Freddie Mac 2006 Annual Report Download - page 73

Foreign-Currency Risk. Foreign-currency risk is the risk that Öuctuations in currency exchange rates (e.g., foreign
currencies to the U.S. dollar) will adversely aÅect shareholder value. We are exposed to foreign-currency risk because we
have debt denominated in currencies other than the U.S. dollar, our functional currency. We eliminate virtually all of our
foreign-currency risk by entering into swap transactions that eÅectively convert foreign-currency denominated obligations
into U.S. dollar-denominated obligations.
Portfolio Market Value Sensitivity and Measurement of Interest-Rate Risk
We employ a risk management strategy that seeks to substantially match the duration characteristics of our assets and
liabilities. To accomplish this, we employ an integrated strategy encompassing asset selection and structuring and asset and
liability management.
Through our asset selection process, we seek to purchase mortgage assets with desirable prepayment expectations based
on our evaluation of their yield-to-maturity, option-adjusted spreads and credit characteristics. Through this selection
process and the restructuring of mortgage assets, we seek to retain cash Öows with more stable risk and investment return
characteristics while selling oÅ the cash Öows that do not meet our investment proÑle.
Through our asset and liability management process, we mitigate interest-rate risk by issuing a wide variety of debt
products. The prepayment option held by mortgage borrowers drives the fair value of our mortgage assets such that the
combined fair value of our mortgage assets and non-callable debt will decline if interest rates move signiÑcantly in either
direction. We mitigate much of our exposure to changes in interest rates by funding a signiÑcant portion of our mortgage
portfolio with callable debt. When interest rates change, our option to redeem this debt oÅsets a large portion of the fair
value change driven by the mortgage prepayment option. At December 31, 2006, approximately 50 percent of our Ñxed-
rate mortgage assets were funded and economically hedged with callable debt. However, because the mortgage prepayment
option is not fully hedged by callable debt, the combined fair value of our mortgage assets and debt will be aÅected by
changes in interest rates.
To further reduce our exposure to changes in interest rates, we hedge a signiÑcant portion of the remaining prepayment
risk with option-based derivatives. These derivatives primarily consist of call swaptions, which tend to increase in value as
interest rates decline, and put swaptions, which tend to increase in value as interest rates increase. With the addition of
these option-based derivatives, the fair value of net assets becomes relatively stable over a wide range of interest rates
because a greater portion of our prepayment risk has been hedged. The fair value of net assets is further stabilized by our
ongoing portfolio rebalancing, primarily involving interest-rate swaps. Although we do not hedge all of our exposure to
changes in interest rates, these exposures are generally well understood, are subject to established limits, and are monitored
and controlled through our disciplined risk management process. See ""CONSOLIDATED FAIR VALUE BALANCE
SHEETS ANALYSIS Ì Key Components of Changes in Fair Value of Net Assets Ì Changes in mortgage-to-debt OAS''
for further information.
We measure our exposure to key interest-rate risks every day against both internal management limits and limits set by
our board of directors. Throughout 2006, our interest-rate risk remained low and well below management and board limits.
PMVS and Duration Gap. Our primary interest-rate risk measures are PMVS and duration gap. PMVS is measured
in two ways, one measuring the estimated sensitivity of our portfolio market value (as deÑned below) to parallel moves in
interest rates (PMVS-L) and the other to nonparallel movements (PMVS-YC).
Our PMVS and duration gap estimates are determined using models that involve our best judgment of interest-rate and
prepayment assumptions. In addition, in the case of PMVS, daily calculations are based on an estimate of the fair value of
our net assets attributable to common stockholders. Accordingly, while we believe that PMVS and duration gap are useful
risk management tools, they should be understood as estimates rather than as precise measurements.
While PMVS and duration gap estimate the exposure of the fair value of net assets attributable to common stockholders
(measured as the fair value of total net assets less the fair value of preferred stock) to changes in interest rates, they do not
capture the potential impact of certain other market risks, such as changes in volatility, basis, prepayment model,
mortgage-to-debt option-adjusted spreads and foreign-currency risk. The impact of these other market risks can be
signiÑcant. See ""Sources of Interest-Rate Risk and Other Market Risks'' discussed above and ""CONSOLIDATED FAIR
VALUE BALANCE SHEETS ANALYSIS Ì Key Components of Changes in Fair Value of Net Assets Ì Changes in
mortgage-to-debt OAS '' for further information.
‚ PMVS-L shows the estimated loss in pre-tax portfolio market value, expressed as a percentage of our after-tax fair
value of net assets attributable to common stockholders, from an immediate adverse 50 basis point parallel shift in
the level of LIBOR rates (i.e., when the yield at each point on the LIBOR yield curve increases or decreases by
50 basis points).
61 Freddie Mac