Freddie Mac 2015 Annual Report Download - page 146

Management's Discussion and Analysis Risk Management | Interest Rate Risk and Other Market Risks
Freddie Mac 2015 Form 10-K 144
We actively measure and manage our duration gap exposure on a daily basis. In addition to duration
gap management, we also measure and manage the price sensitivity of our portfolio to a number of
different specific interest rate changes along the yield curve. The price sensitivity of an instrument to
specific changes in interest rates is known as the instrument’s key rate duration risk. By managing
our duration exposure both in aggregate through duration gap and to specific changes in interest
rates through key rate duration, we expect to limit our fair value exposure to interest rate changes for
a wide range of interest rate yield curve scenarios. However, hedging our overall duration gap
exposure could result in increased volatility in our financial results, as our derivatives and several
types of our financial assets are measured at fair value, while our financial liabilities are generally not
measured at fair value.
• PMVS - An estimate of the change in the market value of our financial assets and liabilities with
spreads held constant from an instantaneous shock to interest rates, assuming no rebalancing
actions are undertaken and assuming the mortgage rate-to-LIBOR basis does not change. PMVS is
measured in two ways, one measuring the estimated sensitivity of our portfolio market value to a 50
basis point parallel movement in interest rates (PMVS-Level or PMVS-L) and the other to a
nonparallel movement (PMVS-Yield Curve or PMVS-YC), resulting from a 25 basis point change in
slope of the LIBOR yield curve. The 50 basis point shift and 25 basis point change in slope of the
LIBOR yield curve used for our PMVS measures reflect reasonably possible near-term changes that
we believe provide a meaningful measure of our interest-rate risk sensitivity.
• We calculate our exposure to changes in interest rates using effective duration and effective
convexity based on our models. Effective duration measures the percentage change in the price
of financial instruments from a 100 basis point 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. The net effective duration of our
portfolio is expressed in months as our duration gap.
• Effective convexity measures the change in effective duration for a 100 basis point change in
interest rates. Effective duration is not constant over the entire yield curve and effective convexity
measures how effective duration changes over large changes in interest rates.
• 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 estimate the two PMVS metrics. The duration and
convexity measures are used to estimate PMVS using the following formula:
PMVS = -[Duration] multiplied by [rate shock] plus [0.5 multiplied by Convexity] multiplied by [rate
shock]2
In the equation, [rate shock] represents the interest-rate change expressed in fair value terms.
Assuming an adverse 50 basis point change, the result of this formula is the fair value sensitivity
to the change in rate, which is expressed as: PMVS = (0.5 absolute value of duration) + (0.125
convexity), assuming convexity is negative.
• To estimate PMVS-L, an instantaneous parallel 50 basis point shock is applied to the yield curve,
as represented by the swap curve, holding all spreads to the swap curve constant. This shock is
applied to the duration and convexity of all interest-rate sensitive financial instruments. The
resulting change in market value for the aggregate portfolio is computed for both the up rate and
down rate shock and the change in market value in the more adverse scenario of the up and