Freddie Mac 2012 Annual Report Download - page 203

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 10:
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 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 “NOTE 16: FAIR
VALUE DISCLOSURES — Valuation Processes and 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 are set at values below
those set at the Board level, which is intended to allow us to follow a series of predetermined actions in the event of a breach
of the management limits and helps ensure proper oversight to reduce the possibility of exceeding the Board limits. We also
establish management limits that do not have corresponding Board limits.
Portfolio Market Value Sensitivity and Measurement of Interest-Rate Risk
PMVS and Duration Gap
Our primary interest-rate risk measures are PMVS and duration gap. PMVS is an estimate of the change in the fair value
of all interest-earning assets, interest-bearing liabilities, and derivatives on a pre-tax basis from an instantaneous 50 basis
point shock to interest rates, assuming no rebalancing actions are undertaken and assuming the mortgage-to-LIBOR basis
does not change. (The shock used for calculating PMVS is not the same as the shock used for calculating duration and
convexity, described above under “Duration Risk and Convexity Risk.”) PMVS is measured in two ways, one measuring the
estimated sensitivity of our portfolio market value to parallel movements in interest rates (PMVS-Level or PMVS-L) and the
other to nonparallel movements (PMVS-YC).
• We calculate our exposure to changes in interest rates using effective duration. Effective duration measures the
percentage change in the price of financial instruments from a 1% change in interest rates. Financial instruments with
positive duration increase in value as interest rates decline. Conversely, financial instruments with negative duration
increase in value as interest rates rise.
• Together, duration and convexity provide a measure of an instrument’s overall price sensitivity to changes in interest
rates. We utilize the aggregate duration and convexity risk of all interest-rate sensitive instruments on a daily basis to
198 Freddie Mac