Freddie Mac 2004 Annual Report Download - page 111

Interest-Rate Risk and Other Market Risks
We are exposed to the risk that changes in interest rates or in other market factors will adversely aÅect
our cash Öows, the fair value of net assets and/or future earnings. We take an active and disciplined approach
to the management of these risks. Our disciplined approach to risk management is essential to generating fair
value growth for stockholders in a wide range of interest-rate environments. Our interest-rate risk exposure
results primarily from mortgage loans and mortgage-related securities held in our Retained portfolio and the
liabilities funding this portfolio. To a lesser extent, we are also exposed to interest-rate risk through our credit
guarantee activities.
Oversight of Interest-Rate Risk and Other Market Risks
The purpose of the Market Risk Oversight group is to provide independent oversight of market risk,
including interest-rate risk, and to enhance our market risk measurement and management capabilities so that
they are consistent with industry best practice. Market Risk Oversight fulÑlls its mission by reporting to senior
management concerning the key investment strategies and market risks taken throughout the corporation, the
consistency of market risk positions with stated strategies and the appropriateness of limits and policies related
to risk exposure. The Models and Methods group, also a part of the Enterprise Risk Oversight function, is
responsible for independently assessing the design and adequacy of all key models, including prepayment
models.
Sources of Interest-Rate Risk and Other Market Risks
Retained Portfolio. Our Retained portfolio activities expose us to interest-rate risk and other market
risks. This exposure results primarily from the uncertainty as to when borrowers will pay the outstanding
principal balance of mortgage loans and mortgage-related securities held in the Retained portfolio, known as
prepayment risk, and the resulting potential mismatch in the timing of our receipt of cash Öows on our assets
versus the timing of our obligation to make payments on our liabilities. For the vast majority of our mortgage-
related investments, the mortgage borrower has the option to make unscheduled payments of additional
principal or to completely pay oÅ a mortgage loan at any time before its scheduled maturity date (without
having to pay prepayment penalties) or to hold the mortgage to its stated maturity. The borrower's option
makes the timing and amount of mortgage prepayments (and thus the timing and amount of mortgage cash
Öows received by us) very sensitive to changes in interest rates, among other factors.
The Retained portfolio comprises mortgage investments with a range of diÅerent characteristics,
including diÅerent stated maturities, underlying collateral, principal and interest payment structures and
prepayment patterns. To manage the interest-rate risk associated with this wide range of mortgage-related
investments, we employ a risk management strategy that seeks to substantially match the duration
characteristics of our assets and liabilities. We use various instruments, including short-term debt, callable and
non-callable long-term debt and interest-rate derivatives, to mitigate the risk that mortgage investments may
prepay faster or slower than expected.
The types of interest-rate risk and other market risks to which we are exposed through our Retained
portfolio are described below.
‚Duration Risk. Duration is a measure of a Ñnancial instrument's price sensitivity to changes in
interest rates. We actively manage duration risk through asset selection and structuring (that is,
by identifying or structuring mortgage-related securities with attractive prepayment and other
characteristics), by issuing a broad range of both callable and non-callable debt instruments and
by transacting in interest-rate derivatives.
We monitor duration against limits and reporting thresholds established by senior management
and the Board of Directors. Our interest-rate sensitivity is estimated and reported through our
PMVS and duration gap measures. These measures are estimated on a daily basis and publicly
reported on a monthly basis. See ""Measurement of Interest-Rate Risk'' below.
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