Freddie Mac 2010 Annual Report Download - page 170

purposes, to make business decisions and to manage risks. Market conditions have raised these risks and uncertainties” for a
discussion of the risks associated with our use of models. Given the importance of models to our investment management
practices, model changes undergo a rigorous model change review process. As a result, it is common for model changes to
take several months to complete. Given the time consuming nature of the model change review process, it is sometimes
necessary for risk management purposes to make 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.
Foreign-Currency Risk
Foreign-currency risk is the risk that fluctuations in currency exchange rates (e.g., Euros 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.
Risk Management Strategy
Although we cannot hedge all of our exposure to changes in interest rates, this exposure is subject to established limits
and is monitored through our risk management process. 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 callable and non-callable 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. 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. It was more difficult for us to
implement this strategy at the end of 2008 and during the first half of 2009, as our ability to issue callable debt and other
long-term debt was limited due to the weakened market conditions.
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. 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.
Portfolio Market Value Sensitivity and Measurement of Interest-Rate Risk
PMVS and Duration Gap
Our primary interest-rate risk measures are PMVS and duration gap. PMVS is the change in the market value of our net
assets and liabilities from 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 to parallel
movements in interest rates (PMVS-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, mortgage-to-debt OAS and foreign-currency risk.
The impact of these other market risks can be significant. Definitions of our primary interest rate risk measures follow:
• To estimate PMVS-L, 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 market value for the aggregate portfolio is computed for both the up rate and down rate shock
and the change in market value in the more adverse scenario of the up and down rate shocks is the PMVS. Because
this process uses a parallel, or level, shock to interest rates, we refer to this measure as PMVS-L.
• 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 more adverse yield curve scenario is then used to
determine the PMVS-yield curve. Because this process uses a non-parallel shock to interest rates, we refer to this
measure as PMVS-YC.
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