Freddie Mac 2009 Annual Report Download - page 203

management purposes to make on-top adjustments to our interest rate risk statistics that reflect the expected impact of the
pending model change. These adjustments are included in our PMVS and duration gap disclosures.
To improve the accuracy of our models, changes to the underlying assumptions or modeling techniques are made on a
periodic basis. In volatile environments like 2009, where market conditions or underlying mortgage assumptions change
rapidly, it is necessary to change our models more frequently. In 2009, for example, we made several changes to our
mortgage prepayment model to reflect the impact of house prices, the availability of mortgage credit and the impact of the
MHA Program on mortgage prepayment behavior.
Foreign-Currency Risk
Foreign-currency risk is the risk that fluctuations in currency exchange rates (e.g., foreign currencies to the U.S. dollar)
will adversely affect GAAP total equity (deficit). We are exposed to foreign-currency risk because we have debt
denominated in currencies other than the U.S. dollar, our functional currency. We mitigate virtually all of our foreign-
currency risk by entering into swap transactions that effectively 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. Through our asset and liability management process, we seek to 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
significantly in either direction. We seek to mitigate much of our exposure to changes in interest rates by funding a
significant portion of our mortgage portfolio with callable debt. When interest rates change, our option to redeem this debt
offsets a large portion of the fair value change driven by the mortgage prepayment option. At December 31, 2009,
approximately 32% of our fixed-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 affected by changes in interest rates. In addition, due to the weakened market conditions, our ability to issue
callable debt and other long-term debt was limited in the first half of 2009. However, the Federal Reserve was an active
purchaser in the secondary market of our long-term debt under its purchase program and spreads on our debt and our access
to the debt markets have improved in 2009 as a result of this activity.
To further reduce our exposure to changes in interest rates, we hedge a significant 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, a greater portion of our prepayment risk has been hedged. We also seek to manage interest-rate risk
by changing the effective interest terms of the portfolio, primarily using interest-rate swaps, which we refer to as
rebalancing. Although we do not hedge all of our exposure to changes in interest rates, these exposures are subject to
established limits and are monitored and controlled through our risk management process.
PMVS and Duration Gap
Our primary interest-rate risk measures are PMVS and duration gap. Our key measure of PMVS is the change in the
value of our net assets and liabilities for an instantaneous 50 basis point shock to interest rates and assumes no rebalancing
actions are undertaken. PMVS is measured in two ways, one measuring the estimated sensitivity of our portfolio market
value (as defined below) to parallel movements in interest rates (Portfolio Market Value Sensitivity-Level or (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. 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 our exposure to changes in interest rates, they do not capture the potential
impact of certain other market risks, such as changes in volatility, basis, model, mortgage-to-debt OAS and foreign-currency
risk. The impact of these other market risks can be significant. See “Sources of Interest-Rate Risk and Other Market Risks”
discussed above for further information. Definitions of our primary interest rate risk measures follow:
• To estimate PMVS-L with a 50 basis point shock, an instantaneous parallel 50 basis point shock is applied to the
yield curve, as represented by the US swap curve, holding all spreads to the swap curve constant. This shock is
applied to all financial instruments. The resulting change in value for the aggregate portfolio is computed for both the
up rate and down rate shock and the change in market value in the adverse scenario of the up and down rate shocks is
the PMVS. Because the rate shock utilized in this process is a parallel, or level, shock to interest rates, we refer to
this measure as PMVS-L.
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