Freddie Mac 2008 Annual Report Download - page 179

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 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 OAS and
foreign-currency risk. The impact of these other market risks can be significant. See “Sources of Interest-Rate Risk and Other
Market Risks” discussed above for further information. Definitions of our primary interest rate risk measures follow:
• PMVS-L shows the estimated loss in pre-tax portfolio market value from an immediate adverse 50 basis point parallel
shift in the level of LIBOR (i.e., when the yield at each point on the LIBOR yield curve increases or decreases by
50 basis points).
• PMVS-YC shows the estimated loss in pre-tax portfolio market value 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 two-year and ten-year LIBOR by an equal amount (12.5 basis points), but in opposite
directions. LIBOR shifts between the two-year and ten-year points are interpolated.
• We calculate our exposure to changes in interest rates using effective duration. Effective duration measures the
percentage change in price of financial instruments to a 1% change in interest rates. Financial instruments with
positive duration increase in value as interest rates decline. Conversely, financial instruments with negative duration
increase in value as interest rates rise.
Duration gap measures the difference in price sensitivity to interest rate changes between our assets and liabilities,
and is expressed in months relative to the market value of assets. For example, assets with a six month duration and
liabilities with a five month duration would result in a positive duration gap of one month. A duration gap of zero
implies that the duration of our assets equals the duration of our liabilities. As a result, the change in the value of
assets from an instantaneous move in interest rates, either up or down, will be accompanied by an equal and
offsetting change in the value of liabilities, thus leaving the fair value of equity unchanged. A positive duration gap
indicates that the duration of our assets exceeds the duration of our liabilities which, from a net perspective, implies
that the fair value of equity will increase in value when interest rates fall and decrease in value when interest rates
rise. A negative duration gap indicates that the duration of our liabilities exceeds the duration of our assets which,
from a net perspective, implies that the fair value of equity will increase in value when interest rates rise and decrease
in value when interest rates fall. Multiplying duration gap (expressed as a percentage of a year) by the fair value of
our assets will provide an indication of the change in the fair value of our equity resulting from a 1% change in
interest rates.
The convexity of a financial instrument measures the extent to which the duration or price sensitivity of an instrument
changes for a 1% change in interest rates. As a result of convexity, actual changes in fair value from interest changes
may differ from those implied by duration gap alone. For that reason, we believe duration gap is most useful when
used in conjunction with PMVS-L.
The 50 basis point shift and 25 basis point change in slope of the LIBOR yield curve used for our PMVS measures
reflect reasonably possible near-term changes that we believe provide a meaningful measure of our interest-rate risk
sensitivity. Our PMVS measures assume instantaneous shocks. Therefore, these PMVS measures do not consider the effects
on fair value of any rebalancing actions that we would typically take to reduce our risk exposure.
The expected loss in portfolio market value is an estimate of the sensitivity to changes in interest rates of the fair value
of all interest-earning assets, 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 flows related to certain credit guarantee-
related items, including net buy-ups and expected gains or losses due to net interest from float. In making these calculations,
we do not consider the sensitivity to interest-rate changes of the following assets and liabilities:
•Credit guarantee portfolio. We do not consider the sensitivity of the fair value of the credit guarantee portfolio to
changes in interest rates except for the guarantee-related items mentioned above (i.e., net buy-ups and float), because
we believe the expected benefits from replacement business provide an adequate hedge against interest-rate changes
over time.
•Other assets with minimal interest-rate sensitivity. We do not include other assets, primarily non-financial
instruments such as fixed assets and REO, because we estimate their impact on PMVS and duration gap to be
minimal.
Limitations of Market Risk Measures
There are inherent limitations in any methodology used to estimate exposure to changes in market interest rates. Our
sensitivity analyses for PMVS and duration gap contemplate only certain movements in interest rates and are performed at a
particular point in time based on the estimated fair value of our existing portfolio. These sensitivity analyses do not
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