Freddie Mac 2011 Annual Report Download - page 199

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Interest-Rate Risk and Other Market Risks
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” and “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 principal 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). We compute each instrument’s duration by applying an interest-rate shock, both upward and downward, to the
LIBOR curve and evaluating the impact on the instrument’s fair value. As interest rates have reached historically low
levels, the methodology previously used by management to calculate duration and convexity began to produce risk
sensitivities that were increasingly unstable and not representative of expected price movements. In order to alleviate the
instability, we changed the shift size required to calculate duration and convexity from 50 basis points to 25 basis points
beginning November 14, 2011. The effect of this change on our duration and convexity measures was not material.
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 the shock, both upward and downward, to the
LIBOR curve and evaluating the impact on the duration. Currently, short-term interest rates are at historically low levels
and, at some points, the LIBOR curve is less than 25 basis points (and less than 50 basis points that was the threshold
before the November 14, 2011 change). As a result, the 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 selection and structuring (that is, by acquiring or
structuring mortgage-related securities with attractive prepayment and other characteristics), by issuing a broad range of
both callable and non-callable debt instruments, and by using interest-rate derivatives and written options. Managing the
impact of duration risk and convexity risk is the principal focus of our daily market risk management activities. These
risks are encompassed in our PMVS and duration gap risk measures, discussed in greater detail below. We use
prepayment models to determine the estimated duration and convexity of mortgage assets for our PMVS and duration gap
measures. When interest rates decline, mortgage asset prices tend to rise, but the rise is limited by the increased likelihood
of prepayments, which exposes us to negative convexity. Through the use of our models, we estimate on a weekly basis
the negative convexity profile of our portfolio over a wide range of interest rates. This process is designed to help us to
identify the particular interest rate scenarios where the convexity of our portfolio appears to be most negative, and
therefore the particular interest rate scenario where the interest rate price sensitivity of our financial instruments appears
to be most acute. We use this information to develop hedging strategies that are customized to provide interest-rate risk
protection for the specific interest rate environment where we believe we are most exposed to negative convexity risk.
This strategy allows us to select hedging instruments that are expected to be most efficient for our portfolio, thereby
reducing the overall cost of interest rate hedging activities.
194 Freddie Mac