Annual Report - CoBank

The total notional amount of our derivatives portfoliodecreased by $1.6 billion in 2010. The decrease was largelydue to lower levels of liquidity management derivatives, as weissued larger amounts of floating-rate term debt to meet ourliquidity objectives instead of using derivatives that convertfixed-rate term debt to floating-rate. This was partially offsetby increased options risk management hedging to manage ourrisk to rising interest rates and higher levels of equitypositioning hedging resulting from the Bank’s continuedgrowth in capital.Liquidity ManagementA majority of our interest rate swaps are executed toimprove liquidity, primarily by converting specific longertermfixed-rate bonds and notes into floating-rate debt indexedto LIBOR or similar short-term rates. The fixed rate receivedon the swap largely offsets the fixed rate paid on theassociated debt leaving a net floating rate payment on theswap. This allows us to issue longer-term debt and still matchfund the predominantly short-term repricing nature of ourinterest-sensitive asset portfolio. Liquidity risk management isdiscussed further beginning on page 52.Equity PositioningWe also use interest rate swaps to manage interest raterisk as it relates to investment of our equity. If the cash flowsof loans and investments on the balance sheet do not create thetargeted maturity for the investment of our equity, we enterinto receive-fixed interest rate swaps to produce the desiredequity investment maturity profile.Options Risk ManagementIn the course of managing risk in the investment portfolio,we periodically hedge cap risk embedded within our floatingrateinvestment securities that do not meet our current riskmanagement objectives. We enter into offsetting derivativetransactions to hedge this risk.Customer TransactionsDerivatives are offered to customers as a service to enablethem to modify or reduce their interest rate and foreignexchange risk by transferring such risk to us. We substantiallyoffset this risk transference by concurrently entering intooffsetting agreements with counterparties.Foreign Currency Risk ManagementWe enter into foreign exchange spot and forwardcontracts to manage currency risk on our relatively nominalamount of loans denominated in foreign currencies. Typically,foreign currency contracts are purchased to fund the principalcash flows of the loan and simultaneously sold to lock in theprincipal and interest cash flows upon the repricing ormaturity date of the loan.Counterparty ExposureThe use of derivative instruments exposes us tocounterparty credit risk. Credit risk associated with derivativesis measured based on the replacement cost that would beincurred should the counterparties with contracts in a net gainposition with respect to CoBank fail to perform. We minimizethis risk by diversifying our derivative positions amongvarious counterparties, using master netting agreements,requiring collateral with daily posting and zero thresholds tosupport credit exposures with active counterparties, evaluatingthe creditworthiness of each counterparty, establishingindividual credit exposure limits and dealing exclusively withcounterparties that have an investment grade or better creditrating from a major credit rating agency. In addition, wemonitor counterparty credit default swap spreads and othermarket-related information which may indicate reducedcreditworthiness of a counterparty.We measure counterparty credit risk daily based on thecurrent fair values of our derivative positions. Personnel whoare independent of the derivative portfolio managementmonitor the derivative exposures against approved limits.Exceptions to approved limits are reported to the CLC, alongwith a plan detailing actions to address limit overages.Changes to the counterparty limits must be approved by theCLC.We also perform stress tests on the derivative portfoliousing asset/liability models to analyze the potential effects ofmarket rate changes on fair value, including extreme ratechanges. The forward interest rate curves used to project thefuture expected cash flows for the derivative positions aremodeled under potential scenarios which increase anddecrease interest rates within a 99 percent confidence interval.These extreme rate scenarios are then used to further evaluatepotential counterparty credit risk and to establish placementlimits.Notwithstanding our credit evaluation process and themaintenance of collateral agreements with our derivativecounterparties, the failure of a counterparty to perform on itsobligations could negatively impact our earnings.Furthermore, although our credit evaluations consider thepossibility of default by a counterparty, our ultimate exposureto default by a counterparty could be greater than expected.The following table details the notional amount of ourderivatives and related exposure to dealer counterpartiesclassified by their Standard & Poor’s credit rating as ofDecember 31, 2011.Derivative Counterparty Exposure ($ in Millions)AAA AA A Below AExposure to Counterpartiesin Net Gain Position$ - $ 327 $ 542 $ -Collateral Held - 321 530 -Exposure, Net of Collateral $ - $ 6 $ 12 $ -Total Notional Amount $ - $ 8,784 $ 13,683 $ -Total Number ofCounterparties- 6 11 -CoBank 2011 Annual Report51