Freddie Mac 2010 Annual Report Download - page 168

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Interest-Rate Risk and Other Market Risks
Interest-Rate Risk Management Framework
Our approach to managing interest rate risk is designed to be disciplined and comprehensive. Our objective is to
minimize our interest rate risk exposure across a range of interest rate scenarios. To do this, we analyze the interest rate
sensitivity of financial assets and liabilities at the instrument level on a daily basis and across a variety of interest rate
scenarios. For risk management purposes, the interest rate characteristics of each instrument are determined daily based on
market prices and internal models. The fair values of our assets, liabilities and derivatives are primarily based on either third
party prices, or observable market based inputs. These fair values, whether direct from third parties or derived from
observable inputs, are reviewed and validated by groups that are separate from our trading and investing function. See
“MD&A — FAIR VALUE MEASUREMENTS AND ANALYSIS — Fair Value Measurements — Controls over Fair Value
Measurement.”
Our interest rate risk framework includes interest rate risk guidelines. Annually, our Board of Directors establishes
certain limits for risk measures, and if we exceed these limits we are required to notify the Business and Risk Committee of
the Board of Directors as well as provide our expected course of action to return below the limits. These limits encompass a
range of interest rate risks that include duration risk, convexity risk, volatility risk, and yield curve risk associated with our
use of various financial instruments, including derivatives. Also on an annual basis, our Enterprise Risk Management division
establishes management limits and makes recommendations with respect to the limits to be established by the Board of
Directors. These limits are reviewed by our Enterprise Risk Management Committee, which is responsible for reviewing
performance as compared to the established limits. The management limits are set at values below those set by our Board of
Directors, which is intended to allow us to follow a series of predetermined actions in the event of a breach of the
management limits and helps ensure proper oversight to reduce the possibility of exceeding the limits set by our Board of
Directors.
Sources of Interest-Rate Risk and Other Market Risks
Our investments in mortgage loans and mortgage-related securities expose us to interest-rate risk and other market risks
arising primarily from the uncertainty as to when borrowers will pay the outstanding principal balance of mortgage loans and
mortgage-related securities, known as prepayment risk, and the resulting potential mismatch in the timing of our receipt of
cash flows related to our assets versus the timing of payment of cash flows related to our liabilities used to fund those assets.
For the vast majority of our mortgage-related investments, the mortgage borrower has the option to make unscheduled
payments of additional principal or to completely pay off a mortgage loan at any time before its scheduled maturity date
(without having to pay a prepayment penalty) or make principal payments in accordance with their contractual obligation.
We use derivatives as an important part of our strategy to manage interest rate and prepayment risk. When determining to
use derivatives to mitigate our exposures, we consider a number of factors, including cost, efficiency, exposure to
counterparty risks, and our overall risk management strategy. See “MD&A — RISK MANAGEMENT” for a discussion of
our exposure to credit risks, our use of derivatives, and operational risks of our business. See “RISK FACTORS” for a
discussion of our market risk exposure, including those related to derivatives, institutional counterparties, and other market
risks.
Our credit guarantee activities also expose us to interest-rate risk because changes in interest rates can cause fluctuations
in the fair value of our existing credit guarantees. We generally do not hedge these changes in fair value except for interest-
rate exposure related to net buy-ups and float. Float, which arises from timing differences between when the borrower makes
principal payments on the loan and the reduction of the PC balance, can lead to significant interest expense if the interest
rate paid to a PC investor is higher than the reinvestment rate earned by the securitization trusts on payments received from
mortgage borrowers and paid to us as trust management income.
The types of interest-rate risk and other market risks to which we are exposed are described below.
Duration Risk and Convexity Risk
Duration is a measure of a financial instrument’s price sensitivity to changes in interest rates (expressed in percentage
terms). For mortgage assets, we compute each instrument’s duration by applying a 50 basis point shock, both upward and
downward, to the LIBOR curve and evaluating the impact on the instrument’s fair value. Convexity is a measure of how
much a financial instrument’s duration changes as interest rates change. Similar to the duration calculation, we compute each
instrument’s convexity by applying a 50 basis point shock, both upward and downward, to the LIBOR curve and evaluating
the impact on the duration. Currently, short-term interest rates are historically low and, at some points, the LIBOR curve is
less than 50 basis points. As a result, the 50 basis point shock to the LIBOR curve described above is bounded by zero. Our
convexity risk primarily results from prepayment risk. We seek to manage duration risk and convexity risk through asset
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