Freddie Mac 2014 Annual Report Download - page 143

138 Freddie Mac
forecasts of the effect a change in market interest rates would have on the estimated fair values of our assets. We manage our
model risk by reviewing the performance of our models and making changes to the underlying assumptions or modeling
techniques when warranted. Model development and model testing are reviewed and approved independently by our Enterprise
Risk Management division. Model performance is also reported regularly through a series of internal management committees.
For more information about the risks associated with our use of models, see “MD&A — RISK MANAGEMENT —
Operational Risk Profile” and “RISK FACTORS — Operational Risks — We face risks and uncertainties associated with the
models that we use for financial accounting and reporting purposes, to make business decisions, and to manage risks. Market
conditions have raised these risks and uncertainties.” Given the importance of models to our investment management
practices, model changes undergo a rigorous review process. As a result, it is common for model changes to take several
months to complete, which could affect our estimation of risk metrics.
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 an estimate of the change in the market value of our financial assets and liabilities from an instantaneous
50 basis point shock to interest rates, assuming no rebalancing actions are undertaken and assuming the mortgage-to-LIBOR
basis does not change. 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).
• We calculate our exposure to changes in interest rates using effective duration. Effective duration measures the
percentage change in the 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.
• Together, duration and convexity provide a measure of an instrument’s overall price sensitivity to changes in interest
rates. We utilize the aggregate duration and convexity risk of all interest-rate sensitive instruments on a daily basis to
estimate the two PMVS metrics. The duration and convexity measures are used to estimate PMVS under the following
formula:
PMVS = –[Duration] multiplied by [rate shock] plus [0.5 multiplied by Convexity] multiplied by [rate shock]2
In the equation, [rate shock] represents the interest-rate change expressed in fair value terms. Assuming an adverse 50
basis point change, the result of this formula is the fair value of sensitivity to the change in rate, which is expressed as:
PMVS = (0.5 absolute value of duration) + (0.125 convexity), assuming convexity is negative.
• 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 the duration and convexity of
all interest-rate sensitive 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. In cases where both the up rate and down rate shock results in a positive
impact, the PMVS is zero. 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 the duration of all interest-rate sensitive 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.
• 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 expect to take to reduce our risk exposure.
Duration gap measures the difference in price sensitivity to interest rate changes between our financial 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, would be expected to be accompanied by an equal and offsetting
change in the value of liabilities, thus leaving the fair value of net assets 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 net
assets 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 net assets will increase in value when interest rates rise and decrease in value when interest rates fall.
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