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Energy Risk Professional (ERP) Examination

Practice Exam 1

Energy Risk Professional Examination (ERP) Practice Exam 1

TABLE OF CONTENTS

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

ERP Practice Exam 1 Candidate Answer Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3

ERP Practice Exam 1 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5

ERP Practice Exam 1 Answer Sheet/Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .19

ERP Practice Exam 1 Explanations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .21

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Energy Risk Professional Examination (ERP) Practice Exam 1

Introduction The ERP Exam is a practice-oriented examination. Its questions are derived from a combination of theory, as set forth in the core readings, and real-world work experience. Candidates are expected to understand energy risk management concepts and approaches and how they would apply to an energy risk managers day-to-day activities. The ERP Examination is also a comprehensive examination, testing an energy risk professional on a number of risk management concepts and approaches. It is very rare that an energy risk manager will be faced with an issue that can immediately be slotted into just one category. In the real world, an energy risk manager must be able to identify any number of risk-related issues and be able to deal with them effectively. The ERP Practice Exam 1 has been developed to aid candidates in their preparation for the ERP Examination. This practice exam is based on a sample of actual questions from past ERP Examinations and is suggestive of the questions that will be in the 2012 ERP Examination. The ERP Practice Exam 1 contains 40 multiple choice questions. Note that the 2012 ERP Examination will consist of a morning and afternoon session, each containing 80 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 1 does not necessarily cover all topics to be tested in the 2012 ERP Examination. For a complete list of topics and core readings, candidates should refer to the 2012 ERP Examination 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 Examination are derived from these core readings in their entirety. As such, it is strongly suggested that candidates review all core readings listed in the 2012 ERP Study Guide in-depth prior to sitting for the exam. Suggested Use of Practice Exams To maximize the effectiveness of the practice exams, candidates are encouraged to follow these recommendations:

1. Plan a date and time to take the practice exam. Set dates appropriately to give sufficient study/review time for the practice exam prior to the actual exam. 2. Simulate the test environment as closely as possible. Take the practice exam in a quiet place. Have only the practice exam, candidate answer sheet, calculator, and writing instruments (pencils, erasers) available. Minimize possible distractions from other people, cell phones, televisions, etc.; put away any study material before beginning the practice exam. Allocate 2 minutes per question for the practice exam and set an alarm to alert you when a total of 80 minutes have passed (or 2-40 minute sessions with a break in between to simulate the actual exam conditions). Complete the entire exam but note the questions answered after the 80-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 2012 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 1 Calculate your score by comparing your answer sheet with the practice exam answer key. Only include questions completed within the first 80 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 candidates, so use your scores only to gauge your own progress and level of preparedness.

2012 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.

Energy Risk Professional(ERP ) Examination


Practice Exam 1
Answer Sheet

Energy Risk Professional Examination (ERP) Practice Exam 1

a. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23.

b.

c.

d. 24. 25. 26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36. 37. 38. 39. 40.

a.

b.

c.

d.

Correct way to complete 1. Wrong way to complete 1.

2012 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.

Energy Risk Professional(ERP ) Examination


Practice Exam 1
Questions

Energy Risk Professional Examination (ERP) Practice Exam 1

1.

The relationship between cash and futures prices can vary due to systematic and unsystematic changes in basis. Which of the following is synonymous with characteristics of systematic changes in basis, leading to convergence between cash and futures price? a. b. c. d. Delta Gamma Theta Vega

2.

Victor is a natural gas trader based in Chicago. He has just learned that a large coal-fired electricity generating plant in Pennsylvania will be shutting down for unplanned maintenance in a few days, increasing demand for natural gas to fuel backup plants. Victor plans to take advantage of this speculative opportunity by purchasing gas on the spot market, storing it briefly and then selling it when demand rises as the natural gas power plants come on line. This is an example of what kind of natural gas spread trade? a. b. c. d. Location Heat Rate Time Swing

3.

Heinz provides risk management support to a multinational energy trading desk. His primary responsibility is to inform the Chief Risk Officer about derivatives trades executed each day along with all trader risk limit exceptions. Which of the following risk control categories best describes Heinzs primary responsibility? a. b. c. d. Risk Risk Risk Risk Reporting Review Assessment Control

4.

Andrew Willingham, ERP, is modeling the volatility of WTI forward contract prices using a single-factor log-of-price mean reverting model. What will the output from the model indicate about the correlation between spot and forward price returns assuming the initial price level in the spot and forward market are equal? a. b. c. d. Correlation will remain perfect across all points between the front and back-end of the forward price curve. Correlation will decrease between the front and back-end of the forward price curve. Correlation will increase between the front and back-end of the forward price curve. Correlation will fluctuate due to seasonality.

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Energy Risk Professional Examination (ERP) Practice Exam 1

5.

Karachaganak, Kazakhstan is one of the largest gas condensate fields in the world, with proven reserves of 1.9 billion barrels of oil and 13 trillion cubic feet of gas. In 2004, the field produced about 220,000 barrels of oil and 1.3 billion cubic feet of gas per day. What is the producing gas-oil ratio? a. b. c. d. 4,300 5,909 6,842 7,523

6.

LNG suppliers must assure the quality and heat content of the gas from their LNG terminals. This is done in order to fulfill which of the following requirements? a. b. c. d. To To To To ensure ensure ensure ensure the the the the LNG LNG LNG LNG maintains the same characteristics of the gas extracted from the reservoir. is consistent with the sellers specifications. is free of methane. is consistent with the specifications of end use customers.

7.

Two manufacturing plants Factory Alpha and Factory Bravo are told by the government they each need to reduce their greenhouse gas emissions. The target reductions and expenses required to meet this goal for each factory are shown in the table below. Alpha 10 tons USD 120 per ton USD 1,200 Bravo 10 tons USD 40 per ton USD 400

Required emissions reductions Cost of emissions reductions Total cost of reductions

Under an emissions trading scheme, Factory Alpha can pay Factory Bravo to reduce its emissions by an additional 10 tons, in effect, buying the needed emissions credit from Bravo. What will Bravos final emission reduction cost be if it charges Alpha USD 600 for the emissions credit? a. b. c. d. USD USD USD USD 200 600 800 1,000

2012 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.

Energy Risk Professional Examination (ERP) Practice Exam 1

8.

Which of the following statement(s) about barrier options is/are correct? I. II. a. b. c. d. An up-and-out-floor is less expensive than a standard Asian option. An up-and-out floor is canceled if the underlying market price is less than the barrier price. Statement I only Statement II only Both statements Neither statement

9.

Although the industry has known about shale gas resources for decades, the resources have only recently become the focus of serious commercial exploration and production activities. What characteristic of shale gas has historically made exploration and production uneconomical? a. b. c. d. Shale Shale Shale Shale has low natural permeability. is an extremely dense rock that is difficult to drill through. gas is typically wet, requiring extensive processing. reserves tend to be in remote, hard-to-access locations.

10.

Based on the refined product yield from the three refineries summarized in the table below, identify the complexity of Refinery X, Y and Z assuming they each operate using the same sour, heavy crude oil supply. Refined Product Gasoline Jet Fuel Distillate Fuel Residual Fuel Coke Refinery Fuel Gain Refinery X 60 15 25 5 15 (20) Refinery Y 50 15 25 5 10 (5) Refinery Z 30 15 20 30 8 (3)

a. b. c. d.

X X X X

= = = =

simple, Y = complex, Z = very complex simple, Y = very complex, Z = complex complex, Y = simple, Z = very complex very complex, Y = complex, Z = simple

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Energy Risk Professional Examination (ERP) Practice Exam 1

11.

High operating costs and operational constraints make which of the following types of facility the least desirable option for underground natural gas storage? a. b. c. d. Depleted oil and gas fields Aquifers Salt caverns Storage tanks

12.

Consider a power grid that relies on combined cycle natural gas turbine plants for electricity production. What would the spark spread be for this particular power grid based on the following assumptions? a. b. c. d. Average plant heat rate is 8,500 Btu/kWh Current price of natural gas is USD 5.00/MMBtu Current price of electricity is USD 30.00/MWh. USD USD USD USD 0.0125/kWh 0.1250/kWh -0.0125/kWh -0.1250/kWh

13.

High pressure in subsurface reservoirs can cause a significant volume of natural gas to be dissolved in underground crude oil reserves. Which of the following is the correct term for this build-up of gas? a. b. c. d. Non-associated gas Crude oil gas Associated gas Working gas

14.

Claudio has been put in charge of developing a site for a new nuclear power plant. Because of the disaster in Fukushima, Japan, public sentiment has turned against nuclear power at this location. For this reason, Claudio is recommending the construction of a pebble-bed modular reactor (PBMR). What is the main advantage of the PBMR? a. b. c. d. The PBMR does not use uranium as fuel. PMBRs are considered safe because they cannot melt down like other designs. PBMRs produce more electricity than other similarly-sized reactor designs. Unlike other reactor designs, PBMRs do not generate high levels of heat.

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Energy Risk Professional Examination (ERP) Practice Exam 1

15.

Andreas purchased a monthly 100 MW on-peak power call option for a month that has 20 business days. The strike price is USD 75/MWh and the premium is USD 5/MWh. What would the gross settlement amount be if Andreas exercised the call option in a month when the average on-peak power price was USD 85/MWh? a. b. c. d. USD USD USD USD 160,000 240,000 320,000 480,000

16.

Makati and Sons Heating Oil Company expects customer demand to average 2,200 gallons of heating oil during the upcoming heating season. The company sells oil to customers using fixed price contracts and has decided to store enough oil to meet average customer demand of 2,300 gallons. They have also purchased call options to protect against the risk of a much colder than expected winter. What risk is the company primarily seeking to hedge? a. b. c. d. Volume Risk Supply Risk Credit Risk Location Basis Risk

17.

On June 20, Caufield Refining estimates it will need to purchase 40,000 barrels of crude on October 12. Caufield decides to hedge price risk using a November NYMEX futures contract. The November futures price on June 20 is USD 67.00/bbl. On October 12, Caufield is ready to purchase its required crude oil and closes out the futures contract on that day; at this time the spot price is USD 70.10/bbl and the futures price is USD 68.50/bbl. In this scenario, what is the effective price paid per barrel? a. b. c. d. USD USD USD USD 68.50 68.60 70.10 70.40

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Energy Risk Professional Examination (ERP) Practice Exam 1

18.

Steve Dolan is a power manager at Upstate Electric. He is negotiating a one-day contract to sell 100 MW of electricity at USD 55/MWh for a 24-hour period and has been asked to calculate the Value-at-Risk (VaR) for the contract. If the daily volatility of electricity prices is 2%, what is the daily VaR on the contract assuming a 95% confidence interval? a. b. c. d. USD USD USD USD 180 3,447 4,330 5,412

19.

Neptune Gas Exporters receives natural gas streams from several fields, each with a different heating content. Prior to distributing the gas through pipelines, Neptune blends the gases to ensure the exported gas is within a consistent heating range (expressed in Btu content per cubic foot). Neptunes blended gas should fall into what heating range? a. b. c. d. 500 to 800 Btu/cf 900 to 1,200 Btu/cf 1,200 to 1,500 Btu/cf 1,500 to 1,800 Btu/cf

20.

Markus Frackus seeks protection against electricity on-peak price spikes during a summer month in the PJM market. There are 20 business days in the month and 16 on-peak hours per day. Markus has obtained a daily on-peak option quote for 100 MW, with a strike price of USD 100/MWh and a premium of USD 10/MWh per day. Markus forecasts that there will be two days where prices will spike to USD 500/MWh and USD 700/MWh during the on-peak hours (the prices for all other on-peak periods would be less than USD 100/MWh). What is the profit on his option strategy if his forecast is accurate? a. b. c. d. USD USD USD USD 320,000 960,000 1,280,000 1,600,000

10

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Energy Risk Professional Examination (ERP) Practice Exam 1

21.

Consider the power grid shown below, which operates using a postage stamp pricing model with two designated zones labeled Zone A and Zone B. The two zones are interconnected via a high-capacity transmission line, allowing for electricity generated in one zone to be used in the other.

Zone A

Zone B

Main Transmission
When the transmission line experiences congestion, it is Zone B that sets the market clearing price for both Zones A and B. Given this information, which of the following statements is correct? a. b. c. d. Zone Zone Zone Zone A is a net exporter of electricity to Zone B. B is a net exporter of electricity to Zone A. B has a higher electricity demand than Zone A. A has a higher electricity demand than Zone B.

22.

Which of the following tests can be used to demonstrate that model errors are unbiased and normally distributed? I. QQ plot II. R-squared III. Autocorrelation test a. b. c. d. Statement I only Statements I and III Statements II and III Statements I, II and III

23.

Bordeaux Electrique is a utility company in southwest France that is required to meet local clean air emissions standards. In the past, Bordeaux Electrique has purchased emissions credits through bilateral, over-thecounter (OTC) trades. This year, Bordeaux Electrique has decided to buy credits through the European Climate Exchange (ECX). What is the main advantage of buying emission credits through an allowance exchange instead of through OTC deals? a. b. c. d. Exchanges avoid the heavy taxation levied against OTC profits. There are more arbitrage opportunities available on allowance exchanges. Allowance exchanges eliminate counterparty risk. The European Union is mandating the shift from OTC to exchange-based systems for allowance trading.

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11

Energy Risk Professional Examination (ERP) Practice Exam 1

24.

Patel is long 100 put options on the March Peak Forward contract. If the delta of the put options is -0.4, what position in the March Peak Forward contract will Patel need to create for the combined portfolio to be delta neutral? a. b. c. d. Short 40 March Peak Forward contracts Long 40 March Peak Forward contracts Short 60 March Peak Forward contracts Long 60 March Peak Forward contracts

25.

Samantha is trading heating oil for a large financial institution. Long term forecasts call for unusually volatile weather patterns for the upcoming months of January and February. Samantha decides to enter into a long straddle trade. There is currently a 1-month NYMEX heating oil call option with a strike price of USD 3.20 per gallon and premium of USD 0.15 per gallon and a 1-month NYMEX put option with a strike price of USD 3.20 per gallon and premium of USD 0.17 per gallon. What would be the net profit per contract if the price of heating oil is USD 2.80 at the time of expiration? a. b. c. d. USD USD USD USD 2,520 per contract 3,360 per contract 4,200 per contract 5,040 per contract

26.

Which of the following statements correctly defines the role of a system operator in an electric transmission network? a. b. c. d. The system operator ensures that all electric generating units on the transmission grid are maintained in accordance with system specifications. The system operator coordinates all activity on the distribution grid. The system operator coordinates the dispatch of generating units within the transmission pool. There is no need for a system operator in this case, since each member company independently plans and implements its own transmission network strategy.

12

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Energy Risk Professional Examination (ERP) Practice Exam 1

27.

A 3-month natural gas option with a strike of USD 6.00 on an August contract is trading at a Black-implied volatility of 45%. A call option with the same contract specifications, but a strike price of USD 6.50, is trading at a Black-implied volatility of 50%, producing a volatility smile. Which of the following conclusions can be made given the market information above? a. b. c. d. The volatility smile indicates that the market is feeling good about the economy and prices are expected to go higher. The different volatilities for the call option positions indicate that the lognormal Black model cannot capture the true underlying price behavior with a single volatility measure. A third call option with the same contract specifications, but a strike price of USD 7.00 must therefore be trading at a Black-implied volatility of 55%. The two options should have exactly the same volatility, creating a market arbitrage opportunity: the USD 6.00 option is under-priced relative to the USD 6.50 option.

Questions 28 - 29 use the information below: Colin is the procurement manager for a regional heating oil distributor in Alberta, Canada. In September, Colin notices the 3-month forward price for heating oil is trading at CAD 4.65 per gallon a price that appears too high relative to current market economics. Given a spot price of CAD 4.00 per gallon, a monthly storage cost of CAD .05 per gallon and annual risk-free interest rate of 4.25%?

28.

What would the net realized profit/loss per gallon be in 3 months if Colin executed a transaction to take a dvantage of a perceived mispricing between the spot and forward markets? a. b. c. d. CAD CAD CAD CAD -0.03 per gallon 0.12 per gallon 0.46 per gallon 0.61 per gallon

29.

Assuming Colins market information is accurate, other market participants pursue the same arbitrage opportunity, and no other market conditions change, what effects would you expect Colins trading strategy to have on the heating oil market? a. b. c. d. Speculative Speculative Speculative Speculative inventories inventories inventories inventories will will will will rise, driving the forward price down and the spot price up. rise, driving the forward price up and the spot price down. fall, driving the forward price down and the spot price up. fall, driving the forward price up and the spot price down.

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13

Energy Risk Professional Examination (ERP) Practice Exam 1

30.

Roger has constructed a portfolio of crude oil option contracts that he has delta hedged. Over a one month period, Roger observes that his portfolio is not performing as expected and he is concerned that the change in portfolio delta, relative to the change in the underlying price of oil, is too high. Which of the following port folio risk characteristics should Roger neutralize so that his hedge strategy more effectively responds to changes in the underlying price of oil? a. b. c. d. Beta Gamma Theta Vega

31.

Heinrich is the CRO for TransGlobal Petroleum, an oil company with production, refining and trading operations around the world. The senior management team at TransGlobal has decided to invest in a new integrated trading system and has asked Heinrich to outline a plan to ensure operational risk is minimized in the system design and launch. Which of the following statement(s) is/are correct about the trading system design? I. II. The system should capture all trading activity and be integrated with TransGlobals accounts system to manage properly the operational risks associated with reconciliation and accounting. The system should be integrated with the back-office deal monitoring system to ensure all trading and counterparty exposures are properly recorded and monitored. Statement I only Statement II only Both Statements Neither Statement

a. b. c. d.

32.

Eloise, ERP, is the risk manager for a large natural gas company. Her company uses a VaR model with a 95% confidence level to measure risk exposure and compliance with risk limits. If Eloise is concerned with the impact of extreme events, she should: a. b. c. d. Move the VaR confidence level down to 90%. Move the VaR confidence level up to 97%. Continue VaR testing at the 95% confidence level but adjust her risk limits. Implement stress testing to assess the impact of extreme events.

14

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Energy Risk Professional Examination (ERP) Practice Exam 1

33.

Akiko, an ERP, is pricing a daily transportation deal between Henry Hub and Houston Ship Channel using the mean-reverting Ornstein-Uhlenbeck process to model gas prices. In order to calculate the at-the-money (ATM) implied volatilities for Henry Hub and Houston Ship Channel Akiko will need to do which of the following? a. b. c. d. Calculate the correct volatilities since the implied volatilities from a Black-Scholes calculation are not the same volatilities used in the Ornstein-Uhlenbeck process. Scale the implied volatilities by 365250 since it is a daily deal. Roughly estimate implied volatilities. Nothing else needs to be done. Scale the implied volatilities by 250365 since it is a daily deal.

34.

Hydroelectric projects are not being pursued in many developed nations despite the fact they are an emissions-free source of power. What is the primary reason most developed countries are not building hydroelectric plants? a. b. c. d. National environmental regulations make the construction of new hydro projects extremely difficult. Without a global cap-and-trade emissions scheme, it is less-expensive to build fossil fuel-powered generation plants. Government incentives favor renewable projects like wind and solar over hydroelectric plants. Most developed nations have already largely exploited their hydroelectric potential.

35.

Which of the following statements is true about extra heavy crude oils that typically have an API below 15? a. b. c. d. Extra-heavy oil is not considered genuine petroleum. Extra-heavy oils are not commercially viable. Reserves of extra-heavy oil are concentrated in North America. The total global resources of extra-heavy oils may be four times as large as the worlds proven reserves of conventional oils.

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15

Energy Risk Professional Examination (ERP) Practice Exam 1

36.

Electricity generation using wind power has experienced rapid growth during the past three decades. Which of the following statements regarding the use of wind energy is correct? a. b. c. d. The commercial wind energy industry in the United States grew rapidly in the 1980s, despite high production costs due to legislation and federal regulation. As wind velocity increases, the amount of electricity generated by a wind turbine also increases without limit. Thanks to their persistent on-shore wind flows, the states of the U.S. West Coast (California, Oregon, Washington) have dubbed themselves the Saudi Arabia of Wind. The average output of a wind turbine is usually only 25-40% of its rated output.

37.

Which of the following is a weakness in applying single-factor mean-reverting models in option valuation? a. b. c. d. Black-equivalent volatility goes to zero with increasing time to expiration. Black-equivalent volatility increases with increasing time to expiration. The Black-equivalent volatility decreases with increasing time to expiration. Black-equivalent volatility is proportional to spot price volatility.

38.

Assume that a call option on natural gas with a strike price of USD 5.60/MMBtu has a vega of 1.0893. What would be the vega of a put option with the same strike price assuming the current price of natural gas is USD 5.80/MMBtu and the current risk-free interest rate is 2.5%. a. -1.0893 b. 0.0893 c. 1.0893 d. There is not enough information to compute vega.

16

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Energy Risk Professional Examination (ERP) Practice Exam 1

39.

Consider the following two option contracts: Option 1: January 2012 daily call, strike price of USD 30, call value of USD 5.45 Option 2: January 2012 monthly call, strike price of USD 33, call value of USD 6.00

What is the biggest challenge in estimating the implied volatility for these two contracts assuming the following parameters? a. b. c. d. Valuation date: 11/10/2011 Risk free rate: 4% Underlying value: USD 28 The options are based on different time intervals (daily vs. monthly). The option quotes have different strike prices. The option quotes are both for call options. Winter power options are highly volatile due to seasonality factors.

40.

An August natural gas futures contract is currently priced at USD 5.60. You have been asked to structure a costless collar for a client who consumes natural gas and expects natural gas prices to rise. The following option quotes for calls and puts on August natural gas futures are currently available: Strike (USD) 5.650 5.625 5.600 5.575 5.525 Call Price (USD) 0.31 0.32 0.34 0.35 0.37 Put Price (USD) 0.36 0.35 0.34 0.32 0.30

Considering the information above, which one of the following portfolios would you suggest for your client? I. II. a. b. c. d. A short call with a strike of 5.575 and a long put with a strike of 5.625 A long call with a strike of 5.625 and a short put with a strike of 5.575 Portfolio I only Portfolio II only Either portfolio Neither portfolio

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17

Energy Risk Professional(ERP ) Examination


Practice Exam 1
Answers

Energy Risk Professional Examination (ERP) Practice Exam 1

a. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23.

b.

c.

d. 24. 25. 26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36. 37. 38. 39. 40.

a.

b.

c.

d.

Correct way to complete 1. Wrong way to complete 1.

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19

Energy Risk Professional(ERP ) Examination


Practice Exam 1
Explanations

Energy Risk Professional Examination (ERP) Practice Exam 1

1.

The relationship between cash and futures prices can vary due to systematic and unsystematic changes in basis. Which of the following is synonymous with characteristics of systematic changes in basis, leading to convergence between cash and futures price? a. b. c. d. Delta Gamma Theta Vega

Correct answer: c Explanation: Answer c is correct because, both systematic basis and Theta have values that degrade with time. Since answer c is correct, all other answers are incorrect. We note that the Greeks are not discussed in the chapter, but from other readings the candidate should be able to understand that Theta degrades as time to expiration diminishes and, likewise, so does systematic basis. Reading reference: Fundamentals of Trading Energy Futures & Options, 2nd Edition, Errera and Brown, Chapter 3, p.50.

2.

Victor is a natural gas trader based in Chicago. He has just learned that a large coal-fired electricity generating plant in Pennsylvania will be shutting down for unplanned maintenance in a few days, increasing demand for natural gas to fuel backup plants. Victor plans to take advantage of this speculative opportunity by purchasing gas on the spot market, storing it briefly and then selling it when demand rises as the natural gas power plants come on line. This is an example of what kind of natural gas spread trade? a. b. c. d. Location Heat Rate Time Swing

Correct answer: d Explanation: Swing trades rely on a traders ability to store gas for short periods of time, allowing them to buy low and sell high by delivering the gas on the spot market when demand is high. Time spreads are simultaneous buy/sells of future, forward, or swap contracts with differing maturity dates; winter vs. spring, for example. Similarly, a locational spread is a simultaneous buy/sell at different locations with the same maturity while a heat rate is a simultaneous buy/sell of power and gas matching either the spread trading in the market or the underlying heat rate of a physical plant. Reading reference: Energy Trading & Investing, Edwards, Chapter 2.1, page 81-82.

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21

Energy Risk Professional Examination (ERP) Practice Exam 1

3.

Heinz provides risk management support to a multinational energy trading desk. His primary responsibility is to inform the Chief Risk Officer about derivatives trades executed each day along with all trader risk limit exceptions. Which of the following risk control categories best describes Heinzs primary responsibility? a. b. c. d. Risk Risk Risk Risk Reporting Review Assessment Control

Correct answer: a Explanation: Reporting derivatives positions to upper management is a duty that falls under the reporting (communications) category of risk control; it is an important aspect of risk management because if upper management is not informed of derivative usage the effects on the company can be devastating. Daily reporting of derivative positions is not the same as an in-depth internal review of a company's finances or an audit, thus b is not the correct answer; nor do the reporting duties fall under the risk assessment or management control categories. Reading reference: Energy Markets: Price Risk Management and Trading, James, Chapter 10, page 183-84.

4.

Andrew Willingham, ERP, is modeling the volatility of WTI forward contract prices using a single-factor log-of-price mean reverting model. What will the output from the model indicate about the correlation between spot and forward price returns assuming the initial price level in the spot and forward market are equal? a. b. c. d. Correlation will remain perfect across all points between the front and back-end of the forward price curve. Correlation will decrease between the front and back-end of the forward price curve. Correlation will increase between the front and back-end of the forward price curve. Correlation will fluctuate due to seasonality.

Correct answer: a Explanation: Single factor models assume all factors move in tandem. Assuming the initial price level for spot and forward prices are equal, the correlation between spot and forward price returns will remain perfect between the front and back-end of the forward price curve. Reading reference: Energy Risk: Valuing and Managing Energy Derivatives, Pilipovic, Chapter 8, page 234-236.

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Energy Risk Professional Examination (ERP) Practice Exam 1

5.

Karachaganak, Kazakhstan is one of the largest gas condensate fields in the world, with proven reserves of 1.9 billion barrels of oil and 13 trillion cubic feet of gas. In 2004, the field produced about 220,000 barrels of oil and 1.3 billion cubic feet of gas per day. What is the producing gas-oil ratio? a. b. c. d. 4,300 5,909 6,842 7,523

Correct answer: b Explanation: Answer b is correct. The definition of producing gas-oil ratio requires gas production (in cubic feet) to be divided by oil production (in barrels). Thus, GOR = (1,300,000,000 cf)/(220,000 bbl) = 5,909. Note that the gas-oil ratio of the proved reserves is computed as (13 Tcf)/(1.9 Bbbl) = 6,842 which denotes a field with oil (condensate) and gas production. Reading reference: Nontechnical Guide to Petroleum Geology, Exploration, Drilling, and Production, 2nd Edition, Hyne, Chapter 1, page 11.

6.

LNG suppliers must assure the quality and heat content of the gas from their LNG terminals. This is done in order to fulfill which of the following requirements? a. b. c. d. To To To To ensure ensure ensure ensure the the the the LNG LNG LNG LNG maintains the same characteristics of the gas extracted from the reservoir. is consistent with the sellers specifications. is free of methane. is consistent with the specifications of end use customers.

Correct answer: d Explanation: Answer d is correct. The quality of the gas that comes from an LNG import terminal must be consistent with the requirements of downstream gas customers or meet the specifications of the interconnected gas transmission lines, which vary by region and by country. Reading reference: Department of Energy. Liquefied Natural Gas: Understanding the Basic Facts, page 15.

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23

Energy Risk Professional Examination (ERP) Practice Exam 1

7.

Two manufacturing plants Factory Alpha and Factory Bravo are told by the government they each need to reduce their greenhouse gas emissions. The target reductions and expenses required to meet this goal for each factory are shown in the table below. Alpha 10 tons USD 120 per ton USD 1,200 Bravo 10 tons USD 40 per ton USD 400

Required emissions reductions Cost of emissions reductions Total cost of reductions

Under an emissions trading scheme, Factory Alpha can pay Factory Bravo to reduce its emissions by an additional 10 tons, in effect, buying the needed emissions credit from Bravo. What will Bravos final emission reduction cost be if it charges Alpha USD 600 for the emissions credit? a. b. c. d. USD USD USD USD 200 600 800 1,000

Correct answer: a Explanation: By making the deal with Factory Alpha, Factory Bravos total cost of reductions will be USD 200 (answer a). Bravo will now have to reduce their emissions by 20 tons, at USD 40 per ton; this will cost Bravo USD 800. Bravo will receive a payment from Alpha of USD 600, making their final costs USD 200 (800 600 = 200). Reading reference: The Handbook of Commodity Investing, Fabozzi, Chapter 37.

8.

Which of the following statement(s) about barrier options is/are correct? I. II. a. b. c. d. An up-and-out-floor is less expensive than a standard Asian option. An up-and-out floor is canceled if the underlying market price is less than the barrier price. Statement I only Statement II only Both statements Neither statement

Correct answer: a Explanation: Answer a is correct. Statement I is true an up and out floor is by definition less expensive than a standard Asian option; statement II is false, the option is canceled if the market price exceeds the barrier price. Reading reference: Managing Energy Price Risk, Kaminski, Chapter 3, pages 113-115.

24

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Energy Risk Professional Examination (ERP) Practice Exam 1

9.

Although the industry has known about shale gas resources for decades, the resources have only recently become the focus of serious commercial exploration and production activities. What characteristic of shale gas has historically made exploration and production uneconomical? a. b. c. d. Shale Shale Shale Shale has low natural permeability. is an extremely dense rock that is difficult to drill through. gas is typically wet, requiring extensive processing. reserves tend to be in remote, hard-to-access locations.

Correct answer: a Explanation: The correct answer is a. Shale naturally has low permeability, meaning only a small amount of a reservoir is able to flow towards a drilled hole. Improvements in hydraulic fracturing technology and techniques, which open fissures within the shale allowing for the free flow of gas, have made shale reserves commercially viable, making a the correct answer. Many shale reserves in the United States are near population and natural gas consumption centers, while shale gas is not typically wet, but in the cases of wet gas, these hydrocarbons can form an important revenue stream. Reading reference: Impact of Shale Gas Development on Global Gas Markets, Kenneth Medlock.

10.

Based on the refined product yield from the three refineries summarized in the table below, identify the complexity of Refinery X, Y and Z assuming they each operate using the same sour, heavy crude oil supply. Refined Product Gasoline Jet Fuel Distillate Fuel Residual Fuel Coke Refinery Fuel Gain a. b. c. d. X X X X = = = = Refinery X 60 15 25 5 15 (20) Refinery Y 50 15 25 5 10 (5) Refinery Z 30 15 20 30 8 (3)

simple, Y = complex, Z = very complex simple, Y = very complex, Z = complex complex, Y = simple, Z = very complex very complex, Y = complex, Z = simple

Correct answer: d Explanation: Answer d is correct. Refinery complexity refers to the capacity and type of processing units that comprise a refinery. Refinery complexity will increase when complex units with large capacity are added since they have greater ability to convert (heavy) crude input into gasoline. For a given grade of crude oil (in this case, medium sour, heavy), as the complexity of the refinery increases the gasoline yield increases and the residual fuel yield decreases (the residual fuel stream is being converted to gasoline). Reading reference: Petroleum Refining in Nontechnical Language, 3rd Edition, Leffler, Chapter 20, page 196.
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Energy Risk Professional Examination (ERP) Practice Exam 1

11.

High operating costs and operational constraints make which of the following types of facility the least desirable option for underground natural gas storage? a. b. c. d. Depleted oil and gas fields Aquifers Salt caverns Storage tanks

Correct answer: b Explanation: Answer b is correct. Aquifers are considered the least desirable underground storage facility for several reasons the geology of the aquifer is usually not well understood, infrastructure (wells, pumps, compressors, etc.) is unavailable at the site, greater injection pressures mean higher operating cost, gas will need to be dehydrated, and more stringent environmental regulations will be in place. Reading reference: Fundamentals of Natural Gas, Chandra: Chapter 2, page 69-73.

12.

Consider a power grid that relies on combined cycle natural gas turbine plants for electricity production. What would the spark spread be for this particular power grid based on the following assumptions? a. b. c. d. Average plant heat rate is 8,500 Btu/kWh Current price of natural gas is USD 5.00/MMBtu Current price of electricity is USD 30.00/MWh. USD USD USD USD 0.0125/kWh 0.1250/kWh -0.0125/kWh -0.1250/kWh

Correct answer: c Explanation: Answer c is correct, the calculation for determining the spark spread in this scenario is as follows: Spark Spread = Output Price Input Price Output Price = USD 30/MWh x 1MWh/1000kWh = USD 0.03/kWh Input Price = 8500 Btu/kWh x USD 5/1,000,000Btu = USD 0.0425/kWh Therefore, the Spark Spread = -0.0125 Reading reference: Managing Energy Price Risk, Kaminski, Chapter 3, page 120.

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Energy Risk Professional Examination (ERP) Practice Exam 1

13.

High pressure in subsurface reservoirs can cause a significant volume of natural gas to be dissolved in underground crude oil reserves. Which of the following is the correct term for this build-up of gas? a. b. c. d. Non-associated gas Crude oil gas Associated gas Working gas

Correct answer: c Explanation: Answer c is correct. Because of high pressure in the subsurface reservoir, a considerable volume of natural gas can be dissolved in crude oil. The formation, dissolved or solution gas/oil ratiois the cubic feet of natural gas dissolved in one barrel of oil in that reservoir under subsurface conditions. The volume measurements are reported under surface conditions. In general, as the pressure of the reservoir increases with depth, the amount of natural gas that can be dissolved in crude oil increases. When crude oil is lifted up a well to the surface, the pressure is relieved, and the natural gas, called solution gas, bubbles out of the oil. The producing gas-oil ratio (GOR) of a well is the number of cubic feet of gas the well produces per barrel of oil. Non-associated natural gasis gas that is not in contact with oil in the subsurface. A non-associated gas well produces almost pure methane. Associated natural gas occurs in contact with crude oil in the subsurface. It occurs both as gas in the free gas cap above the oil and gas dissolved in the crude oil. Reading reference: Nontechnical Guide to Petroleum Geology, Exploration, Drilling, and Production, Hyne, Chapter 1, page 11.

14.

Claudio has been put in charge of developing a site for a new nuclear power plant. Because of the disaster in Fukushima, Japan, public sentiment has turned against nuclear power at this location. For this reason, Claudio is recommending the construction of a pebble-bed modular reactor (PBMR). What is the main advantage of the PBMR? a. b. c. d. The PBMR does not use uranium as fuel. PMBRs are considered safe because they cannot melt down like other designs. PBMRs produce more electricity than other similarly-sized reactor designs. Unlike other reactor designs, PBMRs do not generate high levels of heat.

Correct answer: b Explanation: Thanks to their design, PBMRs will shut down if operating temperatures get too high, meaning that a core meltdown, as nearly happened in the Three Mile Island incident, is impossible, thus b is the correct answer. PBMRs still use uranium as fuel, generate high temperatures to produce steam to drive a turbine to generate electricity, and a PBMR does not produce more electricity than other designs, in fact PBMRs are typically smaller (per unit) than PWRs and BWRs. Reading reference: Energy for the 21st Century: A Comprehensive Guide to Conventional and Alternative Sources, Nersesian, Chapter 8, pages 287-88.

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27

Energy Risk Professional Examination (ERP) Practice Exam 1

15.

Andreas purchased a monthly 100 MW on-peak power call option for a month that has 20 business days. The strike price is USD 75/MWh and the premium is USD 5/MWh. What would the gross settlement amount be if Andreas exercised the call option in a month when the average on-peak power price was USD 85/MWh? a. b. c. d. USD USD USD USD 160,000 240,000 320,000 480,000

Correct answer: c Explanation: The correct answer is c; the payoff does not include the amount of premium (32,000 MWh x USD 85 USD 75). Payout is max(St k,0) x Q, wherein Q = quantity. Answer a is incorrect, because it includes the premium cost of USD 160,000 (i.e. 32,000 MWh x USD 5). Answer b is incorrect, because it assumes an all-day usage of 48,000 MWh and thus a premium cost (48,000 MWh x USD 85 USD 75-USD 5); while answer d is incorrect, because it assumes 48,000 MWh (48,000 MWh x USD 85 USD 75). Assumes candidates will know on-peak power call option means for 16 hours per day. Reading reference: Managing Energy Price Risk, Kaminski, chapter 2, page 46.

16.

Makati and Sons Heating Oil Company expects customer demand to average 2,200 gallons of heating oil during the upcoming heating season. The company sells oil to customers using fixed price contracts and has decided to store enough oil to meet average customer demand of 2,300 gallons. They have also purchased call options to protect against the risk of a much colder than expected winter. What risk is the company primarily seeking to hedge? a. b. c. d. Volume Risk Supply Risk Credit Risk Location Basis Risk

Correct answer: a Explanation: Answer a is correct, the heating oil company is concerned about a colder than expected winter, but does not want to be stuck with an excess of inventory. Call options allow the company to purchase additional inventory at a set price should temperatures drop below normal, the options can expire unused if the winter temperatures are at a normal level. Reading reference: Surviving Energy Prices, Beutel, Chapter 3, pages 29-30.

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Energy Risk Professional Examination (ERP) Practice Exam 1

17.

On June 20, Caufield Refining estimates it will need to purchase 40,000 barrels of crude on October 12. Caufield decides to hedge price risk using a November NYMEX futures contract. The November futures price on June 20 is USD 67.00/bbl. On October 12, Caufield is ready to purchase its required crude oil and closes out the futures contract on that day; at this time the spot price is USD 70.10/bbl and the futures price is USD 68.50/bbl. In this scenario, what is the effective price paid per barrel? a. b. c. d. USD USD USD USD 68.50 68.60 70.10 70.40

Correct answer: b Explanation: The effective price paid (in dollars per barrel) is the final spot price less the gain on the futures, or 70.10 1.50 = 68.60. This can also be calculated as the initial futures price plus the final basis, 67.00 + 1.60 = 68.60. Reading reference: Fundamentals of Trading Energy Futures & Options, Errera and Brown, Chapter 3, page 43-44.

18.

Steve Dolan is a power manager at Upstate Electric. He is negotiating a one-day contract to sell 100 MW of electricity at USD 55/MWh for a 24-hour period and has been asked to calculate the Value-at-Risk (VaR) for the contract. If the daily volatility of electricity prices is 2%, what is the daily VaR on the contract assuming a 95% confidence interval? a. b. c. d. USD USD USD USD 180 3,447 4,330 5,412

Correct answer: c Explanation: Answer c is correct. The correct application of the VaR calculation in this case is the lot size multiplied by the hourly rate multiplied by the time period of the contract multiplied by the daily volatility measurement multiplied by the confidence level factor, which in this case is: 100 x 55 x 24 x .02 x 1.64 = USD 4,330. Since the contract is for one day, no time adjustment is needed. Reading reference: Price Risk Management in the Energy Industry: The Value at Risk Approach, Mauro, Section 6.

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Energy Risk Professional Examination (ERP) Practice Exam 1

19.

Neptune Gas Exporters receives natural gas streams from several fields, each with a different heating content. Prior to distributing the gas through pipelines, Neptune blends the gases to ensure the exported gas is within a consistent heating range (expressed in Btu content per cubic foot). Neptunes blended gas should fall into what heating range? a. b. c. d. 500 to 800 Btu/cf 900 to 1,200 Btu/cf 1,200 to 1,500 Btu/cf 1,500 to 1,800 Btu/cf

Correct answer: b Explanation: Answer b is correct. Almost all gas produced in the world has a heat content that ranges between 900 and 1200 Btu per cubic foot. Natural gases produced in association with crude oil will typically have a higher Btu content, because the gas is in contact with crude oil and absorbs some of the heavier components in the crude oil. Non-associated natural gas and gases with a high CO2 content and related impurities will have a lower Btu content due to the dominance of methane and because most impurities do not burn, thus reducing the heat content. Reading reference: Nontechnical Guide to Petroleum Geology, Exploration, Drilling, and Production, 2nd Edition, Hyne, Chapter 1, page 13.

20.

Markus Frackus seeks protection against electricity on-peak price spikes during a summer month in the PJM market. There are 20 business days in the month and 16 on-peak hours per day. Markus has obtained a daily on-peak option quote for 100 MW, with a strike price of USD 100/MWh and a premium of USD 10/MWh per day. Markus forecasts that there will be two days where prices will spike to USD 500/MWh and USD 700/MWh during the on-peak hours (the prices for all other on-peak periods would be less than USD 100/MWh). What is the profit on his option strategy if his forecast is accurate? a. b. c. d. USD USD USD USD 320,000 960,000 1,280,000 1,600,000

Correct answer: c Explanation: Answer c is correct, using the following formula: Premium = USD 320,000 or (USD 10 x 100 MW x 16 x 20) Option Payoff = USD 1,600,000 or ((500-100+700-100) x16 x100) Option Profit = USD 1,280,000 or (USD 1,600,000-USD 320,000) Reading reference: Managing Energy Price Risk, Kaminski, Chapter 2, pages 59-60.

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Energy Risk Professional Examination (ERP) Practice Exam 1

21.

Consider the power grid shown below, which operates using a postage stamp pricing model with two designated zones labeled Zone A and Zone B. The two zones are interconnected via a high-capacity transmission line, allowing for electricity generated in one zone to be used in the other.

Zone A

Zone B

Main Transmission
When the transmission line experiences congestion, it is Zone B that sets the market clearing price for both Zones A and B. Given this information, which of the following statements is correct? a. b. c. d. Zone Zone Zone Zone A is a net exporter of electricity to Zone B. B is a net exporter of electricity to Zone A. B has a higher electricity demand than Zone A. A has a higher electricity demand than Zone B.

Correct answer: a Explanation: Answer a is correct. Under Postage Stamp pricing, the zone that is a net exporter of electricity receives the clearing price of the zone that imports from it. Answer b is incorrect because a is correct. Answer c and d are also incorrect, demand is not the sole factor that drives the MCP in a particular zone. It is possible that an exporting zone can have a higher demand than the importing zone with the importing zone still setting the marginal price.Topic: pmSubtopic: BlankAIMS: Describe why locational issues are important for electrical systems; list the requirements for locational charging. Reading reference: Electricity Markets: Pricing, Structures and Economics, Harris, Chapter 7, pages 250-251.

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Energy Risk Professional Examination (ERP) Practice Exam 1

22.

Which of the following tests can be used to demonstrate that model errors are unbiased and normally distributed? I. QQ plot II. R-squared III. Autocorrelation test a. b. c. d. Statement I only Statements I and III Statements II and III Statements I, II and III

Correct answer: b. Explanation: Answer b is correct. The QQ plot and the autocorrelation test are used for testing that errors are normally distributed and that there is no bias from error to error. R-squared measure, on the other hand, measures how well the model fits the data. It tells us nothing about the distribution of the errors, but gives us general information about model performance. Hence, the correct answer is b. Reading reference: Energy Risk, Pilipovic, Chapter 4, pages 81-84.

23.

Bordeaux Electrique is a utility company in southwest France that is required to meet local clean air emissions standards. In the past, Bordeaux Electrique has purchased emissions credits through bilateral, over-thecounter (OTC) trades. This year, Bordeaux Electrique has decided to buy credits through the European Climate Exchange (ECX). What is the main advantage of buying emission credits through an allowance exchange instead of through OTC deals? a. b. c. d. Exchanges avoid the heavy taxation levied against OTC profits. There are more arbitrage opportunities available on allowance exchanges. Allowance exchanges eliminate counterparty risk. The European Union is mandating the shift from OTC to exchange-based systems for allowance trading.

Correct answer: c Explanation: In the newly-developing emissions allowance market, often buyers and sellers have no previous knowledge of one another, making credit, or counterparty, risk a major concern in their transactions; trades executed through an exchange eliminate this risk, making c the correct answer. Reading reference: Handbook of Commodity Investing, Fabozzi (ed.), Chapter 37, page 849.

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Energy Risk Professional Examination (ERP) Practice Exam 1

24.

Patel is long 100 put options on the March Peak Forward contract. If the delta of the put options is -0.4, what position in the March Peak Forward contract will Patel need to create for the combined portfolio to be delta neutral? a. b. c. d. Short 40 March Peak Forward contracts Long 40 March Peak Forward contracts Short 60 March Peak Forward contracts Long 60 March Peak Forward contracts

Correct answer: b Explanation: Answer b is correct. A Long Put is really a short position in the underlying, in this case March Peak Power. In order to make the portfolio delta neutral Patel needs to purchase enough forward contracts to offset the potential downside risk in the option position(-0.4*100 = -40). Consequently, Patel should be long 40 March Peak Forward contracts. Reading reference: Energy Derivatives: Pricing and Risk Management, Clewlow and Strickland, Chapter 9.2, pages 164-167.

25.

Samantha is trading heating oil for a large financial institution. Long term forecasts call for unusually volatile weather patterns for the upcoming months of January and February. Samantha decides to enter into a long straddle trade. There is currently a 1-month NYMEX heating oil call option with a strike price of USD 3.20 per gallon and premium of USD 0.15 per gallon and a 1-month NYMEX put option with a strike price of USD 3.20 per gallon and premium of USD 0.17 per gallon. What would be the net profit per contract if the price of heating oil is USD 2.80 at the time of expiration? a. b. c. d. USD USD USD USD 2,520 per contract 3,360 per contract 4,200 per contract 5,040 per contract

Correct answer: b Explanation: Answer b is correct because: at 2.80, the profit is 3.20 - 2.80 -.15 -.17 = .08 multiplied by 42,000 gallons per contract. In this situation the long put provided the profit, while the premium payments reduced the profit. Reading reference: Energy Markets: Price Risk Management and Trading, James, Chapter 13, pages 253-255.

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33

Energy Risk Professional Examination (ERP) Practice Exam 1

26.

Which of the following statements correctly defines the role of a system operator in an electric transmission network? a. b. c. d. The system operator ensures that all electric generating units on the transmission grid are maintained in accordance with system specifications. The system operator coordinates all activity on the distribution grid. The system operator coordinates the dispatch of generating units within the transmission pool. There is no need for a system operator in this case, since each member company independently plans and implements its own transmission network strategy.

Correct answer: c Explanation: While the system operator has many responsibilities, the one listed in answer c is the only correct one of the alternatives listed. Answer a is incorrect, since the system operator does not play a role in maintaining the condition of generation units. Answer b is incorrect since the system operator manages the transmission network, not the distribution network. Answer d is incorrect, since PJM and other pools have a system operator. Doing otherwise could result in gaming, due to a lack of an independent party. Reading reference: Making Competition Work, Hunt, Chapter 2, pages 20-21.

27.

A 3-month natural gas option with a strike of USD 6.00 on an August contract is trading at a Black-implied volatility of 45%. A call option with the same contract specifications, but a strike price of USD 6.50, is trading at a Black-implied volatility of 50%, producing a volatility smile. Which of the following conclusions can be made given the market information above? a. b. c. d. The volatility smile indicates that the market is feeling good about the economy and prices are expected to go higher. The different volatilities for the call option positions indicate that the lognormal Black model cannot capture the true underlying price behavior with a single volatility measure. A third call option with the same contract specifications, but a strike price of USD 7.00 must therefore be trading at a Black-implied volatility of 55%. The two options should have exactly the same volatility, creating a market arbitrage opportunity: the USD 6.00 option is under-priced relative to the USD 6.50 option.

Correct answer: b Explanation: Answer b is correct. Black-implied volatilities for options with the same contract specifications but different strikes are necessary to capture the true underlying price behavior and therefore traded option prices. Black option pricing model assumes log-normal price behavior for the underlying forward prices, which generally does not capture the full spectrum of behavior of energy prices given a single volatility measure. Reading reference: Energy Risk, Pilipovic: Chapter 8, page 232.

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Energy Risk Professional Examination (ERP) Practice Exam 1

Questions 28 - 29 use the information below: Colin is the procurement manager for a regional heating oil distributor in Alberta, Canada. In September, Colin notices the 3-month forward price for heating oil is trading at CAD 4.65 per gallon a price that appears too high relative to current market economics. Given a spot price of CAD 4.00 per gallon, a monthly storage cost of CAD .05 per gallon and annual risk-free interest rate of 4.25%?

28.

What would the net realized profit/loss per gallon be in 3 months if Colin executed a transaction to take a dvantage of a perceived mispricing between the spot and forward markets? a. b. c. d. CAD CAD CAD CAD -0.03 per gallon 0.12 per gallon 0.46 per gallon 0.61 per gallon

Correct answer: c Explanation: Answer c is correct because, it properly accounts for cash and carry the forward is too high, so Colin should buy the spot and short the forward. All other answers are incorrect. FV of Spot = CAD 4.00 *(1.0107) = 4.0428 FV of Storage = .05 + .05 * (1.0035)^1 + .05 * (1.0035)^2 = .1506Total FV = 4.19 Forward Price of CAD 4.65> FV of Spot (including storage) CAD 4.19 Arbitrage profit by buying spot, storing, and selling forward short = .46 Reading reference: Fundamentals of Derivatives Markets, McDonald, Chapter 6, pages 181-183.

29.

Assuming Colins market information is accurate, other market participants pursue the same arbitrage opportunity, and no other market conditions change, what effects would you expect Colins trading strategy to have on the heating oil market? a. b. c. d. Speculative Speculative Speculative Speculative inventories inventories inventories inventories will will will will rise, driving the forward price down and the spot price up. rise, driving the forward price up and the spot price down. fall, driving the forward price down and the spot price up. fall, driving the forward price up and the spot price down.

Correct answer: a Explanation: The transaction will have the effect of increasing speculative inventories of the commodity and increasing volumes offered at the current forward price, driving the forward price down and the spot price up. Reading reference: Fundamentals of Trading Energy Futures & Options, Errera and Brown, Chapter 3, pages 32-33.

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35

Energy Risk Professional Examination (ERP) Practice Exam 1

30.

Roger has constructed a portfolio of crude oil option contracts that he has delta hedged. Over a one month period, Roger observes that his portfolio is not performing as expected and he is concerned that the change in portfolio delta, relative to the change in the underlying price of oil, is too high. Which of the following port folio risk characteristics should Roger neutralize so that his hedge strategy more effectively responds to changes in the underlying price of oil? a. b. c. d. Beta Gamma Theta Vega

Correct answer: b Explanation: The correct answer is b. Rogers delta hedge will not perform as well as expected as price of the underlying assets diverge from the prices of the options in his portfolio. The way to counteract this trend is to attempt to neutralize the sensitivity of the portfolio to the change in price between the option and the underlying. This sensitivity is known as gamma, answer b. Reading reference: Energy Derivatives, Clewlow and Strickland, Chapter 9, pages 169-173.

31.

Heinrich is the CRO for TransGlobal Petroleum, an oil company with production, refining and trading operations around the world. The senior management team at TransGlobal has decided to invest in a new integrated trading system and has asked Heinrich to outline a plan to ensure operational risk is minimized in the system design and launch. Which of the following statement(s) is/are correct about the trading system design? I. II. The system should capture all trading activity and be integrated with TransGlobals accounts system to manage properly the operational risks associated with reconciliation and accounting. The system should be integrated with the back-office deal monitoring system to ensure all trading and counterparty exposures are properly recorded and monitored. Statement I only Statement II only Both Statements Neither Statement

a. b. c. d.

Correct answer: c Explanation: To help mitigate operational risk an integrated trading system should link to the accounts system of an organization to ensure trade reconciliation and accounting. The system should also provide for the reporting and ongoing monitoring of all transactions to ensure counterparty exposures are recorded and monitored properly. Reading reference: Energy Markets: Price Risk Management and Trading, James, Chapter 15, page 309.

36

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Energy Risk Professional Examination (ERP) Practice Exam 1

32.

Eloise, ERP, is the risk manager for a large natural gas company. Her company uses a VaR model with a 95% confidence level to measure risk exposure and compliance with risk limits. If Eloise is concerned with the impact of extreme events, she should: a. b. c. d. Move the VaR confidence level down to 90%. Move the VaR confidence level up to 97%. Continue VaR testing at the 95% confidence level but adjust her risk limits. Implement stress testing to assess the impact of extreme events.

Correct answer: d Explanation: Answer d is correct, VaR measures only possible realities given a set of inputs, it does not account for unexpected or extreme events. Reading reference: Incorporating Stress Tests Into Market Risk Modeling, Aragones, Blanco, and Dowd.

33.

Akiko, an ERP, is pricing a daily transportation deal between Henry Hub and Houston Ship Channel using the mean-reverting Ornstein-Uhlenbeck process to model gas prices. In order to calculate the at-the-money (ATM) implied volatilities for Henry Hub and Houston Ship Channel Akiko will need to do which of the following? a. b. c. d. Calculate the correct volatilities since the implied volatilities from a Black-Scholes calculation are not the same volatilities used in the Ornstein-Uhlenbeck process. Scale the implied volatilities by 365250 since it is a daily deal. Roughly estimate implied volatilities. Nothing else needs to be done. Scale the implied volatilities by 250365 since it is a daily deal.

Correct answer: a Explanation: Answer a is correct. Volatility has to be estimated in the context of the stochastic process Black-Scholes model. The volatility for the Ornstein-Uhlenbeck process has units of dollars. The volatilities in Black-Scholes and Ornstein-Uhlenbeck are not interchangeable. Reading reference: Energy Derivatives: Pricing and Risk Management, Clewlow and Strickland, Chapter 3.2.2, page 41.

2012 Global Association of Risk Professionals. All rights reserved. It is illegal to reproduce this material in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

37

Energy Risk Professional Examination (ERP) Practice Exam 1

34.

Hydroelectric projects are not being pursued in many developed nations despite the fact they are an emissions-free source of power. What is the primary reason most developed countries are not building hydroelectric plants? a. b. c. d. National environmental regulations make the construction of new hydro projects extremely difficult. Without a global cap-and-trade emissions scheme, it is less-expensive to build fossil fuel-powered generation plants. Government incentives favor renewable projects like wind and solar over hydroelectric plants. Most developed nations have already largely exploited their hydroelectric potential.

Correct answer: d Explanation: While all are factors, d is the major reason. With the exception of Canada, most developed nations have already constructed hydroelectric plants at suitable sites within their national borders. Much of the future growth in hydropower will come from developing nations like China, Indonesia and Brazil. Reading reference: Renewable Energy in Nontechnical Language, Chambers, Chapter 6, pages 150-152.

35.

Which of the following statements is true about extra heavy crude oils that typically have an API below 15? a. b. c. d. Extra-heavy oil is not considered genuine petroleum. Extra-heavy oils are not commercially viable. Reserves of extra-heavy oil are concentrated in North America. The total global resources of extra-heavy oils may be four times as large as the worlds proven reserves of conventional oils.

Correct answer: d Explanation: According to the text, extra-heavy resources are four times the proven reserves of conventional oil, making d the correct answer. Answer a is incorrect as per the text, extra-heavy oil is genuine petroleum; extra-heavy oils are currently produced commercially in Canada and Venezuela, making b incorrect; and while North America has large extra-heavy reserves, so too do Russia, Venezuela and Indonesia, making c incorrect as well. Reading reference: Oil, Gas Exploration, and Production, Institut Francais du Petrole Publications, Chapter 3, page 105.

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Energy Risk Professional Examination (ERP) Practice Exam 1

36.

Electricity generation using wind power has experienced rapid growth during the past three decades. Which of the following statements regarding the use of wind energy is correct? a. b. c. d. The commercial wind energy industry in the United States grew rapidly in the 1980s, despite high production costs due to legislation and federal regulation. As wind velocity increases, the amount of electricity generated by a wind turbine also increases without limit. Thanks to their persistent on-shore wind flows, the states of the U.S. West Coast (California, Oregon, Washington) have dubbed themselves the Saudi Arabia of Wind. The average output of a wind turbine is usually only 25-40% of its rated output.

Correct answer: d Explanation: Answer d is correct; when times of insufficient wind flow, downtime for maintenance, etc., are factored in, a turbine usually only produces 25-40% of its rated capacity. Answer a is incorrect, the Public Utilities Regulatory Policies Act (PURPA) actually spurred a major investment in wind production in California that led to nationwide expansion; answer b is incorrect, wind turbines must shut down during times of high wind speed to avoid causing damage to the turbine structure or to the turbine itself; answer c is also incorrect, the states of the U.S. Great Plains, not the West Coast, have dubbed themselves the Saudi Arabia of Wind. Reading reference: Energy for the 21st Century: A Comprehensive Guide to Conventional and Alternative Sources, Nersesian, Chapter 9, p. 308.

37.

Which of the following is a weakness in applying single-factor mean-reverting models in option valuation? a. b. c. d. Black-equivalent volatility goes to zero with increasing time to expiration. Black-equivalent volatility increases with increasing time to expiration. The Black-equivalent volatility decreases with increasing time to expiration. Black-equivalent volatility is proportional to spot price volatility.

Correct answer: a Explanation: Implementing single factor mean-reverting models for option valuation can be very dangerous if pricing long-term options. Single factor mean-reversion forces price distributions to stop growing in width as time to expiration gets large, resulting in effective volatility of the option to move toward zero over its life time. Hence the correct answer is a. Reading reference: Energy Risk, Pilipovic, Chapter 5, pages 105-09.

2012 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.

39

Energy Risk Professional Examination (ERP) Practice Exam 1

38.

Assume that a call option on natural gas with a strike price of USD 5.60/MMBtu has a vega of 1.0893. What would be the vega of a put option with the same strike price assuming the current price of natural gas is USD 5.80/MMBtu and the current risk-free interest rate is 2.5%. a. -1.0893 b. 0.0893 c. 1.0893 d. There is not enough information to compute vega. Correct answer: c Explanation: Answer c, 1.0893, is correct. Vegas for puts and calls with the same strike price will be the same. This answer follows from the put/call parity relationship. Reading reference: Energy Derivatives: Pricing and Risk Management, Clewlow and Strickland, Chapter 9, page 173.

39.

Consider the following two option contracts: Option 1: January 2012 daily call, strike price of USD 30, call value of USD 5.45 Option 2: January 2012 monthly call, strike price of USD 33, call value of USD 6.00

What is the biggest challenge in estimating the implied volatility for these two contracts assuming the following parameters? a. b. c. d. Valuation date: 11/10/2011 Risk free rate: 4% Underlying value: USD 28 The options are based on different time intervals (daily vs. monthly). The option quotes have different strike prices. The option quotes are both for call options. Winter power options are highly volatile due to seasonality factors.

Correct answer: a Explanation: Reconciling the daily volatility of Option 1 with the monthly volatility of Option 2 can make it very difficult to select the right parameters in the modeling process. The volatilities will tend to be correlated but different. Reading reference: Energy Risk, Pilipovic, Chapter 8, pages 226-228.

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2012 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.

Energy Risk Professional Examination (ERP) Practice Exam 1

40.

An August natural gas futures contract is currently priced at USD 5.60. You have been asked to structure a costless collar for a client who consumes natural gas and expects natural gas prices to rise. The following option quotes for calls and puts on August natural gas futures are currently available: Strike (USD) 5.650 5.625 5.600 5.575 5.525 Call Price (USD) 0.31 0.32 0.34 0.35 0.37 Put Price (USD) 0.36 0.35 0.34 0.32 0.30

Considering the information above, which one of the following portfolios would you suggest for your client? I. II. a. b. c. d. A short call with a strike of 5.575 and a long put with a strike of 5.625 A long call with a strike of 5.625 and a short put with a strike of 5.575 Portfolio I only Portfolio II only Either portfolio Neither portfolio

Correct answer: b Explanation: A costless collar is formed with a long out of the money call and a short out of the money put so that the premium paid for the call and the premium received for selling the put equal to zero. In this case only portfolio II qualifies as a costless collar. Reading reference: Managing Energy Price Risk, Kaminski, Chapter 2, pages 68-72.

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