Energy Risk Professional (ERP ) Examination. Practice Quiz 3: Financial Products

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1 Energy Risk Professional (ERP ) Examination Practice Quiz 3: Financial Products

2 TABLE OF CONTENTS Introduction ERP Practice Quiz 3 Candidate Answer Sheet ERP Practice Quiz 3 Questions ERP Practice Quiz 3 Answer Sheet/Answers ERP Practice Quiz 3 Explanations Global Association of Risk Professionals. All rights reserved. It is illegal to reproduce this material i

3 Introduction The ERP Practice Quizzes were developed for use in conjunction with the ERP Exam Preparation Handbook. The 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 the ERP Examination. Each Practice Quiz includes a series of ten review questions drawn from specific sections of the ERP Examination: Hydrocarbons, Electricity/Renewables, Financial Products, and Modeling/Risk Management techniques. The Practice Quizzes provide candidates with a tool to review and test their comprehension of key concepts as they work through the study plans outlined in the Exam Preparation Handbook. It is strongly suggested that Practice Quizzes be taken after a candidate completes their review of the core readings preceding each quiz (please see the 15- and 20-week reading plans outlined in the ERP Exam Preparation Handbook for more information). Practice Quizzes include explanations of the correct answer for each question so that candidates can better understand their incorrect replies and identify areas of weakness that need reinforcement. Suggested Use of Practice Quizzes To maximize the effectiveness of the practice quizzes, candidates are encouraged to do the following: 1. Complete ERP Core Readings prior to taking each Practice Quiz. Questions are derived specifically from Core Readings and represent a small sampling of the content covered in the Core Readings that proceed each scheduled quiz. 2. Simulate the test environment as closely as possible. Take the practice quiz in a quiet place. Have only the practice quiz, candidate answer sheet, calculator (see the ERP Preparation Handbook for a listing of GARP-approved calculators), and writing instruments (pencils, erasers) available. Minimize possible distractions from other people, cell phones, televisions, etc.; put away any study material before beginning the practice exam. Allocate two minutes per question for the practice quiz and set an alarm to alert you when a total of 20 minutes have passed. 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 Global Association of Risk Professionals. All rights reserved. It is illegal to reproduce this material 1

4 Energy Risk Professional(ERP ) Examination Practice Quiz 3 Answer Sheet

6 Energy Risk Professional(ERP ) Examination Practice Quiz 3 Questions

7 1. Assume you configured a natural gas trade with the expectation that the spread between Contract A and Contract B would widen. What would be your profit/loss on the transaction if the contracts had the following characteristics and you were short Contract A and long Contract B? Contract A has an initial value of USD 4.00 and a terminal value of USD 4.10 Contract B has an initial value of USD 4.20 and a terminal value of USD 4.25 a. USD 0.15 b. USD 0.05 c. USD 0.10 d. USD Which statement best describes a bull spread option trade? a. The maximum profit occurs when the futures price equals the strike price of the out-of-the-money call option. b. Upside profit potential is unlimited. c. The structure is created by buying an out-of-the-money put option and selling an out-of-the-money call option. d. The structure is created by selling an out-of-the-money put option and buying an out-of-the-money call option. 3. Heating oil is quoted on the spot market at USD 3.40/gal. Financing for the purchase of a contract is available for USD 0.20/gal per month while the cost of storage for the physical commodity is USD 0.15/gal per month. The price for a 1-month heating oil futures contract is USD 3.75/gal. Given these parameters, how would you execute a riskless cash/futures arbitrage trade at a profit? a. Do nothing; no strategy would result in a riskless profit. b. Buy cash heating oil at USD 3.40/gal and simultaneously sell futures contracts for an equal number of units at USD 3.75/gal. c. Sell cash heating oil at USD 3.40/gal and simultaneously buy futures contracts for an equal number of units at USD 3.75/gal. d. Buy heating oil on the spot market at USD 3.40, store it for one month and then sell it on the spot market. 4. Assume a call option with a strike price of USD is selling at USD If the delta of the option is.55, what will be the estimated option premium if the value of the underlying asset increases by USD 2.00? a. USD 6.10 b. USD 6.50 c. USD 7.10 d. USD Global Association of Risk Professionals. All rights reserved. It is illegal to reproduce this material 5

8 5. 1 are bilateral contracts to buy or sell a specific amount of a commodity at a fixed price at some time in the future, 2 are standardized contracts to buy or sell a commodity at some time in the future through the use of a commodity exchange, which acts as a central counterparty for all transactions. 1 2 a. Forwards Futures b. Swaps Forwards c. Futures Forwards d. Swaps Futures 6. What is correct about contango and backwardation in energy commodity markets? a. Commodity markets must be either contango or backwardated markets. b. A backwardated market is one where cash prices are greater than a series of futures prices. c. Partial or complete full carry has no impact on the whether a market is in contango or backwardation. d. A carrying charge is associated with a backwardated or inverted market. 7. Assume you hold the following option contracts on WTI futures: Short one July 2012 put option with a strike price of USD and a premium of USD 6.00 Long one July 2012 call option with a strike price of USD and a premium of USD 3.00 If the current WTI spot price is USD , what is the net economic value of your position? a. USD 0.00 b. USD 3.00 c. USD 6.20 d. USD Global Association of Risk Professionals. All rights reserved. It is illegal to reproduce this material

9 8. 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. Volume Risk b. Supply Risk c. Credit Risk d. Location Basis Risk 9. Assume a natural gas-fired power generation plant has a heat rate of If natural gas fuel costs are USD 4.25/MMBtu and electricity is sold at USD 76.25/MWh, what is the spark spread for the plant? a b c d The CFO of Tonka Trucking Company is considering the use of commodity swaps as a hedging strategy instead of using call options on futures contracts to protect against rising diesel fuel prices. Which of the following statement(s) is correct? I. Tonka Trucking will sell a commodity swap to hedge the risk of rising diesel fuel prices. II. Tonka Trucking will have counterparty credit exposure on the commodity swap. a. Statement I only b. Statement II only c. Both statements d. Neither statement 2012 Global Association of Risk Professionals. All rights reserved. It is illegal to reproduce this material 7

10 Energy Risk Professional(ERP ) Examination Practice Quiz 3 Answers

12 Energy Risk Professional(ERP ) Examination Practice Quiz 3 Explanations

13 1. Assume you configured a natural gas trade with the expectation that the spread between Contract A and Contract B would widen. What would be your profit/loss on the transaction if the contracts had the following characteristics and you were short Contract A and long Contract B? Contract A has an initial value of USD 4.00 and a terminal value of USD 4.10 Contract B has an initial value of USD 4.20 and a terminal value of USD 4.25 a. USD 0.15 b. USD 0.05 c. USD 0.10 d. USD 0.15 Correct answer: b Explanation: Answer b is correct. Under the assumption that the spread between contract A and contract B would widen Alonzo would have initially sold contract A at USD 4.00 and purchased contract B at USD In fact the spread narrowed and Alonzo realized a net loss on the trade of USD 0.05 as he was forced to close out contract A at USD 4.10 (loss of USD -0.10), and contract B at USD 4.25 (gain of USD 0.05). Reading reference: Fundamentals of Trading Energy Futures & Options, 2nd Edition, Errera, Chapter 4, pages Which statement best describes a bull spread option trade? a. The maximum profit occurs when the futures price equals the strike price of the out-of-the-money call option. b. Upside profit potential is unlimited. c. The structure is created by buying an out-of-the-money put option and selling an out-of-the-money call option. d. The structure is created by selling an out-of-the-money put option and buying an out-of-the-money call option. Correct answer: a Explanation: Answer a is correct because the maximum profit occurs when the futures price equals the strike price of the out-of-money call option. For this structure, an ATM call is purchased and OTM call, with a higher striking price, is sold. Both options have the same tenor. The sale of the call caps the upside of the lower strike long call. This is the point where the bull spread shows its maximum profit the futures prices equals the strike price of the short call. The lower strike price call has its own floor. Reading reference: Managing Energy Price Risk, Kaminski, Chapter 2, page Global Association of Risk Professionals. All rights reserved. It is illegal to reproduce this material 11

14 3. Heating oil is quoted on the spot market at USD 3.40/gal. Financing for the purchase of a contract is available for USD 0.20/gal per month while the cost of storage for the physical commodity is USD 0.15/gal per month. The price for a 1-month heating oil futures contract is USD 3.75/gal. Given these parameters, how would you execute a riskless cash/futures arbitrage trade at a profit? a. Do nothing; no strategy would result in a riskless profit. b. Buy cash heating oil at USD 3.40/gal and simultaneously sell futures contracts for an equal number of units at USD 3.75/gal. c. Sell cash heating oil at USD 3.40/gal and simultaneously buy futures contracts for an equal number of units at USD 3.75/gal. d. Buy heating oil on the spot market at USD 3.40, store it for one month and then sell it on the spot market. Correct answer: a Explanation: Answer a is correct, there is no riskless arbitrage opportunity in this situation since the 1-month futures contract (USD 3.75/gal) is equal to the spot price with financing and storage costs (USD USD USD 0.15 = USD 3.75), therefore the correct decision is to do nothing. Note: purchasing heating oil at USD 3.40 and storing it for a month for sale back onto the spot market (answer d ) could net a profit if the spot price has risen above the 1-month futures price of USD 3.75, but this is not a riskless strategy since there is no guarantee that the prices will rise above this level. Reading reference: Fundamentals of Trading Energy Futures and Options, 2nd Edition, Errera and Brown, Chapter 3, pages Assume a call option with a strike price of USD is selling at USD If the delta of the option is.55, what will be the estimated option premium if the value of the underlying asset increases by USD 2.00? a. USD 6.10 b. USD 6.50 c. USD 7.10 d. USD 8.00 Correct answer: c Explanation: Answer c is correct; it is the correct application of the delta valuation formula: USD (.55 x USD 2.00) = USD All other answers are incorrect. Reading reference: Managing Energy Price Risk, Kaminski, Chapter 2, pages Global Association of Risk Professionals. All rights reserved. It is illegal to reproduce this material

15 5. 1 are bilateral contracts to buy or sell a specific amount of a commodity at a fixed price at some time in the future, 2 are standardized contracts to buy or sell a commodity at some time in the future through the use of a commodity exchange, which acts as a central counterparty for all transactions. 1 2 a. Forwards Futures b. Swaps Forwards c. Futures Forwards d. Swaps Futures Correct answer: a Explanation: Answer a is correct. Forwards are bilateral agreements, their specifications are set by the parties, while futures must be standardized so that they are fully interchangeable via an exchange (for example, NYMEX Crude Oil contracts are all for lot sizes of 1,000 barrels per contract). Swaps are typically traded via an OTC exchange and not bilaterally. Reading reference: Derivatives Markets, McDonald, Chapter What is correct about contango and backwardation in energy commodity markets? a. Commodity markets must be either contango or backwardated markets. b. A backwardated market is one where cash prices are greater than a series of futures prices. c. Partial or complete full carry has no impact on the whether a market is in contango or backwardation. d. A carrying charge is associated with a backwardated or inverted market. Correct answer: b Explanation: The correct answer is b; a backwardated market is marked by spot prices being higher than futures prices, typically because of a shortage in supply or unexpectedly high demand. Answer a is incorrect because, the markets can be either contango or backwardated or some combination of the two. (for example, natural gas with its seasonal structure is typically in contango for part of the year and backwardated for the rest). Answer c also incorrect since a market in full carry would be in contango. Answer d is incorrect since, a carrying charge is associated with a contango market (also, referred to as a carrying charge market). Reading reference: Fundamentals of Trading Energy Futures & Options, 2nd Edition, Errera and Brown, Chapter 3, pages Global Association of Risk Professionals. All rights reserved. It is illegal to reproduce this material 13

16 7. Assume you hold the following option contracts on WTI futures: Short one July 2012 put option with a strike price of USD and a premium of USD 6.00 Long one July 2012 call option with a strike price of USD and a premium of USD 3.00 If the current WTI spot price is USD , what is the net economic value of your position? a. USD 0.00 b. USD 3.00 c. USD 6.20 d. USD 9.20 Correct answer: c Explanation: Answer c is correct. The payoff from the short put is max[k-s,0] = max[ ,0] = 0 while the payoff for the long call is max[s-k,0] = max[ ,0] = USD You will have received USD 6.00 for selling the put, while you would have spent USD 3.00 to purchase the call option, leaving you with a net USD 3.00 on the purchase/sale of the options. When combined with the USD 3.20 in profit from the exercise of the call, this gives you a net of USD Reading reference: Managing Energy Price Risk, Kaminski, Chapter 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. Volume Risk b. Supply Risk c. Credit Risk d. 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 Global Association of Risk Professionals. All rights reserved. It is illegal to reproduce this material

17 9. Assume a natural gas-fired power generation plant has a heat rate of If natural gas fuel costs are USD 4.25/MMBtu and electricity is sold at USD 76.25/MWh, what is the spark spread for the plant? a b c d Correct answer: c Explanation: The correct answer is c. The spark spread is the price of electricity minus the price of fuel (here natural gas) multiplied by the heat rate; in this case (4.25 * 7) = Answer a is simply the cost of electricity divided by the fuel cost; b is electricity multiplied by gas and divided by the heat rate; d is electricity multiplied by heat rate divided by the fuel costs, all are incorrect formulas. Reading reference: Energy Trading & Investing, Edwards, Chapter 2.2, page The CFO of Tonka Trucking Company is considering the use of commodity swaps as a hedging strategy instead of using call options on futures contracts to protect against rising diesel fuel prices. Which of the following statement(s) is correct? I. Tonka Trucking will sell a commodity swap to hedge the risk of rising diesel fuel prices. II. Tonka Trucking will have counterparty credit exposure on the commodity swap. a. Statement I only b. Statement II only c. Both statements d. Neither statement Correct answer: b Explanation: Answer b is correct. Statement II is correct as commodity swaps are traded OTC and have financial settlement and, therefore, credit counterparty risk. Statement I is incorrect because consumers like Tonka Trucking would typically buy a commodity swap to hedge price risk. Reading reference: Managing Energy Price Risk, Kaminski, Chapter 1, pages Global Association of Risk Professionals. All rights reserved. It is illegal to reproduce this material 15

18 Creating a culture of risk awareness. Global Association of Risk Professionals 111 Town Square Place Suite 1215 Jersey City, New Jersey USA nd Floor Bengal Wing 9A Devonshire Square London, EC2M 4YN UK + 44 (0) About GARP The Global Association of Risk Professionals (GARP) is a not-for-profit global membership organization dedicated to preparing professionals and organizations to make better informed risk decisions. Membership represents over 150,000 risk management practitioners and researchers from banks, investment management firms, government agencies, academic institutions, and corporations from more than 195 countries and territories. GARP administers the Financial Risk Manager (FRM ) and the Energy Risk Professional (ERP ) Exams; certifications recognized by risk professionals worldwide. GARP also helps advance the role of risk management via comprehensive professional education and training for professionals of all levels Global Association of Risk Professionals. All rights reserved