Fannie Mae 2004 Annual Report Download - page 167

flexibility while maintaining our low risk tolerance. The types of derivative instruments we use most often to
rebalance our portfolio include pay-fixed and receive-fixed interest rate swaps.
In addition to our three primary uses of derivatives, we may also use derivatives for the following purpose:
(4) To hedge foreign currency exposure.
We occasionally issue debt in a foreign currency. Because all of our assets are denominated in U.S. dollars,
we enter into currency swaps to effectively convert the foreign-denominated debt into U.S. dollar-denominated
debt. By swapping out of foreign currencies completely at the time of the debt issue, we minimize our
exposure to any currency risk. Our foreign-denominated debt represents less than 1% of our total debt
outstanding.
Types of Derivatives We Use
Derivative instruments may be privately negotiated contracts, which are often referred to as OTC derivatives,
or they may be listed and traded on an exchange. Our derivatives consist primarily of OTC contracts that fall
into three broad categories.
Interest rate swap contracts. An interest rate swap is a transaction between two parties in which each agrees
to exchange payments tied to different interest rates or indices for a specified period of time, generally based
on a notional amount of principal. The types of interest rate swaps we use include:
•Pay-fixed, receive variable—an agreement whereby we pay a predetermined fixed rate of interest based
upon a set notional amount and receive a variable interest payment based upon a stated index, with the
index resetting at regular intervals over a specified period of time. These contracts generally increase in
value as interest rates rise.
•Receive-fixed, pay variable—an agreement whereby we make a variable interest payment based upon a
stated index, with the index resetting at regular intervals, and receive a predetermined fixed rate of interest
based upon a set notional amount and over a specified period of time. These contracts generally increase
in value as interest rates fall.
•Basis swap—an agreement that provides for the exchange of variable interest payments, based on notional
amounts, tied to two different underlying interest rate indices.
Interest rate option contracts. These contracts primarily include the following:
•Pay-fixed swaptions—an option that allows us to enter into a pay-fixed, receive variable interest rate swap
at some point in the future. These contracts generally increase in value as interest rates rise.
•Receive-fixed swaptions—an option that allows us to enter into a receive-fixed, pay variable interest rate
swap at some point in the future. These contracts generally increase in value as interest rates fall.
•Interest rate caps—although an interest rate cap is not an option it has option-like characteristics. It is a
contract in which we receive money when a reference interest rate, typically LIBOR, exceeds an agreed-
upon referenced strike price (“cap”). The value generally increases as reference interest rates rise.
Foreign currency swaps. Swaps that convert debt we issue in foreign-denominated currencies into
U.S. dollars. We enter into foreign currency swaps only to the extent that we issue foreign currency debt.
Summary of Derivative Activity
The decisions to reposition our derivative portfolio are based upon current assessments of our interest rate risk
profile and economic conditions, including the composition of our consolidated balance sheets and expected
trends, the relative mix of our debt and derivative positions, and the interest rate environment. Table 37
presents our risk management derivative activity by type for the year ended December 31, 2004, along with
the stated maturities of derivatives outstanding as of December 31, 2004. Table 37 does not include mortgage
commitments that are accounted for as derivatives. We discuss our mortgage commitments in “Business
Segment Results—Capital Markets Group.”
162