Freddie Mac 2015 Annual Report Download - page 27

Management's Discussion and Analysis Consolidated Results of Operations | Derivative Gains (Losses)
Freddie Mac 2015 Form 10-K 25
DERIVATIVE GAINS (LOSSES)
EXPLANATION OF KEY DRIVERS OF DERIVATIVE GAINS (LOSSES)
Derivative instruments are a key component of our interest-rate risk management strategy. We use
derivatives to economically hedge our interest-rate risk exposure. We primarily use interest-rate swaps,
option-based derivatives such as swaptions, and futures to manage our exposure to changes in interest-
rates. We consider the cost of derivatives used in interest-rate risk management to be an inherent part of
the cost of funding our mortgage-related investments portfolio.
In addition, while not part of our interest-rate risk management activities, we routinely enter into
commitments to purchase and sell loans and mortgage-related securities. The majority of these
commitments are accounted for as derivative instruments.
Derivative gains (losses) consist of both fair value changes and accrual of periodic cash settlements:
• Fair value changes - Represent changes in the fair value of our derivatives based on market
conditions at the end of the period or at the time the derivative instrument is terminated. These
amounts may or may not be realized over time, depending on future changes in market conditions
and the terms of our derivative instruments.
• Accrual of periodic cash settlements - Consists of the net amount we accrue during a period for
interest-rate swap payments that we will make or receive. This accrual represents the ongoing cost of
our hedging activities, and is economically equivalent to interest expense.
Gains and losses on derivatives are affected by a number of factors, including:
• Changes in interest rates - Our primary derivative instruments are interest-rate swaps, including
pay-fixed and receive-fixed interest-rate swaps. With a pay-fixed interest-rate swap, we pay a fixed
rate of interest and receive a variable rate of interest based on a specified notional balance (the
notional balance is for calculation purposes only). With a pay-fixed interest-rate swap, as interest
rates decline, we recognize derivative losses, as the amount of interest we pay remains fixed, and the
amount of interest we receive declines. As rates rise, we recognize derivative gains, as the amount of
interest we pay remains fixed, but the amount of interest we receive increases. With a receive-fixed
interest-rate swap, the opposite results occur.
• Implied volatility - Many of our assets and liabilities have embedded prepayment options. We use
option-based derivatives, including swaptions, to economically hedge the prepayment options
embedded in our mortgage assets and callable debt. Fair value gains and losses on swaptions are
sensitive to changes in both interest rates and implied volatility, which reflects the market’s
expectation of future changes in interest rates. Assuming all other factors are unchanged, including
interest rates, purchased swaptions generally become more valuable as implied volatility increases
and less valuable as implied volatility decreases, with the opposite being true for written swaptions.
• Changes in the shape of the yield curve - We own assets and have outstanding debt with different
cash flows along the yield curve. We use derivatives to hedge the yield exposure of assets and debt,
resulting in derivatives with different maturities. As a result, changes in the shape of the yield curve
will affect our derivative gains (losses).