Current Exposure Method (CEM)

What Is the Current Exposure Method (CEM)?

The current exposure method (CEM) is a system utilized by financial institutions to measure the risks around losing anticipated cash flows from their derivatives portfolios due to counterparty default.

CEM features the replacement cost of a derivative contract and recommends a capital buffer that ought to be kept up with against the potential default risk.

Grasping the Current Exposure Method

Banks and other financial institutions have normally utilized CEM to model their exposure on particular derivatives to dispense adequate capital to cover potential counterparty risks. Under the current exposure method, a financial institution's total exposure is equivalent to the replacement cost of all marked-to-market contracts plus an add-on that is intended to mirror the expected future exposure (PFE).

The add-on is the notional principal amount of the underlying asset that has a weighting applied to it. Put all the more essentially, the total exposure under CEM will be a percentage of the total value of the trade. The type of asset underlying the derivative will have an alternate weighting applied in view of the asset type and the maturity.

Illustration of the CEM

For instance, say an interest rate derivative with a maturity of one to five years will have a PFE add-on of 0.5% yet a precious metals derivative excluding gold would have an add-on of 7%. So a $1 million dollar contract for an interest rate swap has a PFE of $5,000 yet a comparative contract for precious metals has a mark to market of $70,000. The current exposure method will join these two amounts ($75,000), and bring about a CME of 7.5%. This addresses the replacement cost of the $70,000 contract marked to market plus the $5,000 PFE.

In reality, most contracts are for a lot bigger dollar figures and financial institutions hold many, with some playing offsetting jobs. So the current exposure method is intended to assist a bank with showing that it has set sufficient capital to the side to cover overall negative exposure.

The History Behind the Current Exposure Method

The current exposure method was systematized under the main Basel accords to deal explicitly with counterparty credit risk (CCR) in over-the-counter (OTC) derivatives. The Basel Committee on Banking Supervision goal is to work on the financial area's ability to deal with financial stress. Through further developing risk management and bank transparency, the international accord desires to keep away from a cascading type of influence of bombing institutions.

In spite of the current exposure method being in practice, its limitations were uncovered through the financial crisis that started, in part, due to lacking capital to cover derivatives exposure at financial institutions. The primary analysis of CEM highlighted the lack of differentiation between margined and un-margined transactions.

Further, the existing risk determination methods were too centered around current pricing rather than on fluctuations of cash flows from now on. To counteract this, the Basel Committee distributed the Standardized Approach to Counterparty Credit Risk (SA-CCR) in 2017 to supplant both the CEM and the normalized method (an alternative to CEM). The SA-CCR generally applies higher add-on factors to a large portion of the asset classes and builds the categories inside those classes.

Features

• The current exposure method (CEM) is a way for firms to oversee counterparty risk associated with derivatives transactions.
• The CEM method for risk management was organized in response to the developing concern about the size and murkiness of the OTC derivatives market, which could lead to systemic disappointment whenever left ridiculous.
• CEM utilizes a modified replacement cost calculation with a weighting mechanism that will rely upon the type of derivative contract held.