Freddie Mac 2004 Annual Report Download - page 43

borrower's option exposes us to a potential mismatch in cash inÖows from the mortgage assets we purchase for
investment as compared to cash outÖows required to make payments on our debt. We manage this interest-
rate risk through various investment and funding activities, as well as through the use of derivatives.
We recognize all derivatives, whether designated in hedging relationships or not, at fair value as either
assets or liabilities on our consolidated balance sheets. Derivatives that are expected to be highly eÅective in
reducing the risk associated with the exposure being hedged may be designated for accounting purposes as a
hedge of:
‚ The cash Öows of a variable-rate instrument or a forecasted transaction, or a ""cash Öow hedge;''
‚ The changes in fair value of a Ñxed-rate instrument, or a ""fair value hedge;'' or
‚ Foreign currency fair value or cash Öow, or a ""foreign currency hedge.''
We report the change in fair value of derivatives that are not in hedge accounting relationships in our
consolidated statements of income in the period in which the change in value occurs. We record the change in
fair value of derivatives that are in cash Öow hedge accounting relationships, to the extent these relationships
are eÅective, as a separate component of AOCI and reclassify this amount into earnings when the earnings
eÅect of the hedged risk is recorded. We record the change in fair value of derivatives in fair value hedge
accounting relationships each period in earnings along with the change in fair value of the hedged item.
The determination of whether a derivative qualiÑes for hedge accounting requires judgment about the
application of SFAS 133. SFAS 133 requires contemporaneous documentation of our hedge relationships,
including identiÑcation of the hedged item, the hedging instrument, the nature of the hedged risk and the
method used to assess the eÅectiveness of the hedge relationship. We use statistical analysis or comparison of
the critical terms of the hedging instrument to those of the hedged item to assess the eÅectiveness of hedges.
If our documentation and assessments are not adequate, the derivative does not qualify for hedge accounting.
Hedge accounting also requires us to measure hedge ineÅectiveness and recognize it currently in
earnings. For certain cash Öow hedging relationships, we have used the hypothetical derivative method, one of
three methods acceptable under GAAP. This method requires us to develop a hypothetical derivative whose
terms match those of the hedged item and compare estimated changes in its fair value to changes in the fair
value of the hedging derivative. Development of hypothetical derivatives requires us to make certain
assumptions and estimates. The use of diÅerent assumptions and estimates could result in a materially
diÅerent amount of recorded ineÅectiveness. We believe that our assumptions and estimates used to develop
hypothetical derivatives are reasonable.
Derivatives designated as cash Öow hedges generally hedge interest-rate risk related to forecasted
issuances of debt. For these hedging relationships to qualify for hedge accounting both at inception and over
the life of the derivative, we must estimate the probable future level of certain types of debt issuances. These
estimates are based on our expectation of future funding needs and the future mix of funding sources. Our
expectations about future funding are based upon projected growth and historical activity. If these estimates
had been lower, a smaller notional amount of derivatives would have been eligible for designation as cash Öow
hedges and potentially material amounts that were deferred and reported in AOCI would have been reported
in Derivative gains (losses) in the consolidated statements of income in the period they occurred. If estimated
future fundings do not occur, or are probable of not occurring, potentially material amounts that were deferred
and reported in AOCI would be immediately recognized in Derivative gains (losses) in the consolidated
statements of income. We believe that the forecasted issuances of debt previously hedged in cash Öow hedging
relationships are suÇciently likely to occur so that we may continue recording previously deferred amounts in
AOCI.
For a more detailed description of our use of derivatives and summaries of derivative positions, see
""RISK MANAGEMENT Ì Interest-Rate Risk and Other Market Risks Ì Use of Derivatives and Interest-
Rate Risk Management'' and ""NOTE 12: DERIVATIVES'' to the consolidated Ñnancial statements.
Freddie Mac
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