Freddie Mac 2014 Annual Report Download - page 142

137 Freddie Mac
“MD&A — RISK MANAGEMENT — Institutional Credit Risk Profile” and “RISK FACTORS” for a discussion of our
market risk exposures, including those related to derivatives, institutional counterparties, and other market risks.
Interest-Rate Risk Management Strategy and Framework
We employ a risk management framework, using the fair value of financial instruments, that seeks to maintain certain
interest rate characteristics of our assets and liabilities within our risk limits through a number of different strategies, including:
• asset selection and structuring: We may acquire or structure mortgage-related securities with certain expected
prepayment and other characteristics;
• callable and non-callable unsecured debt; and
• interest rate derivatives, including swaptions and swaps.
To maintain our interest-rate risk exposure across a range of interest-rate scenarios within our risk limits, we analyze the
interest-rate sensitivity of financial assets and liabilities at the instrument level on a daily basis and across a variety of interest
rate scenarios. For risk management purposes, the interest-rate characteristics of each instrument are determined daily based on
market prices and models. The fair values of our assets, liabilities and derivatives are primarily based on either third-party
prices, or observable market-based inputs. For more information, see “NOTE 16: FAIR VALUE DISCLOSURES — Valuation
Processes and Controls over Fair Value Measurement.”
Annually, the Risk Committee of our Board of Directors establishes certain Board limits for interest-rate risk measures,
and if we exceed these limits we are required to notify the Risk Committee and address the limit breach. These limits
encompass a range of interest-rate risks that include duration risk, convexity risk, volatility risk, and yield curve risk associated
with our use of various financial instruments, including derivatives. Also, on an annual basis, our Enterprise Risk Management
division establishes management limits and makes recommendations with respect to the limits to be established at the Board
level. These limits are reviewed by our Enterprise Risk Management Committee, which is responsible for reviewing
performance as compared to the established limits. The management limits are set at values below those set at the Board level,
which is intended to allow us to follow a series of predetermined actions in the event of a breach of the management limits and
helps ensure proper oversight to reduce the possibility of exceeding the Board limits.
The principal types of interest-rate risk and other market risks to which we are exposed are described below.
Duration Risk and Convexity Risk
Duration is a measure of a financial instrument’s price sensitivity to a 100 basis point change in interest rates along the
yield curve (expressed in percentage terms). Convexity is a measure of how much a financial instrument’s duration changes as
interest rates change. Similar to the duration calculation, we compute each instrument’s convexity by applying the shock, both
upward and downward, to the LIBOR curve and evaluating the impact on the duration. We are exposed to convexity risk in
both our mortgage-related investments portfolio and our callable debt portfolio.
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 the fair value of net assets and ultimately adversely affect our net worth. 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 affect the fair value of our financial assets and liabilities and ultimately affect our net worth. We are exposed to volatility
risk in both our mortgage-related investments portfolio and our callable debt portfolio. We actively manage our volatility risk
exposure over a range of interest rate scenarios by using option-based interest-rate derivatives.
Spread Risk
Spread risk is the risk that interest rates in different market sectors will not move in tandem and will adversely affect the
fair value of net assets and ultimately adversely affect our net worth. This risk arises principally because the mortgage-related
investments generally do not move in tandem with our financial liabilities and derivatives. We are continually exposed to
significant spread risk, also referred to as mortgage-to-debt OAS risk, arising from funding mortgage-related investments with
debt securities. We also incur spread risk when we use LIBOR- or Treasury-based instruments in our risk management
activities.
Model Risk
Models, including mortgage prepayment models, interest rate models, home price models, mortgage default models, and
model adjustments based on new information or changes in conditions, are an integral part of our investment framework. As
market conditions change rapidly, the assumptions that we use in our models for our sensitivity analyses (including PMVS and
duration gap measures) may not keep pace with these market changes. These analyses are not intended to provide precise
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