Final answer:
CEM is an older and less risk-sensitive method for calculating counterparty credit risk in derivatives, using a flat percentage add-on, while SA-CCR considers multiple risk factors, netting, and collateral, providing a more accurate and preferred approach for many financial institutions.
Step-by-step explanation:
The difference between CEM (Current Exposure Method) and SA-CCR (Standardized Approach for Counterparty Credit Risk) is primarily found in the way they calculate counterparty credit risk exposure for derivatives. CEM is a non-risk sensitive method that uses a flat percentage of the notional amount of an OTC derivative transaction increased by an add-on for potential future exposure (PFE), based on the asset class and remaining maturity. CEM tends to overstate exposure for netting sets with offsetting trades and does not consider the mitigating effect of collateral.
On the other hand, SA-CCR is a more risk-sensitive approach which takes into account multiple risk drivers, including the direction of the trade (long or short), asset class, and maturity. It also provides a more nuanced treatment of margined and unmargined trades and recognizes the benefits of netting and collateral. This leads to a more accurate reflection of the economic realities of the trading relationship and is generally seen as a significant improvement over CEM.
Financial institutions are required by regulation to use one of these methods for calculating the exposure amount of derivative contracts for capital requirements. SA-CCR became the preferred method for many institutions following regulatory changes aimed at better risk management in the financial industry.