Erp Practice Quiz 3

Energy Risk Professional
(ERP®) Examination
Practice Quiz 3: Financial Products
Energy Risk Professional Examination (ERP®) Practice Quiz 3
TABLE OF CONTENTS
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1
ERP Practice Quiz 3 Candidate Answer Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3
ERP Practice Quiz 3 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5
ERP Practice Quiz 3 Answer Sheet/Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9
ERP Practice Quiz 3 Explanations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11
© 2012 Global Association of Risk Professionals. All rights reserved. It is illegal to reproduce this material i
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 eﬀectiveness 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 1. Complete ERP Core Readings prior to taking each
ERP Candidates gauge their level of preparedness to take Practice Quiz.
the ERP Examination. Each Practice Quiz includes a series Questions are derived speciﬁcally 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 tech-
niques. 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
listing of GARP-approved calculators), and writing
It is strongly suggested that Practice Quizzes be taken after instruments (pencils, erasers) available.
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.
© 2012 Global Association of Risk Professionals. All rights reserved. It is illegal to reproduce this material 1
Energy Risk
®
Professional(ERP )
Examination
Practice Quiz 3
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. P x
Energy Risk
®
Professional(ERP )
Examination
Practice Quiz 3
Questions
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
2. 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
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 50.00 is selling at USD 6.00. 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
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 99.00 and a premium of USD 6.00
• Long one July 2012 call option with a strike price of USD 104.00 and a premium of USD 3.00
If the current WTI spot price is USD 107.20, 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
6 © 2012 Global Association of Risk Professionals. All rights reserved. It is illegal to reproduce this material
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 7.00. 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. 17.94
b. 46.29
c. 46.50
d. 125.50
10. 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
Energy Risk
®
Professional(ERP )
Examination
Practice Quiz 3
Answers
a. b. c. d.
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
Correct way to complete
1.
Wrong way to complete
1. P x
Energy Risk
®
Professional(ERP )
Examination
Practice Quiz 3
Explanations
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 4.20.
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 59-62.
2. 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 75.
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
c. Sell cash heating oil at USD 3.40/gal and simultaneously buy futures contracts for an equal number of
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 3.40 + USD
0.20 + 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 40-45.
4. Assume a call option with a strike price of USD 50.00 is selling at USD 6.00. 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 6.00 +
(.55 x USD 2.00) = USD 7.10. All other answers are incorrect.
Reading reference: Managing Energy Price Risk, Kaminski, Chapter 2, pages 58-60.
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 6.
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.
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 38-39.
7. Assume you hold the following option contracts on WTI futures:
• Short one July 2012 put option with a strike price of USD 99.00 and a premium of USD 6.00
• Long one July 2012 call option with a strike price of USD 104.00 and a premium of USD 3.00
If the current WTI spot price is USD 107.20, 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[99-107.2,0] = 0 while
the payoff for the long call is max[S-K,0] = max[107.2-104.0,0] = USD 3.20. 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 6.20.
Reading reference: Managing Energy Price Risk, Kaminski, Chapter 2.
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
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.
9. Assume a natural gas-fired power generation plant has a heat rate of 7.00. 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. 17.94
b. 46.29
c. 46.50
d. 125.50
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 76.25 – (4.25 * 7) = 46.50. 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 109.
10. 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 22-30.
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© 2012 Global Association of Risk Professionals. All rights reserved. 8-21-12

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

ERP Practice Quiz 3 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5

ERP Practice Quiz 3 Answer Sheet/Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9

ERP Practice Quiz 3 Explanations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11

Introduction Suggested Use of Practice Quizzes

Correct way to complete

Wrong way to complete

2. Which statement best describes a bull spread option trade?

a. Do nothing; no strategy would result in a riskless profit.

6. What is correct about contango and backwardation in energy commodity markets?

a. Commodity markets must be either contango or backwardated markets.

7. Assume you hold the following option contracts on WTI futures:

Correct way to complete

Wrong way to complete

2. Which statement best describes a bull spread option trade?

a. Do nothing; no strategy would result in a riskless profit.

6. What is correct about contango and backwardation in energy commodity markets?

a. Commodity markets must be either contango or backwardated markets.

7. Assume you hold the following option contracts on WTI futures:

111 Town Square Place

© 2012 Global Association of Risk Professionals. All rights reserved. 8-21-12

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