker costs, margin requirements and other expenses) on the positionbased on the June 30 closing prices?


Answer: c

Explanation: Answer “c” is correct. The trader’s expectations were that the spread of USD 0.16/gal would nar-row; therefore he buys the low price contract and sells the high price contract. He bought the August contract(USD 2.58) and sold the December contract (USD 2.74) for a spread of USD 0.16/gal. In June, he closes outher position by selling the August contract for USD 2.63/gal and buys the December contract for USD2.68/gal. Since he transacted for 10 contracts at 42,000 gallons per contract, his net profit is 420,000 x USD0.11, or USD 46,200. Had the trader thought the spread would widen, he would have reversed the transactions.

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




A risk manager at a large international bank, has compiled the following closing price data on the Brent CrudeOil futures contract for the past 31 trading days:

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

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

Answer: a

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

Reading reference: Clewlow and Strickland, Chapter 10, pp. 184-185.

10/1/2013 10/16/2013 10/31/2013Time

120

115

110

105

100

Fut

ures

Pri

ce (

US

D)



7. While backtesting a 1-year, 99% VaR model, the risk manager finds six exceptions to the VaR model. Howshould he interpret this result relative to Basel requirements?

a. The model is in the “green zone” and is acceptable to use with no further revisionb. The model is in the “yellow zone” and further adjustments must be made such as increasing the safety

multiplier used with the modelc. The model is in the “red zone” and must be dramatically revised before it can be used furtherd. The model is in the “red zone” and the model must be discarded

Answer: b

Explanation: Between 5 and 9 exceptions to a 99% VAR model in a 250-day period puts the model in the“yellow zone” where further actions must be taken in order for the model to continue being used. One poten-tial solution could be raising the “safety multiplier,” which is the number by which the 99% VaR is multipliedby to create the bank’s capital cushion. 10 or more exceedences puts the model into the “red zone” where itmust be substantially revised to continue being used (and the bank often pays a penalty in that case.)

Reading reference: Clewlow and Strickland, Chapter 10, p. 205.

8. The 10-day, 95% VaR for a USD 10,000,000 energy commodity portfolio is USD 2,000,000. Based on the VaRcalculation, what is the correct interpretation of market risk for the portfolio?

a. Portfolio losses over a ten day period are expected to exceed USD 2 million once in every five, ten-day periodsb. Portfolio losses over a ten day period are expected to exceed USD 2 million once in every twenty, ten-day periodsc. There is a 5% chance that portfolio losses will exceed USD 2 million during the next ten trading daysd. There is a 95% chance that portfolio losses will exceed USD 2 million during the next ten trading days

Answer: b

Explanation: The correct answer is b. A 95% confidence level means that there is a one-in-20, or a 5% chance,that a loss should exceed the portfolio VaR over the time period that the VaR specifies. In this case, the 10-day VaR of 2 million indicates that the portfolio should be expected to lose more than USD 2 million once inevery 20 ten-day periods.

Reading reference: Les Clewlow and Chris Strickland. Energy Derivatives: Pricing and Risk Management.Chapter 10.



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

• Cap: USD 125/bbl• Floor: USD 115/bbl• Tenor: Six months (June to November)• Valuation Index: Mean of Platts Singapore (MOPS)

The monthly MOPs Index per barrel are as follows:

• June: USD 132 • September: USD 128• July: USD 120 • October: USD 122• August: USD 111 • November: USD 115

Calculate the net payment owed to/from the airline at settlement on November 30?

a. The airline receives USD 300,000b. The airline pays USD 300,000c. The airline receives USD 500,000d. The airline pays USD 500,000

Answer: a

Explanation: Because the airline is a consumer of oil, the airline will purchase a costless collar composed ofone long 125 call funded by a short 115 put. Settlement payments will be made for June, August andSeptember, the months that the index price is set beyond the cap/floor price threshold. For June the airlinewill receive USD 350,000 (132 – 125 x 50,000); in September, they will receive USD 150,000 (128 – 125 x50,000); in August the airline will pay USD 200,000 (115 – 111 x 50,000) resulting in a total settlement after sixmonths of USD 300,000.

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



10. A market risk analyst has applied a factor-push model to stress test the MtM value of several combinations ofoption positions on the April 2015 NYMEX WTI futures contract. The model applies a four standard deviationdecrease in the price of the underlying futures contract. Each option has the same expiration date and thecurrent settlement price for the April 2015 WTI contract is USD 105.

What combination of options will be least impacted by the factor-push model?

a. A long 95 call and a long 115 callb. A long 100 call and a short 110 callc. A long 105 call and a long 105 putd. A short 100 put and a long 100 call

Answer: c

Explanation: A factor-push model is only useful when the maximum loss on the position occurs when the riskfactor has been “pushed” or stressed the hardest. Therefore the return profile of the underlying position withrespect to the risk factor needs to be monotonic (i.e. steadily increasing or decreasing for every value of therisk factor.) In cases where a position has non-monotonicity, or the maximum loss occurs when the value ofthe risk factor is not at an extreme, a factor push model will not predict the maximum loss. In this case choicea would be correct, since the greatest loss would take place if the underlying remained at USD 105 and theposition would actually increase in value if the factor was pushed in either direction.

Reading reference: Dowd, Managing Market Risk, Chapter 13, pp. 303-304.


A credit analyst at a regional commercial bank has been asked to assess the credit fundamentals related tofour different energy companies. To complete the analysis the analyst has assembled the following data fromthe most recently published balance sheet for each entity:

Balance Sheet(in Millions USD) Company A Company B Company C Company DCash 1,675 5,643 7,610 15,376Short-term investments 1,767 8,259 5,659 5,297Accounts receivable 888 1,337 4,296 6,489Inventory 4,467 21,785 2,145 45,832Total current assets 8,797 37,024 19,710 72,994

Property, plant and equipment 13,370 17,812 3,899 27,432Total assets 22,167 54,836 23,609 100,426

Total current liabilities 5,770 12,893 4,252 48,659Long term debt 10,000 15,555 3,210 0Total liabilities 16,770 28,448 7,462 48,659Total shareholder equity 6,397 26,388 16,147 51,767



11. Which of the following relationships will provide the best measure of financial leverage used by each company?

a. (Total Liabilities)(Total Shareholder Equity)

b (Long Term Debt)(Total Current Assets)

c. (Long Term Assets)(Total Current Liabilities)

d. (Total Liabilities-Long Term Debt)(Total Assets)

Answer: a

Explanation: One of the most important debt management ratios is the debt/equity ratio, which assesses thefinancial leverage of the firm by comparing its level of debt financing to its total net worth. This is expressedas Total liabilities/Total net worth, where total net worth is equal to the firm’s total shareholder equity.

Reading reference: Betty Simkins and Russell Simkins, eds. Energy Finance and Economics: Analysis andValuation, Risk Management, and the Future of Energy, Chapter 9, p. 200.

12. Using the Quick Ratio as a guideline, which company has the highest relative short-term liquidity risk?

a. Company Ab. Company Bc. Company Cd. Company D

Answer: d

Explanation: The Quick Ratio is a more conservative form of the Current Ratio which assumes that a firm willnot be able to easily liquidate its inventory, and in a crisis that a firm will not get full market value for itsinventory. Hence it is a measure of the liquid assets a firm has available to pay back its current obligations.The formula for the Quick Ratio is as follows:

(Current assets-Inventory)(Current Liabilities)

In this case, Company D has the lowest Quick Ratio, at (72,994 – 45,832) / 48,659, or 0.52. This is becausemost of Company D’s current assets are held as inventory, which is not easily liquidated.

The Quick Ratios for companies A, B and C are 0.86, 1.18, and 4.13 respectively.

Reading reference: Betty Simkins and Russell Simkins , eds. Energy Finance and Economics: Analysis andValuation, Risk Management, and the Future of Energy, Chapter 9, p. 197.



13. The variance of historical weekly price returns on the SP-15 on-peak power futures contract is .0323 over a 5-yearperiod. What is the best estimate of annual volatility on the SP15 contract.

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

Answer: d

Explanation: Answer d is the correct answer. As per the text, historical volatility is derived by multiplying thestandard deviation (square root of variance) of price changes by the square root of time (52), the factorrequired to annualize the weekly prices observed in the sample.

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

14. Which VaR methodology provides the greatest flexibility and best approximation for a portfolio of powergenerating assets?

a. Deltab. Delta-Gammac. Historical Simulation using information from the last 90 trading daysd. Monte Carlo Simulation

Answer: d

Explanation: A Monte Carlo simulation will better account for market behavior like price jumps that are often foundin energy commodities (particularly electricity) and option pricing than the other methods; the historical simulationwould also provide a good approximation however the relatively short “lookback” period is not sufficient to captureprice jumps.

Reading reference: Les Clewlow and Chris Strickland. Energy Derivatives: Pricing and Risk Management.Chapter 10.



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

The producer is concerned about migration of the counterparty’s credit rating in the later years of the swap.Which of the following structures will help reduce the producer’s potential long-term counterparty exposure?

a. A CVA adjustment b. A reset agreement c. A take-or-pay provision d. A netting agreement

Answer: b

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 arereset at the prevailing rate, so that exposure becomes 0 after every reset is made. This allows exposure to be “paidout” more frequently and reduces the amount of exposure which could potentially be outstanding in later years ofthe agreement when the health of the counterparty is much less certain.

Reading reference: Jon Gregory. Counterparty Credit Risk: A Continuing Challenge for Global FinancialMarkets, Chapter 4.


On September 1, 2014, a regional airline contracts to purchase 60,000 gallons of jet fuel from a local refineryfor forward delivery in one-year at a fixed-price of USD 3.88/gallon. Terms of the purchase require the airline totake delivery of the jet fuel on September 1, 2015, after making payment in full. The continuously compoundedrisk-free interest rate is 4% per year.

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

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

Answer: b

Explanation: The settlement risk is constant based on the original terms of the fixed price purchase contract.Replacement risk will change with the spot price of the underlying commodity, but not the settlement risk.Reading reference: Markus Burger, Bernhard Graeber, and Gero Schindlmayr. Managing Energy Risk: AnIntegrated View on Power and Other Energy Markets. Chapter 3.4.



17. Assume that by the end of April 2015, the price for jet fuel has risen to USD 4.14/gallon. What is the refinery’sreplacement risk on April 30, 2015 (four months from the delivery date)?


Answer: d

Explanation: The correct answer is d. The replacement risk can be calculated by using the following equation:

R = Volume x Price Difference x (discount factor, at t =4/12 and r =0.04)R = 60,000* (4.14-3.88) * exp(-0.04 x 4/12) = 15,393.

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

18. Assume the daily change in Brent Crude Oil prices and Newcastle Coal prices are independent. What is theprobability that the price of Brent Crude Oil and Newcastle Coal will both increase by more than 2% on agiven day based on the following:

• 40% probability that Brent Crude Oil price will increase more than 2%• 15% probability that Newcastle Coal price will increase more than 2%

a. 6%b. 9%c. 11%d. 55%

Answer: a

Explanation: Correct answer is a. The joint probability of two independent events represents the product ofthe probabilities for each independent outcome. In this case the joint probability is represented by P[B] *P[D] or 6%

B is incorrect: 9% = ((P[B]+P[D]))⁄((P[B]* P[D]) ) C is incorrect: 11% = ((P[B]*P[D]))⁄((P[B]+ P[D]) )D in incorrect: 55% = P[B] + P[D]

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



19. Consider a USD 7,200,000 credit exposure related to a 10-year fixed-rate bond issued by a Baa3/BBB- ratedmidstream oil and gas company. Assuming a USD 8,000,000 par value and an estimated recovery rate of43%, what is the bond’s implied default probability if the expected loss is USD 291,500?

a. 6.19%b. 6.40%c. 6.83%d. 7.10%

Answer: d

Explanation: Correct answer is d. Per the following formula:Expected loss = Loss Given Default x probability of default In this example Loss Given Default can be derived by multiplying the Credit Exposure by (1-Recovery Rate) =USD 4,104,000. Using this information along with the Expected Loss of USD 291,500, the implied probabilityof default is 7.10% or USD 291,500/USD 4,104,000.Note that the par value of the bonds is not used in the calculation.

Reading reference: Allan Malz. Financial Risk Management, Chapter 6, pages 201-203.

20. When executed, which of the following long option positions has the greatest potential for wrong-way riskwith the referenced counterparty?

a. At-the-money call option on an oil future with a BBB rated oil producerb. At-the-money put option on an oil future with an AA rated shipping company c. Out-of-the-money put option on an oil future with a BBB rated shipping company d. Out-of-the-money put option on an oil future with an AA rated oil producer

Answer: d

Explanation: Wrong-way risk arises in cases when the credit risk of the counterparty increases as your expo-sure to that counterparty increases. In other words, there is a positive correlation between your exposure to acounterparty and the credit risk (or default probability) of that counterparty. Choice D has the most wrongway risk: this option position increases in value as the price of oil decreases, but the oil producer’s credit riskwould be increasing at the same time. The farther the option becomes in-the-money, the greater the probabil-ity of counterparty defaulting. That is the wrong-way risk.

Reading reference: Jon Gregory. Counterparty Credit Risk and Credit Value Adjustment: A ContinuingChallenge for Global Financial Markets, Chapter 15.



21. What OTC derivative transaction provides the greatest economic benefit (to the counterparty identified) in abilateral netting arrangement?

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

Answer: b

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

Reading reference: Jon Gregory. Counterparty Credit Risk: A Continuing Challenge for Global FinancialMarkets, Chapter 4.

22. Which statement best explains the difference between risk appetite and risk tolerance?

a. Risk appetite is a measure of how much risk an organization is willing to take on, while risk tolerance is used to communicate a level of acceptable risk

b. Risk appetite expresses a range of risk levels an organization is willing to endure, while risk tolerance is a single definitive figure

c. Risk appetite is a willingness to embrace risk, while risk tolerance is an aversion to enduring riskd. Risk appetite cannot be derived empirically, while risk tolerance can

Answer: a

Explanation: The correct answer is a; this is the correct definition of risk appetite and risk tolerance.

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



23. A refined products trader has structured a 1-year fixed-for-floating swap on 150,000 barrels of gasoil with aBa1/BB+ rated counterparty. The trader has been given the following information from various risk groupswithin the organization:

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

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

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

Answer: b

Explanation: The correct answer is b. CVA can be estimated as: CVA ≈ [(1-d) * Bt * EEt * q (tj-1,tj)] calculatedat each payment period and summed together. Where (1-d) equals the loss given default (hence d is therecovery rate), Bt is the discount factor at time t, EE is the expected exposure and q (tj-1,tj) is the probabilityof default during the specified time period.

Since this is a 1-year period with an annual payment then only one calculation need be made.Explanations for the distracters:Answer a multiplies by the recovery rate instead of by the loss given default.Answer c omits the expected exposure in the calculation.Answer d omits the probability of default in the calculation.

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



24. What best describes the approach senior management should take to develop an effective risk appetite state-ment for an energy company according to the COSO framework?

a. Develop a consistent appetite across all risk classes to ensure the policy can be communicated clearly and powerfully across the company

b. Focus on establishing a financial risk appetite benchmark that can ensure the profitability of each operating unit c. Delegate decisions on risk appetite to individual operational units to ensure fitness for purpose and ownership

at the operating leveld. Consider each major risk class separately and set independent risk appetites for each one

Answer: d

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

Reading reference: COSO, “Understanding and Communicating Risk Appetite.” Pages 4-10.



25. Risk managers at a nuclear power facility are working with plant engineers to develop an engineering-basedmodel assessment of the potential for a catastrophic operational failure. What best describes the weakness inusing this approach to forecast the probability of such an event?

a. It relies on reactive analyses when estimating projectionsb. It does not properly account for the interaction between parts of a complex mechanical systemc. It tends to overweight the potential for a plant meltdown while underweighting the potential for less serious

operational failuresd. It fails to account for the reaction of plant managers to a crisis situation, likely underestimating the probability

of an operational failure

Answer: d

Explanation: The correct answer is d. Engineering models focus on physical processes and materials, and donot typically account for the reaction of the humans who operate the equipment during times of crisis. As such,according to the authors, these models may under-report the likelihood of failure by a factor of 10, or more.

Reading reference: Robert Bea, Ian Mitroff, Daniel Farber, Howard Foster and Karlene H. Roberts, A NewApproach to Risk: The Implications of E3, pages 36-37.

Creating a culture of risk awareness®

Global Association ofRisk Professionals

111 Town Square Place14th FloorJersey City, New Jersey 07310USA+ 1 201.719.7210

2nd FloorBengal Wing9A Devonshire SquareLondon, EC2M 4YNUK+ 44 (0) 20 7397 9630

www.garp.org

© 2015 Global Association of Risk Professionals. All rights reserved. 6-22-15

About GARP | The Global Association of Risk Professionals (GARP) is a not-for-profit global membership organization dedicated topreparing professionals and organizations to make better informed risk decisions. Membership represents over 150,000 risk manage-ment practitioners and researchers from banks, investment management firms, government agencies, academic institutions, and corporations from more than 195 countries and territories. GARP administers the Financial Risk Manager (FRM®) and the Energy Risk Professional (ERP®) Exams; certifications recognized by risk professionals worldwide. GARP also helps advance the role of riskmanagement via comprehensive professional education and training for professionals of all levels. www.garp.org.

erp practice exam3 7115

Documents

erp practice exam

introductionthe erp

actual exam

erppractice exam

erp exam study guide

erp exams

erp examare

practiceoriented examination