Freddie Mac 2011 Annual Report Download - page 201

our models. To improve the accuracy of our models, changes to the underlying assumptions or modeling techniques are
made on a periodic basis. Model development and model testing are reviewed and approved independently by our
Enterprise Risk Management division. Model performance is also reported regularly through a series of internal
management committees. See “MD&A — RISK MANAGEMENT — Operational Risks” and “RISK FACTORS —
Operational Risks — We face risks and uncertainties associated with the internal models that we use for financial
accounting and reporting purposes, to make business decisions and to manage risks. Market conditions have raised these
risks and uncertainties” for a discussion of the developments and risks associated with our use of models. Given the
importance of models to our investment management practices, model changes undergo a rigorous review process. As a
result, it is common for model changes to take several months to complete. Given the time consuming nature of the model
change review process, it is sometimes necessary for risk management purposes for management to make adjustments to
our interest-rate risk statistics that reflect the expected impact of the pending model change. These adjustments are
included in our PMVS and duration gap disclosures.
Foreign-Currency Risk
Foreign-currency risk is the risk that fluctuations in currency exchange rates (e.g., Euros to the U.S. dollar) will
adversely affect the fair value of net assets and ultimately adversely affect GAAP total 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 mitigate 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.
Interest-Rate Risk Management Strategy and Framework
Although we cannot hedge all of our exposure to changes in interest rates, this exposure is subject to established
limits and is monitored through our risk management process. We employ a risk management strategy that seeks to
substantially match the duration characteristics of our assets and liabilities. Through our asset and liability management
process, we seek to mitigate interest-rate risk by issuing a wide variety of callable and non-callable 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. 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.
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. We
also seek to manage interest-rate risk by changing the effective interest terms of the portfolio, primarily using interest-rate
swaps, which we refer to as rebalancing. For further discussion of why we use derivatives and the types of derivatives we
use, see “NOTE 11: DERIVATIVES.”
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.”
Annually, the Business and Risk Committee of our Board of Directors establishes certain Board limits for interest-
rate risk measures, and if we exceed these limits we are required to notify the Business and Risk Committee and address
the limit overage. 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 at the Board level. 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
196 Freddie Mac