ERAC Energy Risk Management Principles 4 — Questions and Answers
Question 1: Which scenario would most directly increase the rollover risk of a futures-based energy hedge?
- A narrowing of bid-ask spreads in the futures market
- A contango market structure where deferred contracts trade at a premium (Correct answer)
- Declining open interest in near-month contracts before expiry
- Stable spot prices during the hedge period
Correct answer: A contango market structure where deferred contracts trade at a premium
In contango, rolling a long futures position forward costs money because each successive contract is priced higher, eroding hedge effectiveness over time.
Question 2: Under CFTC rules, a firm that uses commodity derivatives solely to hedge physical energy price exposure may qualify for:
- Swap dealer registration exemption
- Bona fide hedger status, exempting it from speculative position limits (Correct answer)
- Exemption from all margin posting requirements
- Reduced reporting obligations under Dodd-Frank Title VII
Correct answer: Bona fide hedger status, exempting it from speculative position limits
Bona fide hedgers using derivatives to offset commercial price risk can receive exemptions from speculative position limits imposed by the CFTC.
Question 3: A risk manager calculates the delta of an energy option portfolio. Delta primarily measures:
- The time decay of the option's premium per day
- The sensitivity of the option's price to a one-unit change in the underlying energy price (Correct answer)
- The volatility implied by the current option market price
- The probability that the option expires in the money
Correct answer: The sensitivity of the option's price to a one-unit change in the underlying energy price
Delta measures how much an option's price changes for a $1 move in the underlying commodity price, used to quantity directional price risk.
Question 4: A solar developer is exposed to energy price risk because power purchase agreement (PPA) prices are fixed while merchant prices fluctuate. The best description of this risk is:
- Fixed-price risk relative to a variable cost benchmark
- Merchant price risk where revenues depend on spot or contracted rates (Correct answer)
- Regulatory curtailment risk limiting generation output
- Interconnection risk delaying project completion
Correct answer: Merchant price risk where revenues depend on spot or contracted rates
Merchant price risk captures the exposure of a generator whose revenue is tied to market prices that can fall below contracted costs or expectations.
Question 5: Which of the following best describes 'model risk' in energy risk management?
- Risk that counterparty models underestimate their own credit exposure
- Potential for losses due to errors or incorrect assumptions in the valuation or risk models used (Correct answer)
- Risk that market price models are not approved by regulators
- Uncertainty in physical energy flow models used for dispatch planning
Correct answer: Potential for losses due to errors or incorrect assumptions in the valuation or risk models used
Model risk is the risk of adverse outcomes from flawed assumptions, incorrect implementation, or misuse of quantitative models used for pricing or risk measurement.
Question 6: When assessing counterparty credit risk in energy transactions, a Credit Support Annex (CSA) under ISDA documentation primarily functions to:
- Define the governing law for dispute resolution
- Require posting of collateral when mark-to-market exposure exceeds agreed thresholds (Correct answer)
- Set position limits on the size of bilateral transactions
- Disclose energy trading strategies to regulators
Correct answer: Require posting of collateral when mark-to-market exposure exceeds agreed thresholds
A CSA establishes collateral posting obligations, specifying thresholds and eligible collateral types to mitigate counterparty credit exposure.
Question 7: In energy portfolio management, 'netting' reduces credit risk exposure by:
- Offsetting gains and losses across all trades with the same counterparty to determine net exposure (Correct answer)
- Transferring risk to a central clearinghouse for each individual trade
- Reducing the notional value of each contract by 50%
- Requiring physical delivery instead of financial settlement
Correct answer: Offsetting gains and losses across all trades with the same counterparty to determine net exposure
Netting allows offsetting of positive and negative mark-to-market values across a counterparty's portfolio, reducing the total credit exposure compared to gross settlement.
ERAC Energy Risk Management Principles 4
Which scenario would most directly increase the rollover risk of a futures-based energy hedge?