Freddie Mac 2011 Annual Report Download - page 200

By managing our convexity profile over a wide range of interest rates, we are able to hedge prepayment risk for
particular interest rate scenarios. As a result, the intensity and frequency of our ongoing risk management actions is
relatively constant over a wide range of interest rate environments. Our approach to convexity risk management focuses
our portfolio rebalancing activities for the specific interest rate scenario where market and interest rate volatility appear to
be most pronounced. This approach to convexity risk reduces our ongoing rebalancing activity to a relatively low level
compared to the overall daily trading volume of interest-rate swaps and Treasury futures.
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 activities. We do not consider the sensitivity of the fair value of credit guarantee activities 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.
Yield Curve Risk
Yield curve risk is the risk that non-parallel shifts in the yield curve (such as a flattening or steepening) will
adversely affect the fair value of net assets and ultimately adversely affect GAAP total equity (deficit). Because changes
in the shape, or slope, of the yield curve often arise due to changes in the market’s expectation of future interest rates at
different points along the yield curve, we evaluate our exposure to yield curve risk by examining potential reshaping
scenarios at various points along the yield curve. We manage yield curve risk with the use of derivatives. Our yield curve
risk under a specified yield curve scenario is reflected in our PMVS-YC disclosure.
Volatility Risk
Volatility risk is the risk that changes in the market’s expectation of the magnitude of future variations in interest
rates will adversely affect the fair value of net assets and ultimately adversely affect GAAP total equity (deficit). Volatility
risk arises from the prepayment risk that is inherent in mortgages or mortgage-related securities. Volatility risk is the risk
that the homeowner’s prepayment option will gain or lose value as the expected volatility of future interest rates changes.
In general, as expected future interest rate volatility increases, the homeowner’s prepayment option increases in value, thus
negatively impacting the value of the mortgage security backed by the underlying mortgages. We manage volatility risk
by maintaining a portfolio of callable debt and option-based interest rate derivatives that have relatively long option terms.
We actively manage and monitor our volatility risk exposure over a range of changing interest rate scenarios; however, we
do not eliminate our volatility risk exposure completely.
Basis Risk
Basis risk is the risk that interest rates in different market sectors will not move in tandem and will adversely affect
the fair value of net assets and ultimately adversely affect GAAP total equity (deficit). This risk arises principally because
we generally hedge mortgage-related investments with debt securities. As principally a buy-and-hold investor, we do not
actively manage overall basis risk, also referred to as mortgage-to-debt OAS risk or spread risk, arising from funding
mortgage-related investments with our debt securities. See “MD&A — FAIR VALUE MEASUREMENTS AND
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.
Model Risk
Proprietary models, including mortgage prepayment models, interest rate models, and mortgage default models, are
an integral part of our investment framework. As market conditions change rapidly, as they have since 2007, the
assumptions that we use in our models for our sensitivity analyses may not keep pace with these market changes. As
such, these analyses are not intended to provide precise forecasts of the effect a change in market interest rates would
have on the estimated fair values of our net assets. We actively manage our model risk by reviewing the performance of
195 Freddie Mac