Freddie Mac 2004 Annual Report Download - page 65

Derivative Gains (Losses)
Derivative gains (losses) represents the change in fair value of derivatives not accounted for in hedge
accounting relationships because the derivatives did not qualify for, or we did not elect to pursue, hedge
accounting, resulting in fair value changes being recorded to earnings. Derivative gains (losses) also includes
the accrual of periodic settlements for derivatives that are not in hedge accounting relationships. Although
derivatives are an important aspect of our management of interest-rate risk, they will generally increase the
volatility of reported net income, particularly when they are not accounted for in hedge accounting
relationships.
We generally use interest-rate swaps to mitigate contractual funding mismatches between our assets and
liabilities. A receive-Ñxed swap results in our receipt of a Ñxed interest-rate payment from our counterparty in
exchange for a variable rate payment to the counterparty. Conversely, a pay-Ñxed swap requires us to make a
Ñxed interest-rate payment in exchange for a variable rate payment. Call and put swaptions are options to
enter into receive- and pay-Ñxed interest-rate swaps, respectively. We use swaptions and other option-based
derivatives to adjust the contractual funding of our debt in response to changes in the expected lives of assets
in the Retained portfolio. Mortgage borrowers generally have the right to prepay their mortgages prior to
contractual maturity, and this prepayment option is sensitive to changes in interest rates.
Derivatives that are not in qualifying hedge accounting relationships generally increase the volatility of
reported Non-interest income (loss) because they are marked to fair value through earnings without the
oÅsetting change in value of the economically hedged exposures also being recognized in earnings. The fair
value of receive- and pay-Ñxed interest-rate swaps is primarily driven by changes in interest rates. Generally,
receive-Ñxed swaps increase in value and pay-Ñxed swaps decrease in value when interest rates decrease (and
the opposite being true when interest rates increase). The fair value of purchased call and put swaptions is
sensitive to changes in interest rates in a directionally similar manner to receive- and pay-Ñxed swaps,
respectively. Swaption values are also driven by the market's expectation of potential changes in future interest
rates (referred to as ""implied volatility''). Swaptions generally become more valuable as implied volatility
increases and less valuable as implied volatility decreases. Recognized losses on these purchased options in any
given period are limited to the premium paid to purchase the option plus any unrealized gains previously
recorded.
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