Financial Engineering and Energy Derivatives Midterm Exam Professor Pirrong 2003 Module 2

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1 Financial Engineering and Energy Derivatives Midterm Exam Professor Pirrong 2003 Module 2 Answer all of the following questions. Make your responses as succinct and legible as possible. I make deductions for extraneous material in answers, so make your answers to the point. Point values for each question are indicated in parentheses. Partial credit is awarded depending on the correctness and completeness of the answer. Good Luck! PART I. Short Answer 1. Is the following statement true, false, or uncertain?: My firm is an out-ofposition hedger that never makes or takes delivery on the crude oil futures contracts it trades. Therefore, the delivery specification of the crude oil futures contract is irrelevant to us. Make sure you explain your reasoning. (5 points) 2. Is the following statement true, false, or uncertain?: Futures exchange clearinghouses bear all credit, default, and performance risk related to the futures transactions they clear. Explain your reasoning. (5 points)

2 3. Is the following statement true, false, or uncertain?: My firm doesn t speculate we re strictly hedgers. Therefore, we don t need to forecast spot prices and compare them to the futures price. Explain your reasoning. (5 points) 4. In recent years energy derivatives trading activity has increased substantially in volume at the same time that physical volumes in underlying deliverables (such as Brent crude, WTI, and Henry Hub gas) have been static or declining. Briefly discuss the concerns this raises for hedgers in these markets. How can large traders potentially exploit this situation, and what is the impact of such actions on basis and basis risk? (10 points)

3 5. The WTI crude oil futures contract ( CL ) traded on NYMEX calls for delivery of 1000 barrels (bbl) of crude oil. You buy a CL contract on day 1, when the futures price is On day 2, the CL price falls to 29.72, and on day 3, the price rises to What happens to the balance in your margin account on day 2? On day 3? (5 points) 6. Assume that if the futures price for crude oil equals the expected spot price, long hedging demand exceeds short hedging demand. Under these conditions, is the crude oil futures price an upward biased or downward biased estimate of the expected spot price? Will the crude oil futures price drift up or drift down over time? (5 points)

4 PART 2. Essay. 7. Numerous researchers have found significant differences between the forward price of electricity for delivery in peak periods (e.g., on peak hours during the summer cooling months in the US) and the expected spot price of power during these periods. Why do such differences exist? Evaluate the effects of the following hypothetical developments on the difference between the power forward price and the expected spot price of power: (a) a strong recovery in the economy, (b) a substantial increase in new electricity generation and transmission capacity, (c) the creation of a new cash settled forward contract that reduces the costs that financial institutions (including hedge funds, insurance companies, and banks) incur to participate in the power derivatives market. Explain your reasoning. (25 points)

6 8. The economy has strengthened noticeably in the last quarter, and it is expected that growth will be strong throughout the coming year. How would you expect this improvement in the economy will affect: (a) backwardation in energy prices; (b) inventories of storable energy products such as oil and gasoline; (c) the volatility of energy prices; and (d) the correlation between energy spot prices and six-month forward prices? Explain your reasoning using economic concepts discussed in class. Explain how these developments will affect a hedging firm facing the following decision: The firm has an obligation to deliver gasoline six months hence. The nearby gasoline futures contract is substantially more liquid than the six-month contract, so it is cheaper to trade that contract. Given your answers to (c) and (d) above, in light of the strengthening economy, is the firm more or less likely to use the nearby contract as a hedge? If it uses the nearby contract, does the strengthening economy improve or worsen the effectiveness of the hedge in managing risk? (25 points)

Energy Derivatives Final Exam Professor Pirrong Spring, 2011

Energy Derivatives Final Exam Professor Pirrong Spring, 2011 Answer all of the following questions. Show your work for partial credit; no credit will be given unless your answer provides supporting calculations