Freddie Mac 2004 Annual Report Download - page 211

NOTE 12: DERIVATIVES
Freddie Mac principally uses the following types of derivatives:
‚LIBOR-Based Interest-Rate Swaps: Interest-rate swaps are contractual agreements between two
parties for the exchange of periodic payments based on a pre-determined amount (""notional'') and
agreed-upon Ñxed and Öoating interest rates.
‚LIBOR- and Treasury-Based, Exchange-Traded Futures Contracts: Futures contracts are ex-
change-traded agreements that obligate one party to sell and another party to purchase a speciÑed
amount of a designated Ñnancial instrument at a speciÑed price and date.
‚LIBOR- and Treasury-Based Options and Swaptions: Options are exchange-traded or over-the-
counter (""OTC'') agreements in which the holder pays a one-time up-front premium to another party
in exchange for the right, but not the obligation, to buy or sell a speciÑed asset or enter into a contract
at a speciÑed price during a speciÑed period of time. Option holders will generally exercise their options
only if there is an economic advantage in doing so. Swaptions are OTC options to execute an interest-
rate swap at a speciÑc date and speciÑc rates.
‚LIBOR- and Treasury-Based Interest-Rate Caps and Floors: Interest-rate caps and Öoors are OTC
agreements in which the holder pays a one-time up-front premium to another party in exchange for the
right to receive interest payments based on a particular notional amount and the amount, if any, by
which the agreed-upon index rate exceeds a speciÑed maximum (""cap'') or by which the agreed-upon
index is below a speciÑed minimum (""Öoor'') rate.
‚Foreign-Currency Swaps: Currency swaps are contractual agreements between two parties for the
exchange of a speciÑed amount of a designated foreign currency for a speciÑed amount of U.S. dollars
at the inception and termination of the contract. Each party will also make periodic interest payments
on the currency it receives in the swap at agreed-upon Ñxed or Öoating interest rates.
‚Forward Purchase and Sale Commitments: Forward purchase and sale commitments are OTC
agreements that obligate one party to purchase (sell) and another party to sell (purchase) a speciÑed
amount of a designated Ñnancial instrument at a speciÑed price and date.
‚Other: Certain other agreements entered into are accounted for as derivatives in accordance with
SFAS 133 or SFAS 149. These include (a) a prepayment management agreement in which Freddie
Mac is partially compensated for the adverse impacts caused by disproportionately higher mortgage
prepayments on certain mortgage pools; (b) credit risk-sharing agreements where Freddie Mac remits
or receives payments based upon the default performance of certain mortgage loans; and (c) swap
guarantee derivatives where Freddie Mac guarantees the sponsor's or the borrower's performance as a
counterparty on certain interest-rate swaps.
Hedging Activity
Derivative instruments are reported at their fair value as either Derivative assets, at fair value, or
Derivative liabilities, at fair value, on the consolidated balance sheets.
No hedge designation
At December 31, 2004, most of the company's derivatives portfolio, except for a portion of interest-rate
swaps, foreign-currency swaps and forward purchase and sale commitments, was not designated in hedge
accounting relationships. Freddie Mac reports changes in the fair value of these derivatives as Derivative gains
(losses) on the consolidated statements of income. For interest-rate swaps that are not designated in hedge
accounting relationships, the associated interest received or paid is recognized on an accrual basis and
recorded in Derivative gains (losses) on the consolidated statements of income.
EÅective as of the beginning of the second quarter of 2004, Freddie Mac determined that substantially all
pay-Ñxed interest-rate swaps and other derivatives that previously had been in cash Öow hedge accounting
relationships no longer met the hedged item shared risk exposure requirement and hedge eÅectiveness
Freddie Mac
199