Freddie Mac 2012 Annual Report Download - page 201

Duration Risk and Convexity Risk
Duration is a measure of a financial instrument’s price sensitivity to changes in interest rates along the yield curve
(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 reached
historically low levels in 2011, the methodology then 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 on 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.
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.
PMVS (i.e., 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., buy-ups and float), because we
do not actively manage the change in the fair value of our guarantee business that is attributable to changes in interest
rates. We do not believe that periodic changes in fair value due to movements in interest rates are the best indication
of the long-term value of our guarantee business because these changes do not take into account the potential for new
future guarantee business activity.
•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.
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