ERAC Energy Risk Management Principles 3 — Questions and Answers
Question 1: Which of the following is the primary purpose of stress testing in energy risk management?
- To validate the accuracy of trading algorithms
- To evaluate portfolio performance under extreme but plausible scenarios (Correct answer)
- To calculate daily mark-to-market gains and losses
- To determine the credit rating of counterparties
Correct answer: To evaluate portfolio performance under extreme but plausible scenarios
Stress testing assesses how a portfolio or firm would perform under severe market conditions that may fall outside normal VaR models.
Question 2: In the ALARP (As Low As Reasonably Practicable) principle, a risk is managed to ALARP when:
- The risk is fully eliminated regardless of cost
- The cost of further risk reduction is grossly disproportionate to the benefit gained (Correct answer)
- All residual risk is transferred to insurers
- The risk falls below the broadly acceptable threshold
Correct answer: The cost of further risk reduction is grossly disproportionate to the benefit gained
ALARP requires reducing risk until the cost of additional mitigation outweighs the safety or financial benefit achieved.
Question 3: A refiner enters a crack spread swap to lock in the margin between crude oil input costs and refined product revenues. This strategy is best described as:
- Speculation on crude oil price direction
- A cross-commodity hedge targeting processing margin risk (Correct answer)
- A basis swap to manage location price differences
- A volumetric hedge against demand uncertainty
Correct answer: A cross-commodity hedge targeting processing margin risk
A crack spread swap hedges the spread between crude and refined product prices, protecting the refiner's processing margin from adverse moves.
Question 4: Which regulatory body in the US has primary oversight over wholesale electricity market risk and trading practices?
- EPA
- DOE
- FERC (Correct answer)
- CFTC
Correct answer: FERC
The Federal Energy Regulatory Commission (FERC) regulates wholesale electricity markets, transmission, and associated trading activities in the US.
Question 5: An energy company's risk management policy requires that all commodity positions be marked-to-market daily. This practice primarily supports:
- Reducing tax liability on unrealized gains
- Transparent and timely recognition of changes in portfolio value (Correct answer)
- Limiting physical delivery obligations under forward contracts
- Eliminating basis risk in hedged positions
Correct answer: Transparent and timely recognition of changes in portfolio value
Daily mark-to-market ensures that current market values are reflected in financial statements, enabling timely risk awareness and decision-making.
Question 6: The 'three lines of defense' model in energy risk governance assigns the primary responsibility for day-to-day risk management to:
- Internal audit
- The risk management function (second line)
- Business units and trading desks (first line) (Correct answer)
- External regulators
Correct answer: Business units and trading desks (first line)
In the three lines of defense model, the first line (business units) owns and manages risk in daily operations; the second line oversees and challenges; the third line (audit) independently assesses.
Question 7: Liquidity risk in energy trading most commonly arises from:
- Price volatility in crude oil markets
- Inability to exit or offset a position without significant market impact (Correct answer)
- Counterparty default on a bilateral contract
- Regulatory changes to emissions limits
Correct answer: Inability to exit or offset a position without significant market impact
Liquidity risk is the risk of not being able to transact at a fair price due to insufficient market depth, often exacerbated in illiquid energy markets.
ERAC Energy Risk Management Principles 3
Which of the following is the primary purpose of stress testing in energy risk management?