Current Exposure Method (CEM): Definition, Application, and Considerations
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Summary:
The current exposure method (CEM) is a crucial risk management tool utilized by financial institutions to evaluate the potential loss of anticipated cash flows from derivatives portfolios due to counterparty default. It calculates exposure based on replacement costs and add-ons to reflect potential future exposure (PFE). Despite its use, the CEM’s limitations became evident during the financial crisis, leading to the development of the Standardized Approach to Counterparty Credit Risk (SA-CCR) as an alternative method.
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What is the current exposure method (CEM)?
The current exposure method (CEM) is a risk management approach employed by financial institutions to assess the risk associated with derivatives transactions and potential counterparty default. It focuses on determining the exposure of a firm to particular derivatives in order to allocate adequate capital to cover potential counterparty risks.
Understanding CEM
Under the current exposure method, a financial institution’s total exposure is calculated by considering the replacement cost of all marked-to-market contracts along with an add-on to reflect potential future exposure (PFE). The add-on is determined based on the notional principal amount of the underlying asset, with different weightings applied depending on the asset type and maturity.
Example of CEM
For instance, an interest rate derivative with a maturity of one to five years might have a PFE add-on of 0.5%, while a precious metals derivative excluding gold could have an add-on of 7%. Thus, the total exposure under CEM combines the replacement cost and PFE, resulting in a percentage of the total trade value.
The history behind CEM
The current exposure method was established under the first Basel accords to address counterparty credit risk in over-the-counter derivatives. However, its limitations were exposed during the financial crisis, leading to the development of the Standardized Approach to Counterparty Credit Risk (SA-CCR) in 2017 as an alternative method.
Frequently asked questions
What does CEM stand for?
CEM stands for current exposure method, a risk management approach used by financial institutions.
Why was CEM developed?
CEM was developed to assess and manage the risks associated with derivatives transactions, particularly in terms of potential counterparty default.
What are the limitations of CEM?
CEM may not adequately differentiate between margined and un-margined transactions, and it tends to focus on current pricing rather than future cash flow fluctuations.
How does CEM differ from the Standardized Approach to Counterparty Credit Risk (SA-CCR)?
CEM primarily focuses on replacement costs and potential future exposure (PFE) to assess counterparty risk, whereas SA-CCR was developed as an alternative method to address the limitations of CEM by considering additional factors and categories within asset classes.
What impact did the financial crisis have on the development of risk management methods like CEM?
The financial crisis highlighted the shortcomings of existing risk management methods, including CEM, particularly in adequately assessing and mitigating counterparty credit risk. This led to the development of alternative approaches like the SA-CCR to enhance risk management practices in the financial industry.
Key takeaways
- CEM is a risk management method for assessing counterparty risk in derivatives transactions.
- It calculates exposure based on replacement costs and potential future exposure.
- The method’s limitations led to the development of alternative approaches like the SA-CCR.
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