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114 FANNIE MAE 2002 ANNUAL REPORT
13. Derivative Instruments and Hedging Activities
Fannie Mae issues various types of debt to finance the
acquisition of mortgages. We typically use derivative
instruments to hedge against the impact of interest rate
movements on our debt costs to preserve mortgage-to-debt
spreads. We do not engage in trading or other speculative
usage of derivative instruments.
We principally use interest-rate swaps, basis swaps,
swaptions, and caps in our hedging activities. Swaps provide
for the exchange of fixed and variable interest payments
based on contractual notional principal amounts. These may
include callable swaps, which give counterparties or us the
right to terminate interest rate swaps before their stated
maturities. Or, these may include foreign currency swaps,
where Fannie Mae and our counterparties exchange
payments in different types of currencies. Basis swaps provide
for the exchange of variable payments that have maturities
similar to hedged debt, but have payments based on different
interest rate indices. Swaptions give us the option to enter
into swaps at a future date, thereby mirroring the economic
effect of callable debt. Interest rate caps provide ceilings on
the interest rates of variable-rate debt.
We formally document all relationships between hedging
instruments and the hedged items, including the risk
management objective and strategy for undertaking various
hedge transactions. We link all derivatives to specific assets
and liabilities on the balance sheet or to specific forecasted
transactions and designate them as cash flow or fair value
hedges. We also formally assess, both at the hedge’s inception
and on an ongoing basis, whether the derivatives that we use
in hedging transactions are highly effective in offsetting
changes in the cash flows or fair values of the hedged items.
The following table reflects the hedge classification of the
notional balances of derivatives by type that we held at
December 31, 2002 and 2001.
2002 2001
Fair Value Cash Flow Fair Value Cash Flow
Dollars in millions Hedges Hedges Total Hedges Hedges Total
Interest rate swaps:
Pay-fixed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $16,355 $152,157 $168,512 $ 7,063 $206,617 $213,680
Receive-fixed and basis . . . . . . . . . . . . . . . . . . . . . . . 29,636 48,259 77,895 10,989 75,134 86,123
Interest rate caps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . —122,393 122,393 —75,893 75,893
Swaptions:
Pay-fixed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . —129,225 129,225 —69,650 69,650
Receive-fixed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94,750 51,500 146,250 74,400 — 74,400
Other1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,120 8,200 12,320 8,843 4,550 13,393
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $144,861 $511,734 $656,595 $101,295 $431,844 $533,139
1Includes foreign currency swaps, forward starting swaps, asset swaps, and other derivatives used to hedge anticipated debt issues.
We discontinue hedge accounting prospectively when
•the derivative is no longer effective in offsetting
changes in the cash flows or fair value of a hedged
item;
•the derivative expires or is sold, terminated, or
exercised;
•the derivative is de-designated as a hedge instrument
because it is unlikely that a forecasted transaction will
occur; or,
•the designation of the derivative as a hedge
instrument is no longer appropriate.
Cash Flow Hedges
Objectives and Context
We employ cash flow hedges to lock in the interest spread on
purchased assets by hedging existing variable-rate debt and
the forecasted issuances of debt through our Benchmark
Program. The issuance of short-term Discount Notes and
variable-rate long-term debt during periods of rising interest
rates can result in a mismatch of cash flows relative to fixed-
rate mortgage assets. We minimize the risk of mismatched
cash flows by converting variable-rate interest expense to
fixed-rate interest expense in order to lock-in our funding
costs and interest spread.