Fannie Mae 2006 Annual Report Download - page 158

derivatives and our principal purpose in using derivatives is to manage our aggregate interest rate risk profile
within prescribed risk parameters. We generally only use derivatives that are highly liquid and relatively
straightforward to value. We use derivatives for four primary purposes:
(1) As a substitute for notes and bonds that we issue in the debt markets.
We can use a mix of debt issuances and derivatives to achieve the same duration matching that would be
achieved by issuing only debt securities. The primary types of derivatives used for this purpose include pay-
fixed and receive-fixed interest rate swaps (used as substitutes for non-callable debt) and pay-fixed and
receive-fixed swaptions (used as substitutes for callable debt).
(2) To achieve risk management objectives not obtainable with debt market securities.
As an example, we can use the derivative markets to purchase swaptions to add characteristics not obtainable
in the debt markets. Some of the characteristics of the option embedded in a callable bond are dependent on
the market environment at issuance and the par issuance price of the bond. Thus, in a callable bond we can
not specify certain characteristics, such as specifying an “out-of-the-money” option, which could allow us to
more closely match the interest rate risk being hedged. We use option-based derivatives, such as swaptions,
because they provide the added flexibility to fully specify the terms of the option, thereby allowing us to more
closely match the interest rate risk being hedged.
(3) To quickly and efficiently rebalance our portfolio.
While we have a number of rebalancing tools available to us, it is often most efficient for us to rebalance our
portfolio by adding new derivatives or by terminating existing derivative positions. For example, when interest
rates fall and mortgage durations shorten, we can shorten the duration of our debt by entering into receive-
fixed interest rate swaps that convert longer-duration, fixed-term debt into shorter-duration, floating-rate debt
or by terminating existing pay-fixed interest rate swaps. This use of derivatives helps increase our funding
flexibility while helping us maintain our interest rate risk within policy limits. The types of derivative
instruments we use most often to rebalance our portfolio include pay-fixed and receive-fixed interest rate
swaps.
(4) To hedge foreign currency exposure.
We occasionally issue debt in a foreign currency. Our foreign-denominated debt represents less than 1% of our
total debt outstanding. Because all of our assets are denominated in U.S. dollars, we enter into currency swaps
to effectively convert the foreign-denominated debt into U.S. dollar-denominated debt. We are able to
minimize our exposure to currency risk by swapping out of foreign currencies completely at the time of the
debt issue.
Decisions regarding the repositioning of our derivatives portfolio are based upon current assessments of our
interest rate risk profile and economic conditions, including the composition of our consolidated balance
sheets and relative mix of our debt and derivative positions, the interest rate environment and expected trends.
Table 44 presents, by derivative instrument type, our risk management derivative activity for the years ended
December 31, 2006 and 2005, along with the stated maturities of derivatives outstanding as of December 31,
2006.
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