Freddie Mac 2009 Annual Report Download - page 204

• To estimate sensitivity related to the shape of the yield curve, a yield curve steepening and flattening of 25 basis
points is applied to all instruments. The resulting change in market value for the aggregate portfolio is computed for
both the steepening and flattening yield curve scenarios. The adverse yield curve scenario is then used to determine
the PMVS-yield curve. Because the rate shock utilized in this process is a non-parallel shock to interest rates, we
refer to this measure as PMVS-YC.
• We calculate our exposure to changes in interest rates using effective duration. Effective duration measures the
percentage change in price of financial instruments from a 1% change in interest rates. Financial instruments with
positive duration increase in value as interest rates decline. Conversely, financial instruments with negative duration
increase in value as interest rates rise.
• Duration gap measures the difference in price sensitivity to interest rate changes between our assets and liabilities,
and is expressed in months relative to the market value of assets. For example, assets with a six month duration and
liabilities with a five month duration would result in a positive duration gap of one month. A duration gap of zero
implies that the duration of our assets equals the duration of our liabilities. As a result, the change in the value of
assets from an instantaneous move in interest rates, either up or down, will be accompanied by an equal and offsetting
change in the value of liabilities, thus leaving the fair value of equity unchanged. A positive duration gap indicates
that the duration of our assets exceeds the duration of our liabilities which, from a net perspective, implies that the
fair value of equity will increase in value when interest rates fall and decrease in value when interest rates rise. A
negative duration gap indicates that the duration of our liabilities exceeds the duration of our assets which, from a net
perspective, implies that the fair value of equity will increase in value when interest rates rise and decrease in value
when interest rates fall. Multiplying duration gap (expressed as a percentage of a year) by the fair value of our assets
will provide an indication of the change in the fair value of our equity resulting from a 1% change in interest rates.
• Together, the duration and convexity provide a measure of an instrument’s overall price sensitivity to changes in
interest rates. Freddie Mac utilizes the aggregate duration and convexity risk of all interest rate sensitive instruments
on a daily basis to estimate the Portfolio Market Value Sensitivity or PMVS. The duration and convexity measures
provide a convenient method for estimating the PMVS using the following formula:
PMVS = ⫺[Duration] multiplied by [䉭r] plus [0.5 multiplied by Convexity] multiplied by [䉭r]
2
In the equation, 䉭rrepresents the interest rate change expressed in percent. For example, a 50 basis point change
will be expressed as 0.5%. The result of this formula is the percentage of sensitivity to the change in rate, which is
expressed as: PMVS = (0.5 Duration) + (0.125 Convexity)
The 50 basis point shift and 25 basis point change in slope of the LIBOR yield curve used for our PMVS measures
reflect reasonably possible near-term changes that we believe provide a meaningful measure of our interest-rate risk
sensitivity. Our PMVS measures assume instantaneous shocks. Therefore, these PMVS measures do not consider the effects
on fair value of any rebalancing actions that we would typically take to reduce our risk exposure.
The expected loss in portfolio market value is an estimate of the sensitivity to changes in interest rates of the fair value
of all interest-earning assets, interest-bearing liabilities and derivatives on a pre-tax basis. When we calculate the expected
loss in portfolio market value and duration gap, we also take into account the cash flows related to certain credit guarantee-
related items, including net buy-ups and expected gains or losses due to net interest from float. In making these calculations,
we do not consider the sensitivity to interest-rate changes of the following assets and liabilities:
•Credit guarantee portfolio. We do not consider the sensitivity of the fair value of the credit guarantee portfolio to
changes in interest rates except for the guarantee-related items mentioned above (i.e., net buy-ups and float), because
we believe the expected benefits from replacement business provide an adequate hedge against interest-rate changes
over time.
•Other assets with minimal interest-rate sensitivity. We do not include other assets, primarily non-financial
instruments such as fixed assets and REO, because we estimate their impact on PMVS and duration gap to be
minimal.
Limitations of Market Risk Measures
There are inherent limitations in any methodology used to estimate exposure to changes in market interest rates. Our
sensitivity analyses for PMVS and duration gap contemplate only certain movements in interest rates and are performed at a
particular point in time based on the estimated fair value of our existing portfolio. These sensitivity analyses do not
incorporate other factors that may have a significant effect on our financial instruments, most notably expected future
business activities and strategic actions that management may take to manage interest rate risk. 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
value of our net assets.
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