Freddie Mac 2008 Annual Report Download - page 178

mortgage assets. We manage volatility risk through asset selection and by maintaining a consistently high percentage of
option-embedded liabilities 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 that is acceptable to us.
Basis Risk
Basis risk is the risk that interest rates in different market sectors will not move in tandem and will adversely affect
GAAP stockholders’ equity (deficit). This risk arises principally because we generally hedge mortgage-related investments
with debt securities. We do not actively manage the basis risk arising from funding mortgage-related investments portfolio
investments with our debt securities, also referred to as mortgage-to-debt OAS risk. We generally hold a substantial portion
of our mortgage assets for the long term and we do not believe that periodic increases or decreases in the fair value of net
assets arising from fluctuations in OAS will significantly affect the long-term value of our mortgage-related investments
portfolio. See “MD&A — CONSOLIDATED FAIR VALUE BALANCE SHEETS ANALYSIS — Key Components of
Changes in Fair Value of Net Assets — Changes in Mortgage-To-Debt OAS ” for additional information. We also incur basis
risk when we use LIBOR- or Treasury-based instruments in our risk management activities.
Foreign-Currency Risk
Foreign-currency risk is the risk that fluctuations in currency exchange rates (e.g., foreign currencies to the U.S. dollar)
will adversely affect GAAP stockholders’ equity (deficit). We are exposed to foreign-currency risk because we have debt
denominated in currencies other than the U.S. dollar, our functional currency. We eliminate virtually all of our foreign-
currency risk by entering into swap transactions that effectively convert foreign-currency denominated obligations into U.S.
dollar-denominated obligations.
Portfolio Market Value Sensitivity and Measurement of Interest-Rate Risk
We employ a risk management strategy that seeks to substantially match the duration characteristics of our assets and
liabilities. To accomplish this, we employ an integrated strategy encompassing asset selection and structuring and asset and
liability management.
Through our asset selection process, we seek to purchase mortgage assets with desirable prepayment expectations based
on our evaluation of their yield-to-maturity, OAS and credit characteristics. Through this selection process and the
restructuring of mortgage assets, we seek to retain cash flows with more stable risk and investment return characteristics
while selling off the cash flows that do not meet our investment profile.
Through our asset and liability management process, we seek to mitigate interest-rate risk by issuing a wide variety of
debt products. The prepayment option held by mortgage borrowers drives the fair value of our mortgage assets such that the
combined fair value of our mortgage assets and non-callable debt will decline if interest rates move significantly in either
direction. We seek to mitigate much of our exposure to changes in interest rates by funding a significant portion of our
mortgage portfolio with callable debt. When interest rates change, our option to redeem this debt offsets a large portion of
the fair value change driven by the mortgage prepayment option. At December 31, 2008, approximately 31% of our fixed-
rate mortgage assets were funded and economically hedged with callable debt. However, because the mortgage prepayment
option is not fully hedged by callable debt, the combined fair value of our mortgage assets and debt will be affected by
changes in interest rates. In addition, due to the deteriorating market conditions in 2008, our ability to issue callable debt and
other long-term debt has been extremely limited. If these conditions persist, our ability to manage our interest rate risk may
be significantly adversely affected. However, the Federal Reserve has been an active purchaser in the secondary market of
our long-term debt under its purchase program and spreads on our debt and our access to the debt markets have improved in
early 2009 as a result of this activity.
To further reduce our exposure to changes in interest rates, we hedge a significant portion of the remaining prepayment
risk with option-based derivatives. These derivatives primarily consist of call swaptions, which tend to increase in value as
interest rates decline, and put swaptions, which tend to increase in value as interest rates increase. With the addition of these
option-based derivatives, a greater portion of our prepayment risk has been hedged. We also seek to manage interest-rate risk
by rebalancing the portfolio, primarily using interest-rate swaps. Although we do not hedge all of our exposure to changes in
interest rates, these exposures are subject to established limits and are monitored and controlled through our risk
management process. These limits are refined and updated from time to time. See “MD&A — CONSOLIDATED FAIR
VALUE BALANCE SHEETS ANALYSIS — Key Components of Changes in Fair Value of Net Assets — Changes in
Mortgage-To-Debt OAS” for further information.
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 defined below) to parallel moves in interest rates (Portfolio Market
Value Sensitivity-Level or (PMVS-L)) and the other to nonparallel movements (PMVS-YC). Our PMVS and duration gap
estimates are determined using models that involve our best judgment of interest-rate and prepayment assumptions.
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