What is the Current Exposure Method (CEM)?
The Current Exposure Method (CEM) is a system used by financial institutions to measure the risks associated with the loss of anticipated cash flows from their derivatives portfolios due to the default of a counterparty.
CEM highlights the cost of replacing a derivative contract and suggests a capital buffer that should be maintained against potential default risk.
Key points to remember
- The Current Exposure Method (CEM) is a way for firms to manage the counterparty risk associated with derivative transactions.
- CEM uses a modified replacement cost calculation with a weighting mechanism that will depend on the type of derivative contract held.
- The CEM method of risk management was instituted in response to growing concerns about the size and opacity of the OTC derivatives market, which could lead to systemic failure if not mitigated.
Understand the current exposure method
Banks and other financial institutions have typically used CEM to model their exposure to particular derivatives in order to allocate sufficient capital to cover potential risks. counterparty risks. According to the current risk method, the total risk of a financial institution is equal to the replacement cost of all mark-to-market contracts plus an add-on to reflect potential future exposure (PFE).
The markup is the notional principal amount of the underlying asset to which a weighting is applied. Put simply, the total exposure under CEM will be a percentage of the total trade value. The type of asset underlying the derivative will have a different weighting applied depending on the type of asset and the maturity.
Example of EMC
For example, suppose an interest rate derivative with a duration of one to five years will have a PFE add-on of 0.5%, but a precious metals derivative excluding gold will have an add-on on of 7%. So a $1 million contract for an interest rate swap has a PFE of $5,000, but a similar contract for precious metals has a market value of $70,000. The current exposure method will combine these two amounts ($75,000) and result in an MEC of 7.5%. This represents the contract replacement cost of $70,000 valued at market price plus the DFP of $5,000.
In reality, most contracts are for much larger amounts and financial institutions hold many, with some playing compensatory roles. Thus, the current exposure method is intended to help a bank show that it has set aside enough capital to cover the overall negative exposure.
The story behind the current exposure method
The current exposure method was codified in the early Basel accords to specifically address counterparty credit risk (CCR) in over-the-counter (OTC) derivatives. The Basel Committee on Banking Supervisionis to improve the ability of the financial sector to cope with financial stress. By improving risk management and banking transparency, the international agreement hopes to avoid a domino effect of failing institutions.
Although the current exposure method is in practice, its limitations were revealed by the financial crisis which began, in part, due to insufficient capital to cover financial institutions’ derivatives exposure. The main criticism of the CEM concerned the lack of differentiation between on the sidelines and marginless trades.
In addition, existing methods for determining risk focused too heavily on current prices rather than fluctuations in future cash flows. To counter this, the Basel Committee published in 2017 the standardized approach to counterparty credit risk (SA-CCR) to replace both the CEM and the standardized method (an alternative to the CEM). The SA-CCR generally applies higher add-on factors to most asset classes and increases the categories within those classes.
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