-128-
number (confidence level), if the counterparty to the swap were
to default without recovery by FNBC. The CEM amount at the
inception of a swap was significantly higher than the current
exposure at the inception of the swap; i.e., the CEM amount was a
measure of the maximum that FNBC might receive (lose) on the swap
in the future, within a certain confidence level, while the
current exposure was a measure of the current value of the swap.
During the relevant years, FNBC ascertained its CEM amounts
for financial derivatives by using a system called the VEP
system. FNBC’s VEP system recalculated the CEM amount at least
annually. For transactions where the mark-to-market amount
exceeded the CEM amount, the CEM amount was recalculated monthly.
FNBC calculated the CEM amount for all swaps. A swap that had a
negative value (FNBC was the net payor) always had a CEM amount
that was greater than zero.
b. Hsieh Model
FNBC’s initial VEP system was developed for it in the late
1980s by David A. Hsieh (Hsieh). Hsieh designed FNBC’s VEP
system for risk management purposes to measure credit exposure on
interest rate and currency products in a manner consistent with
the rules of the FRB. The VEP system was designed specifically
for products with a tenor greater than 18 months and had problems
calculating the CEM amount for swaps with shorter maturities.
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