Credit Value Adjustment and Economic Motivation to Trade on PXE

Abstract

Electricity forward contracts can normally be traded in two ways in the Czech Republic: OTC forwards, which means bilaterally or bilaterally through a broker, and futures through the Power Exchange Central Europe. Each way has its own economic pros and cons. As the most crucial point, a counterparty risk and costs of funding are usually mentioned. Contracts traded on the power exchange bear less or no credit risk, as every deal is paired via central counterparty. On the other hand, the power exchange requires a margin deposit and daily profit and loss settlement which might increase funding costs. The fact that the counterparty risk is lower for exchange contracts with higher funding costs is well-known, but rarely quantified. We use the so-called Credit Value Adjustment concept in order to quantify the market value of the credit risk. We compare this value with potential funding costs. The aim of this paper is to compare both the OTC and exchange ways of trading using risk-adjusted economic characteristics.