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.
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,
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.