Freddie Mac 2005 Annual Report Download - page 74

PMVS and Duration Gap. Our primary interest-rate risk measures are PMVS and duration gap. PMVS is measured
in two ways, one measuring the estimated sensitivity of our portfolio market value (as deÑned below) to parallel moves in
interest rates (PMVS-L) and the other to nonparallel movements (PMVS-YC). PMVS-L and PMVS-YC are based on
the assumption of instantaneous yield curve shifts; therefore neither measure includes the eÅect on fair value of any
rebalancing actions that we would typically take to reduce our risk exposure.
Our PMVS and duration gap estimates are determined using models that involve our best judgment of interest-rate and
prepayment assumptions. In addition, in the case of PMVS, daily calculations are based on an estimate of the fair value of
our net assets attributable to common stockholders. Accordingly, while we believe that PMVS and duration gap are useful
risk management tools, they should be understood as estimates rather than as precise measurements.
While PMVS and duration gap estimate the exposure of the fair value of net assets attributable to common stockholders
(measured as fair value of total net assets less the fair value of preferred stock) to changes in interest rates, they do not
capture the potential impact of certain other market risks, such as changes in volatility, basis, prepayment model, mortgage-
to-debt option-adjusted spreads and foreign-currency risk. The impact of these other market risks can be signiÑcant. See
""Sources of Interest-Rate Risk and Other Market Risks'' and ""CONSOLIDATED FAIR VALUE BALANCE SHEETS
ANALYSIS Ì Key Components of Changes in Fair Value of Net Assets Ì Changes in mortgage-to-debt OAS '' for
further information.
‚ PMVS-L shows the estimated loss in pre-tax portfolio market value, expressed as a percentage of our after-tax fair
value of net assets attributable to common stockholders, from an immediate adverse 50 basis point parallel shift in
the level of LIBOR rates (that is, when the yield at each point on the LIBOR yield curve increases or decreases by
50 basis points). We believe the use of an immediate 50 basis point shift in the LIBOR yield curve is a conservative
estimate of interest-rate risk.
‚ PMVS-YC shows the estimated loss in pre-tax portfolio market value, expressed as a percentage of our after-tax fair
value of net assets attributable to common stockholders, from an immediate adverse 25 basis point change in the
slope (up and down) of the LIBOR yield curve. The 25 basis point change in slope for the PMVS-YC measure is
obtained by shifting the two-year and ten-year LIBOR rates by an equal amount (12.5 basis points), but in opposite
directions. LIBOR rate shifts between the two-year and ten-year points are interpolated.
‚ Duration gap estimates the net sensitivity of the fair value of our Ñnancial instruments to movements in interest rates.
Duration gap is presented in units expressed as months. A duration gap of zero implies that the change in value of
assets from an instantaneous rate move will be accompanied by an equal and oÅsetting move in the value of debt
and derivatives thus leaving the net fair value of equity unchanged. However, because duration does not capture
convexity exposure (the amount by which duration itself changes as rates move), actual changes in fair value from
interest-rate changes may diÅer from those implied by duration gap alone. For that reason, we believe duration gap is
most useful when used in conjunction with PMVS.
In measuring the expected loss in portfolio market value, which is the numerator in the fraction used to calculate the
PMVS percentages, we estimate the sensitivity to changes in interest rates of the fair value of all interest-earning assets and
interest-bearing liabilities and derivatives on a pre-tax basis. When we calculate the expected loss in portfolio market value
and duration gap, we also take into account the cash Öows related to certain credit guarantee-related items, including net
buy-ups and expected gains or losses due to net interest from Öoat. In calculating the expected loss in portfolio market value
and duration gap, we do not consider the sensitivity to interest-rate changes of the following assets and liabilities:
‚Credit guarantee portfolio. Except for the guarantee-related items mentioned above (i.e., net buy-ups and Öoat),
the sensitivity of the fair value of the credit guarantee portfolio to changes in interest rates is not included in
calculating the expected loss in portfolio market value or duration gap because we believe the expected beneÑts from
replacement business provide an adequate hedge against interest-rate changes.
‚Other assets with minimal interest-rate sensitivity. Other assets, primarily including non-Ñnancial instruments such
as Ñxed assets and REO, are not included in the calculation of the expected loss in portfolio market value or duration
gap because of the minimal impact they would have on both PMVS and duration gap.
The fair value of the credit guarantee portfolio and certain other assets with minimal interest-rate risk sensitivity is
included in the estimate of the after-tax fair value of net assets attributable to common stockholders, which is the
denominator of the fraction used to calculate the PMVS-L and PMVS-YC percentages.
PMVS Results. Table 33 provides estimated point-in-time PMVS-L and PMVS-YC results at December 31, 2005
and 2004. Table 33 also provides year-end PMVS-L estimates assuming an immediate 100 basis point shift in the LIBOR
yield curve. Because we do not hedge all prepayment option risk, the duration of our mortgage assets changes more rapidly
as changes in interest rates increase. Accordingly, as shown in Table 33, the PMVS-L results based on a 100 basis point shift
58 Freddie Mac