Fannie Mae 2006 Annual Report Download - page 157

Interest Rate Risk Management Strategies
Our portfolio of interest rate-sensitive instruments includes our investments in mortgage loans and securities,
the debt issued to fund those assets, and the derivatives we use to manage interest rate risk. These assets and
liabilities have a variety of risk profiles and sensitivities. We employ an integrated interest rate risk
management strategy that includes asset selection and structuring of our liabilities to match and offset the
interest rate characteristics of our balance sheet assets and liabilities as much as possible. Our strategy consists
of the following principal elements:
•Debt Instruments: We issue a broad range of both callable and non-callable debt instruments to manage
the duration and prepayment risk of expected cash flows of the mortgage assets we own.
•Derivative Instruments: We supplement our issuance of debt with derivative instruments to further
reduce duration and prepayment risks.
•Monitoring and Active Portfolio Rebalancing: We continually monitor our risk positions and actively
rebalance our portfolio of interest rate-sensitive financial instruments to maintain a close match between
the duration of our assets and liabilities.
Debt Instruments
The primary tool we use to manage the interest rate risk implicit in our mortgage assets is the variety of debt
instruments we issue. We fund the purchase of mortgage assets with a combination of equity and debt. The
debt we issue is a mix that typically consists of short- and long-term, non-callable debt and callable debt. The
varied maturities and flexibility of these debt combinations help us in reducing the mismatch of cash flows
between assets and liabilities in order to manage the duration risk associated with an investment in long-term
fixed-rate assets. Callable debt helps us manage the prepayment risk associated with fixed-rate mortgage assets
because the duration of callable debt changes when interest rates change in a manner similar to changes in the
duration of mortgage assets.
Derivative Instruments
Derivative instruments also are an integral part of our strategy in managing interest rate risk. Derivative
instruments may be privately negotiated contracts, which are often referred to as OTC derivatives, or they may
be listed and traded on an exchange. When deciding whether to use derivatives instead of issuing debt
securities to reach the same goal, we consider a number of factors, such as cost, efficiency, the effect on our
liquidity and capital, and our overall interest rate risk management strategy. We choose to use derivatives
when we believe they will provide greater relative value or more efficient execution of our strategy than debt
securities. The derivatives we use for interest rate risk management purposes consist primarily of
OTC contracts that fall into three broad categories:
•Interest rate swap contracts. An interest rate swap is a transaction between two parties in which each
agrees to exchange payments tied to different interest rates or indices for a specified period of time,
generally based on a notional amount of principal. The types of interest rate swaps we use include pay-
fixed, receive variable swaps; receive-fixed, pay variable swaps; and basis swaps.
•Interest rate option contracts. These contracts primarily include pay-fixed swaptions, receive-fixed
swaptions, cancelable swaps and interest rate caps.
•Foreign currency swaps. These swaps convert debt that we issue in foreign-denominated currencies
into U.S. dollars. We enter into foreign currency swaps only to the extent that we issue foreign currency
debt.
We provide additional descriptions of the specific types of derivatives we use, including the typical effect on
the fair value of each instrument as interest rates change, in “Glossary of Terms Used in This Report.”
We use interest rate swaps and interest rate options, in combination with our issuance of debt securities, to
better match both the duration and prepayment risk of our mortgages. We are generally an end user of
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