Freddie Mac 2012 Annual Report Download - page 202

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 our net worth. 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 our net worth. 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 our net worth. 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 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 on a number of occasions since
2007, the assumptions that we use in our models for our sensitivity analyses (including PMVS and duration gap measures)
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 assets. We actively manage our model
risk by reviewing the performance of 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 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 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 our net worth. 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.
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