What is the 'Current Exposure Method (CEM)'

The Current exposure method (CEM) is a measurement of the replacement cost within a derivative contract in the case of a counterparty default. Derivatives include swaps, forwards, options, and other contracts. Banks and other financial institutions typically use the current exposure method.

The current exposure method is also known as "current pre-settlement exposure."

BREAKING DOWN 'Current Exposure Method (CEM)'

Under the current exposure method, an investor's, or a financial institution's total exposure is equal to the replacement cost of all marked to market contracts currently in the money. This value added to the credit exposure risk of potential changes in future prices or volatility of the underlying asset may be significant.

Current exposure and credit risk are different. The former is the value at risk, including the calculation of the initial contract value and future cash flows. The latter is the probability that the counterparty will default, and not the value of that default.
Only over-the-counter (OTC) derivatives contracts are subject to counterparty credit risk. Exchange-traded contracts are protected because the trade exchange guarantees the cash flows and other features of the parties before they enter into a contract. Financial markets have seen problems with risk mispricing time and time again. Even though they are somewhat regulated, over-the-counter markets still lack general transparency, which makes some risks still hidden from view. 
The risk of a counterparty default on a derivative contract is similar to the risk that a holder of a bond experiences if the bond is called, or redeemed early by the issuer. Replication of cash flow is often difficult, if not impossible, to recreate. The difference is that the bondholder would still receive the face value of the investment. Derivatives holders may not get any value back.

The Financial Crisis - Real World Effects of Current Exposure Method

The Basel Committee on Banking Supervision's goal is to improve the financial sector's ability to deal with financial stress. Through improving risk management and bank transparency, the international accord hopes to avoid a domino-effect of failing institutions.

Financial risk management teams still use the current exposure method to determine the cost of default within a swap agreement. Alternatives to the prevailing exposure method are the standardized method (SM) and the internal model method (IMM), as approved under the international regulatory requirements of the Basel Committee, 

The standard practice had been to assign zero or near-zero risk to financial institutions in their derivatives transactions. Banks were considered to be "too big to fail," so when banks such as Lehman Brothers did actually fail, the counterparties were unprepared for the losses that happened. From that point on, the need to adjust current exposure for the realistic probability of a bank's default has resulted in increased regulation.
The way to measure exposure continues to evolve. In 2014, the Basel Committee developed its standardized approach (SA-CCR) for measuring exposure at default (EAD). The SA-CCR will replace both the current exposure method (CEM) and the standardized method (SM).

This change was due to criticism of the current exposure method for limitations. The criticism pointed to the lack of differentiation between margined and unmargined transactions. Further, the existing risk determination methods were too focused on current pricing rather than on fluctuations of cash flows in the future.

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