Fannie Mae 2013 Annual Report Download - page 158

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• 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
Historically, the primary tool we have used to fund the purchase of mortgage assets and manage the interest rate risk implicit
in our mortgage assets is the variety of debt instruments we issue. The debt we issue is a mix that typically consists of short-
and long-term, non-callable 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. See “Liquidity and Capital Management—Liquidity Management—Debt Funding” for
additional information on our debt activity.
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 over-the-counter derivatives, or they may be listed and traded on
an exchange. When deciding whether to use derivatives, we consider a number of factors, such as cost, efficiency, the effect
on our liquidity, results of operations and our overall interest rate risk management strategy.
The derivatives we use for interest rate risk management purposes fall into these broad categories:
• Interest rate swap contracts. An interest rate swap is a transaction between two parties in which each agrees to
exchange, or swap, interest payments. The interest payment amounts are tied to different interest rates or indices for
a specified period of time and are generally based on a notional amount of principal. The types of interest rate swaps
we use include pay-fixed swaps, receive-fixed swaps and basis swaps.
• Interest rate option contracts. These contracts primarily include pay-fixed swaptions, receive-fixed swaptions,
cancelable swaps and interest rate caps. A swaption is an option contract that allows us or a counterparty to enter
into a pay-fixed or receive-fixed swap at some point in the future.
• 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.
• Futures. These are standardized exchange-traded contracts that either obligate a buyer to buy an asset at a
predetermined date and price or a seller to sell an asset at a predetermined date and price. The types of futures
contracts we enter into include Eurodollar, U.S. Treasury and swaps.
We use interest rate swaps, interest rate options and futures, in combination with our issuance of debt securities, to better
match the duration of our assets with the duration of our liabilities. We are generally an end user of derivatives; 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 relatively liquid and 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;
(2) To achieve risk management objectives not obtainable with debt market securities;
(3) To quickly and efficiently rebalance our portfolio; and
(4) To hedge foreign currency exposure.
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 retained mortgage portfolio, our investments in non-
mortgage securities and relative mix of our debt and derivative positions, the interest rate environment and expected trends.
Measurement of Interest Rate Risk
Below we present two quantitative metrics that provide estimates of our interest rate exposure: (1) fair value sensitivity of our
net portfolio to changes in interest rate levels and slope of yield curve; and (2) duration gap. The metrics presented are
calculated using internal models that require standard assumptions regarding interest rates and future prepayments of