Erp Practice Quiz 4 2013

2013
ERP
Examination
Practice
Exam
PRACTICE QUIZ 4
Modeling Energy Prices and
Risk Management Fundamentals
Energy Risk Professional Examination (ERP) Practice Quiz 4
TABLE OF CONTENTS
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1
ERP Practice Quiz 4 Candidate Answer Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3
ERP Practice Quiz 4 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5
ERP Practice Quiz 4 Answer Sheet/Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9
ERP Practice Quiz 4 Explanations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11
2013 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.
Introduction
Suggested Use of Practice Quizzes
The ERP Practice Quizzes were developed for use in con-
To maximize the eectiveness of the practice quizzes,
junction with the ERP Exam Preparation Handbook. The
candidates are encouraged to do the following:
Practice Quizzes are designed to simulate both the style and

range of questions found on the ERP Examination, helping
ERP Candidates gauge their level of preparedness to take
1. Complete ERP Core Readings prior to taking each

Practice Quiz.
the ERP Examination. Each Practice Quiz includes a series
Questions are derived specically from Core Readings
of ten review questions drawn from specific sections of the
and represent a small sampling of the content covered
ERP Examination: Hydrocarbons, Electricity/Renewables,
in the Core Readings that proceed each scheduled quiz.
Financial Products, and Modeling/Risk Management techniques. The Practice Quizzes provide candidates with a tool
2. Simulate the test environment as closely as possible.
to review and test their comprehension of key concepts as
Take the practice quiz in a quiet place.
they work through the study plans outlined in the Exam
Have only the practice quiz, candidate answer sheet,
Preparation Handbook.
calculator (see the ERP Preparation Handbook for a
It is strongly suggested that Practice Quizzes be taken after
instruments (pencils, erasers) available.
listing of GARP-approved calculators), and writing

a candidate completes their review of the core readings pre-
Minimize possible distractions from other people, cell
ceding each quiz (please see the 15- and 20-week reading
phones, televisions, etc.; put away any study material
plans outlined in the ERP Exam Preparation Handbook for
before beginning the practice exam.
more information). Practice Quizzes include explanations of
Allocate two minutes per question for the practice quiz
the correct answer for each question so that candidates can
and set an alarm to alert you when a total of 20
better understand their incorrect replies and identify areas
minutes have passed.
of weakness that need reinforcement.

3. After completing each ERP Practice Quiz
Calculate your score by comparing your answer

sheet with the practice exam answer key.
Use the practice quiz Answers and Explanations to

better understand the correct and incorrect answers
and to identify any topics that require additional
review. Consult the referenced core readings to
continue your preparation for the exam.
Energy Risk
Professional(ERP )
Examination
Practice Quiz 4
Answer Sheet
a.
b.
c.
d.
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
Correct way to complete
1.
Wrong way to complete
1.
Energy Risk
Professional(ERP )
Examination
Practice Quiz 4
Questions
1.
Which statement best describes a characteristic of netting agreements?

a.
b.
c.
d.
2.
On January 15, 2012 Acme Coal Company contracts to sell Great Lakes Power Company 10,000 tons of coal at
a price of USD 60 per ton, for delivery in one year. Calculate Acmes replacement risk on July 15 (6 months
from the delivery date) assuming the current price of coal is USD 75 per ton and the continuously compounded
interest rate is 2.5%/year.
a.
b.
c.
d.
3.
USD
USD
USD
USD
146,296
148,137
150,000
153,797
Sunil is trading natural gas options and has access to 90 days of spot price data. Which factor would he apply
to estimate the annual volatility on his options?
a.
b.
c.
d.
4.
Netting agreements are cancelled in the case of a negative credit event affecting the counterparty.
For an instrument to provide some benefit to a netting agreement, the instrument must have some chance
of having a negative mark-to-market value during its lifetime.
Netting agreements are unlikely to reduce concern about a counterparty experiencing a period of financial
distress.
Netting agreements must be conducted bilaterally to be effective.
90
190
250
365
The CRO of Texas Tea Exploration has just completed a firm wide operational risk assessment and has identified
four significant risk factors, all of which can be mitigated with proper hedging. The CRO strongly recommends a
hedging program to the Board of Directors that is designed to reduce the firms overall risk exposure. Which
action should the Board of Directors take regarding the hedging proposal?
a.
b.
c.
d.
Accept the proposal; a firm should always try to reduce all risks whenever possible.
Reject the proposal and encourage the CRO to eliminate, not simply reduce the risk factors.
Reject the proposal; risk taking is fundamental to the exploration business.
Accept the proposal but only hedge risk if the economic benefit of reducing potential loss exceeds the
cost of hedging.
5.
Jamal has just joined the risk management group at a small firm that produces drilling equipment. After analyzing
the firms current risk management practices, Jamal suggests that the firm establish a risk appetite framework (RAF).
What is the key benefit of the RAF?
a.
b.
c.
d.
6.
EUR
EUR
EUR
EUR
7,980,008
16,692,873
25,235,000
52,787,500
Lognormal distributions are skewed to the right.

Lognormal distributions are skewed to the left.
Lognormal distributions have a skew equal to zero.
The skew of a lognormal distribution is dependent on the modeling inputs used.
Geometric Brownian Motion (GBM) is the industry-standard for modeling spot-price evolution in energy
commodities. However, there are both strengths and weaknesses of the GBM process. Which of the following
is correct with respect to GBM?
a.
b.
c.
d.
can help firms prepare for unexpected events.

would encourage the firm to put more responsibility in the hands of upper management.
can be implemented even when weak internal relationships exist between managers at a firm.
suggests using Value-at-Risk (VaR) to estimate all potential financial risks to the firm.
Which statement best describes the skew of a lognormal distribution?

a.
b.
c.
d.
8.
RAF
RAF
RAF
RAF
Kate is an ERP managing a large energy portfolio that has a 1-day standard deviation of EUR 2,575,000.
What is the 10-day Value-at-Risk (VaR) for Kates portfolio assuming a 98% confidence interval?
a.
b.
c.
d.
7.
A
A
A
A
GBM can incorporate instances of negative pricing, such as those frequently seen in the electricity market.
GBM cannot adequately model cross-commodity spot price correlations that are essential for valuing
spread options.
GBM does not account for the spikes often seen in energy prices, nor does it capture the fat tails in price
distributions often seen in energy commodities.
In a GBM environment, commodity prices tend towards a long-term equilibrium which reflects the cost
of production.
9.
A firm regularly conducts VaR analyses of its portfolios. While the VaR approach has been adequate in the
past, the market is entering a period of heightened volatility and the CRO has suggested stress testing the
firms portfolios as an additional measure. Why would the CRO make this suggestion?
a.
b.
c.
d.
10.
The CRO would not make this suggestion because the firm already conducts regular VaR analyses,
making stress testing redundant.
VaR is a useful measure of normal market risks, while stress testing is useful in measuring more extreme
losses that may occur under unlikely, but plausible, conditions.
Under normal market conditions, VaR will give an estimate to the dollar amount of the portfolio that
could be lost, while stress testing will determine how likely it is that these losses will occur.
For a portfolio in a market with heightened volatility, stress testing is a much more comprehensive risk
management approach than VaR testing.
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. Which class of risk is the company primarily
seeking to hedge?
a.
b.
c.
d.
Financial risk
Strategic risk
Credit Risk
Location Basis Risk
Energy Risk
Professional(ERP )
Examination
Practice Quiz 4
Answers
a.
b.
1.
2.
c.
d.
3.
4.
5.
6.
7.
8.
9.
10.
Correct way to complete
1.
Wrong way to complete
1.
Energy Risk
Professional(ERP )
Examination
Practice Quiz 4
Explanations
1.
Which statement best describes a characteristic of netting agreements?

a.
b.
c.
d.
Netting agreements are cancelled in the case of a negative credit event affecting the counterparty.
For an instrument to provide some benefit to a netting agreement, the instrument must have some chance
of having a negative mark-to-market value during its lifetime.
Netting agreements are unlikely to reduce concern about a counterparty experiencing a period of financial
distress.
Netting agreements must be conducted bilaterally to be effective.
Correct answer: b
Explanation: Answer b is correct; a netting agreement that can only have a positive mark-to-market value (MTM)
will never have a beneficial impact on overall exposure (p. 54). However, instruments with only positive MTM are
frequently included in netting agreements since their own exposure can be mitigated by other offsetting instruments with negative MTM values within the netting agreement.
Reading reference: Jon Gregory, Counterparty Credit Risk, Chapter 3.
2.
On January 15, 2012 Acme Coal Company contracts to sell Great Lakes Power Company 10,000 tons of coal at
a price of USD 60 per ton, for delivery in one year. Calculate Acmes replacement risk on July 15 (6 months
from the delivery date) assuming the current price of coal is USD 75 per ton and the continuously compounded
interest rate is 2.5%/year.
a.
b.
c.
d.
USD
USD
USD
USD
146,296
148,137
150,000
153,797
Correct answer: b
Explanation: Answer b is correct; this follows the formula for calculating replacement risk, in this case: 10,000
tons x (USD 75- USD 60) x exp (-0.025 x 6/12 months) = USD 148,137
Reading reference: Burger, Graeber, Schindlmayr, Managing Energy Risk: An Integrated View on Power and
Other Energy Markets, Chapter 6.3.
11
3.
Sunil is trading natural gas options and has access to 90 days of spot price data. Which factor would he apply
to estimate the annual volatility on his options?
a.
b.
c.
d.
90
190
250
365
Correct answer: c
Explanation: For most products that are only traded on weekdays, like natural gas, one normally scales the
historical volatility by the number of trading days in the period whose volatility is to be estimated. The exact
number of trading days per year varies by market and by product, but 250 is commonly used as an average
figure. Choice d is incorrect, as this would only be the correct factor to use for products which are traded
every day, such as electricity.
Reading reference: Les Clewlow and Chris Strickland, Energy Derivatives: Pricing and Risk Management,
Chapter 3.
4.
The CRO of Texas Tea Exploration has just completed a firm wide operational risk assessment and has identified
four significant risk factors, all of which can be mitigated with proper hedging. The CRO strongly recommends a
hedging program to the Board of Directors that is designed to reduce the firms overall risk exposure. Which
action should the Board of Directors take regarding the hedging proposal?
a.
b.
c.
d.
Accept the proposal; a firm should always try to reduce all risks whenever possible.
Reject the proposal and encourage the CRO to eliminate, not simply reduce the risk factors.
Reject the proposal; risk taking is fundamental to the exploration business.
Accept the proposal but only hedge risk if the economic benefit of reducing potential loss exceeds the
cost of hedging.
Correct answer: d
Explanation: A key principle of risk management is that a firm should only hedge those risks where the benefit
of reducing the risks exceeds the costs of doing so. This could result in reducing certain risks, allowing other
risks to pass through completely to the firms investors, and even exploiting still other risks by increasing the
firms exposure to them. While it may seem tempting for a firm to always reduce its risks whenever possible,
this is not correct as a firm is also able to create value through prudent risk taking and strong risk management.
Reading reference: International Finance Corporation (IFC), Risk Taking: A Corporate Governance Perspective.
12
5.
Jamal has just joined the risk management group at a small firm that produces drilling equipment. After analyzing
the firms current risk management practices, Jamal suggests that the firm establish a risk appetite framework (RAF).
What is the key benefit of the RAF?
a.
b.
c.
d.
A
A
A
A
RAF
RAF
RAF
RAF
can help firms prepare for unexpected events.

would encourage the firm to put more responsibility in the hands of upper management.
can be implemented even when weak internal relationships exist between managers at a firm.
suggests using Value-at-Risk (VaR) to estimate all potential financial risks to the firm.
Correct answer: a
Explanation: A risk appetite framework can help firms prepare for unexpected events by encouraging frequent
discussions by managers on how to manage unexpected events in particular product areas or geographies. In
addition, a well developed RAF can also incorporate the use of techniques such as stress testing and scenario
analysis to help a firm prepare for unexpected events. A strong relationship between managers is required to
implement an effective RAF. In addition, a well-defined RAF will typically suggest that several types of measures
be used to estimate financial risks, such as VaR, stress testing, and scenario analysis.
Reading reference: Senior Supervisors Group, Operations on Developments in Risk Appetite Frameworks and
IT Infrastructure, December 2010.
6.
Kate is an ERP managing a large energy portfolio that has a 1-day standard deviation of EUR 2,575,000.
What is the 10-day Value-at-Risk (VaR) for Kates portfolio assuming a 98% confidence interval?
a.
b.
c.
d.
EUR
EUR
EUR
EUR
7,980,008
16,692,873
25,235,000
52,787,500
Correct answer: b
Explanation: The correct answer is b. The 10-day VaR is arrived at by multiplying the 1-day deviation by the confidence
interval (98% or 2.05) and the square root of the time frame, or: EUR 2,575,000 x 2.05 x 10 = EUR 16,692.873.
Reading reference: Alessandro Mauro, Price Risk Management in the Energy Industry: The Value-at-Risk Approach.
13
7.
Which statement best describes the skew of a lognormal distribution?

a.
b.
c.
d.
Lognormal distributions are skewed to the right.

Lognormal distributions are skewed to the left.
Lognormal distributions have a skew equal to zero.
The skew of a lognormal distribution is dependent on the modeling inputs used.
Correct answer: a
Explanation: The correct answer is a; lognormal distributions are skewed to the right of the mean and always
contain positive values (chart on p. 76).
Reading reference: Dragana Pilipovic, Energy Risk: Valuing and Managing Energy Derivatives, Chapter 4.
8.
Geometric Brownian Motion (GBM) is the industry-standard for modeling spot-price evolution in energy
commodities. However, there are both strengths and weaknesses of the GBM process. Which of the following
is correct with respect to GBM?
a.
b.
c.
d.
GBM can incorporate instances of negative pricing, such as those frequently seen in the electricity market.
GBM cannot adequately model cross-commodity spot price correlations that are essential for valuing
spread options.
GBM does not account for the spikes often seen in energy prices, nor does it capture the fat tails in price
distributions often seen in energy commodities.
In a GBM environment, commodity prices tend towards a long-term equilibrium which reflects the cost
of production.
Correct answer: c
Explanation: GBM is unable to model the spikes seen in real energy prices, nor does it capture the fat tails
seen in energy price distributions. This is one of the key weaknesses of GBM. Other weaknesses of the GBM
process are that it can not take into consideration negative energy prices, and prices modeled using GBM do
not revert towards the mean in the longer term, unlike many energy commodity prices. On the other hand,
one of GBMs key strengths is its ability to model cross-commodity correlations, which is a primary use for
GBM in the energy field.
Reading reference: Les Clewlow and Chris Strickland, Energy Derivatives, Chapter 3.
14
9.
A firm regularly conducts VaR analyses of its portfolios. While the VaR approach has been adequate in the
past, the market is entering a period of heightened volatility and the CRO has suggested stress testing the
firms portfolios as an additional measure. Why would the CRO make this suggestion?
a.
b.
c.
d.
The CRO would not make this suggestion because the firm already conducts regular VaR analyses,
making stress testing redundant.
VaR is a useful measure of normal market risks, while stress testing is useful in measuring more extreme
losses that may occur under unlikely, but plausible, conditions.
Under normal market conditions, VaR will give an estimate to the dollar amount of the portfolio that
could be lost, while stress testing will determine how likely it is that these losses will occur.
For a portfolio in a market with heightened volatility, stress testing is a much more comprehensive risk
management approach than VaR testing.
Correct answer: b
Explanation: The correct answer is b. Stress testing is a useful complement to VaR. VaR will measure potential
losses under typical market conditions, but will not capture losses during the worst conditions. Stress testing
therefore is a useful complement to VaR to gauge the potential for larger magnitude losses during unlikely,
but still plausible, conditions.
Reading reference: Jose Ramon Aragones, Carlos Blanco, and Kevin Dowd, Incorporating Stress Tests Into
Market Risk Modeling.
10.
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. Which class of risk is the company primarily
seeking to hedge?
a.
b.
c.
d.
Financial risk
Strategic risk
Credit Risk
Location Basis Risk
Correct answer: a
Explanation: A much colder than expected winter would most likely lead to an increase in the spot price of oil
as well as an increase in customer demand for oil during the winter. The potential price increase is an example
of a financial risk. In this case, 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, and the options can expire unused if the
winter temperatures are at a normal level.
Reading reference: NERA Economic Consulting, Lessons from the BP Deepwater Horizon Oil Spill.
15
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About GARP | The Global Association of Risk Professionals (GARP) is a not-for-prot global membership organization dedicated to
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Aliates from banks, investment management rms, government agencies, academic institutions, and corporations from more than
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2013 Global Association of Risk Professionals. All rights reserved. 01-29-13

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Energy Risk Professional Examination (ERP) Practice Quiz 4

ERP Practice Quiz 4 Candidate Answer Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3

ERP Practice Quiz 4 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5

ERP Practice Quiz 4 Answer Sheet/Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9

ERP Practice Quiz 4 Explanations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11

Energy Risk Professional Examination (ERP) Practice Quiz 4

Suggested Use of Practice Quizzes

The ERP Practice Quizzes were developed for use in con-

To maximize the eectiveness of the practice quizzes,

junction with the ERP Exam Preparation Handbook. The

candidates are encouraged to do the following:

Practice Quizzes are designed to simulate both the style and

1. Complete ERP Core Readings prior to taking each

the ERP Examination. Each Practice Quiz includes a series

Questions are derived specically from Core Readings

of ten review questions drawn from specific sections of the

and represent a small sampling of the content covered

ERP Examination: Hydrocarbons, Electricity/Renewables,

in the Core Readings that proceed each scheduled quiz.

2. Simulate the test environment as closely as possible.

to review and test their comprehension of key concepts as

Take the practice quiz in a quiet place.

they work through the study plans outlined in the Exam

Have only the practice quiz, candidate answer sheet,

calculator (see the ERP Preparation Handbook for a

It is strongly suggested that Practice Quizzes be taken after

instruments (pencils, erasers) available.

listing of GARP-approved calculators), and writing

Minimize possible distractions from other people, cell

phones, televisions, etc.; put away any study material

plans outlined in the ERP Exam Preparation Handbook for

before beginning the practice exam.

more information). Practice Quizzes include explanations of

Allocate two minutes per question for the practice quiz

the correct answer for each question so that candidates can

and set an alarm to alert you when a total of 20

better understand their incorrect replies and identify areas

minutes have passed.

of weakness that need reinforcement.

Calculate your score by comparing your answer

Use the practice quiz Answers and Explanations to

Energy Risk Professional Examination (ERP) Practice Quiz 4

Correct way to complete

Wrong way to complete

Energy Risk Professional Examination (ERP) Practice Quiz 4

Which statement best describes a characteristic of netting agreements?

Energy Risk Professional Examination (ERP) Practice Quiz 4

Lognormal distributions are skewed to the right.

can help firms prepare for unexpected events.

Which statement best describes the skew of a lognormal distribution?

Energy Risk Professional Examination (ERP) Practice Quiz 4

Energy Risk Professional Examination (ERP) Practice Quiz 4

Correct way to complete

Wrong way to complete

Energy Risk Professional Examination (ERP) Practice Quiz 4

Which statement best describes a characteristic of netting agreements?

Energy Risk Professional Examination (ERP) Practice Quiz 4

Energy Risk Professional Examination (ERP) Practice Quiz 4

can help firms prepare for unexpected events.

Energy Risk Professional Examination (ERP) Practice Quiz 4

Which statement best describes the skew of a lognormal distribution?

Lognormal distributions are skewed to the right.

Energy Risk Professional Examination (ERP) Practice Quiz 4