Freddie Mac 2009 Annual Report Download - page 202

range of both callable and non-callable debt instruments and by using interest-rate derivatives and written options. Managing
the impact of duration risk and convexity risk is the principal focus of our daily market risk management activities. These
risks are encompassed in our PMVS and duration gap risk measures, discussed in greater detail below. We use prepayment
models to determine the estimated duration and convexity of mortgage assets for our PMVS and duration gap measures.
Through the use of our models, we estimate on a weekly basis the negative convexity profile of our portfolio over a very
wide range of interest rates. This process allows us to identify the particular interest rate scenarios where the convexity of
our portfolio is most negative, and therefore the particular interest rate scenario where the interest rate price sensitivity of
our financial instruments is most acute. We use this information to develop hedging strategies that are customized to provide
interest rate risk protection for the specific interest rate environment where we are most exposed to negative convexity risk.
This strategy allows us to select hedging instruments that are most efficient for our portfolio, thereby reducing the overall
cost of interest rate hedging activities.
By carefully managing our convexity profile over a wide range of interest rates, we are able to hedge prepayment risk
for particular interest rate scenarios. As a result, the intensity and frequency of our ongoing risk management actions is
relatively constant over a wide range of interest rate environments. Our approach to convexity risk management focuses our
portfolio rebalancing activities for the specific interest rate scenario where market and interest rate volatility tend to be most
pronounced. This approach to convexity risk reduces our ongoing rebalancing activity to a relatively low level compared to
the overall daily trading volume of interest rate swaps and Treasury futures.
Yield Curve Risk
Yield curve risk is the risk that non-parallel shifts in the yield curve (such as a flattening or steepening) will adversely
affect GAAP total equity (deficit). Because changes in the shape, or slope, of the yield curve often arise due to changes in
the market’s expectation of future interest rates at different points along the yield curve, we evaluate our exposure to yield
curve risk by examining potential reshaping scenarios at various points along the yield curve. Our yield curve risk under a
specified yield curve scenario is reflected in our PMVS-YC disclosure.
Volatility Risk
Volatility risk is the risk that changes in the market’s expectation of the magnitude of future variations in interest rates
will adversely affect GAAP total equity (deficit). Volatility risk arises from the prepayment risk that is inherent in mortgages
or mortgage-related securities. Volatility risk is the risk that the homeowner’s prepayment option will gain or lose value as
the expected volatility of future interest rates changes. In general, as expected future interest rate volatility increases, the
homeowner’s prepayment option increases in value, thus negatively impacting the value of the mortgage security backed by
the underlying mortgages. We manage volatility risk by maintaining a portfolio of callable debt and option-based interest
rate derivatives that have relatively long option terms. We actively manage and monitor our volatility risk exposure over a
wide range of changing interest rate scenarios, however we do not eliminate our volatility risk exposure completely.
Basis Risk
Basis risk is the risk that interest rates in different market sectors will not move in tandem and will adversely affect
GAAP total equity (deficit). This risk arises principally because we generally hedge mortgage-related investments with debt
securities. We do not actively manage the basis risk arising from funding mortgage-related investments with our debt
securities, also referred to as mortgage-to-debt OAS risk. As principally a buy-and-hold investor, we remain exposed and do
not hedge our mortgage-to-debt OAS, or spread risk. See “MD&A — CONSOLIDATED FAIR VALUE BALANCE SHEETS
ANALYSIS — Key Components of Changes in Fair Value of Net Assets — Changes in Mortgage-To-Debt OAS ” for
additional information. We also incur basis risk when we use LIBOR- or Treasury-based instruments in our risk management
activities.
Model Risk
Proprietary models, including mortgage prepayment models, interest rate models and mortgage default models are an
integral part of our investment framework. As market conditions change rapidly, as they have since 2007, the assumptions
that we use in our models for our sensitivity analyses may not keep pace with these market changes. As such, these analyses
are not intended to provide precise forecasts of the effect a change in market interest rates would have on the estimated fair
values of our net assets. We actively manage our model risk by reviewing the performance of our models. Model
development and model testing are reviewed and approved independently by our ERO division. Model performance is also
reported on a monthly basis through a series of internal management committees. See “RISK FACTORS” for a discussion of
the risks associated with our use of models. Given the importance of models to our investment management practices, all
model changes undergo a rigorous model change review process. It is common for this process to take several months to
complete. Given the time consuming nature of the model change review process, it is sometimes necessary for risk
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