Freddie Mac 2004 Annual Report Download - page 112

Although duration risk has been maintained at relatively low levels as indicated by our PMVS and
duration gap estimates (see ""Measurement of Interest-Rate Risk Ì PMVS and Duration Gap''),
fair value gains or losses will generally occur as market conditions change. For example, fair value
gains or losses occur when our duration gap is positive or negative and the level of interest rates or
shape of the yield curve changes.
‚Convexity Risk. Convexity is a measure of how much duration changes as interest rates change.
Convexity risk primarily results from mortgage prepayment risk. We actively mitigate this risk by
maintaining a high percentage of callable debt and option-based derivatives relative to the Ñxed-
rate mortgage assets held in the Retained portfolio.
We do not, however, hedge all prepayment option risk that exists at the time a mortgage is
purchased or that arises over its life. For the portion of risk not hedged at the time of purchase, we
undertake frequent rebalancing actions in order to keep our interest-rate risk exposure within our
internal limits (see ""Use of Derivatives and Interest-Rate Risk Management Ì Use of Deriva-
tives Ì Adjust Funding Mix'' below). Although convexity risks have been maintained at relatively
low levels as indicated by our PMVS estimate (see ""Measurement of Interest-Rate Risk Ì
PMVS and Duration Gap''), fair value gains or losses will generally occur as market conditions
change. For example, because we do not hedge all of the prepayment risk inherent in our
mortgage investment portfolio, fair value gains or losses occur from changes in the relationship
between interest-rate volatility expected at the time a mortgage loan is acquired and the volatility
actually experienced (see ""Volatility Risk'' below for more information).
‚Yield Curve Risk. Yield curve risk is the risk that non-parallel shifts in the yield curve (such as
a Öattening or steepening) will adversely aÅect our cash Öows, fair value of net assets and/or
future earnings. Changes in the shape, or slope, of the yield curve often arise due to changes in the
market's expectation of future interest rates at diÅerent points along the yield curve, including
expectations regarding action by the Federal Reserve Board. For this reason, we evaluate our
exposure to yield curve risk by examining potential reshaping scenarios at various points along the
yield curve. Our yield curve risk under a speciÑed yield curve scenario is reÖected in our PMVS-
Yield Curve, or PMVS-YC, disclosure.
‚Volatility Risk. Volatility risk is the risk that changes in the market's expectation of the
magnitude of future variations in interest rates will adversely aÅect our cash Öows, fair value of net
assets and/or future earnings. The market's expectation about the future volatility of interest rates,
or implied volatility, is a key determinant of the value of an interest-rate option. Higher expected
volatility implies a greater likelihood that the expected life of a mortgage asset will either extend
or contract. For example, higher interest-rate volatility implies a higher likelihood that interest
rates will decline to levels that make mortgage prepayments attractive to homeowners, thereby
making their prepayment option more valuable and making our mortgage assets subject to their
prepayment option less valuable. We manage volatility risk through asset selection and by
maintaining a consistently high percentage of option-embedded liabilities (e.g., callable debt) and
option-based derivatives relative to our mortgage assets. We monitor volatility risk by measuring
exposure levels on a daily basis and we maintain internal limits on the amount of volatility risk
exposure.
‚Basis Risk. Basis risk is the risk that interest rates in diÅerent market sectors will not move in
tandem and will adversely aÅect our cash Öows, fair value of net assets and/or future earnings.
This risk arises principally because we hedge mortgage-related investments with LIBOR- and
Treasury-based interest-rate derivatives. We do not actively manage the basis risk arising from
funding Retained portfolio investments with our debt securities, also referred to as mortgage-to-
debt option-adjusted spread risk. See ""CONSOLIDATED FAIR VALUE BALANCE
SHEETS Ì Key Components of Changes in Fair Value of Net Assets Ì EÅect of changes in
option-adjusted spread (mortgage-to-debt spread)'' for additional information. We also incur
basis risk when we use LIBOR- or Treasury-based instruments in our risk management activities.
We monitor the fair value Öuctuations associated with these basis risks and manage this exposure
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