Derivatives and Hedging Activities

Nature of Business Activity

The FHLBank is exposed to interest rate risk primarily from the effect of interest rate changes on its interest-earning assets and on the funding sources that finance these assets. The goal of the FHLBank's interest-rate risk management strategies is not to eliminate interest-rate risk, but to manage it within appropriate limits. To mitigate the risk of loss, the FHLBank has established policies and procedures, which include guidelines on the amount of exposure to interest rate changes it is willing to accept. In addition, the FHLBank monitors the risk to its interest income, net interest margin and average maturity of interest-earning assets and funding sources.

Consistent with Finance Agency Regulations, the FHLBank enters into derivatives to manage the interest rate risk exposures inherent in otherwise unhedged assets and funding positions, to achieve the FHLBank's risk management objectives and to act as an intermediary between its members and counterparties. The use of derivatives is an integral part of the FHLBank's financial management strategy. However, Finance Agency Regulations and the FHLBank's financial management policy prohibit trading in or the speculative use of derivative instruments and limit credit risk arising from them.

The most common ways in which the FHLBank uses derivatives are to:


▪	reduce the interest rate sensitivity and repricing gaps of assets and liabilities;


▪	manage embedded options in assets and liabilities;


▪	reduce funding costs by combining a derivative with a Consolidated Obligation, as the cost of a combined funding structure can be lower than the cost of a comparable Consolidated Obligation Bond;


▪	preserve a favorable interest rate spread between the yield of an asset (e.g., an Advance) and the cost of the related liability (e.g., the Consolidated Obligation Bond used to fund the Advance); without the use of derivatives, this interest rate spread could be reduced or eliminated when a change in the interest rate on the Advance does not match a change in the interest rate on the Bond; and


▪	protect the value of existing asset or liability positions.

Types of Derivatives

The FHLBank may enter into interest rate swaps (including callable and putable swaps), swaptions, interest rate cap and floor agreements, calls, puts, futures, and forward contracts to manage its exposure to changes in interest rates.

An interest rate swap is an agreement between two entities to exchange cash flows in the future. The agreement sets the dates on which the cash flows will be paid and the manner in which the cash flows will be calculated. One of the simplest forms of an interest rate swap involves the promise by one party to pay cash flows equivalent to the interest on a notional principal amount at a predetermined fixed rate for a given period of time. In return for this promise, this party receives cash flows equivalent to the interest on the same notional principal amount at a variable-rate index for the same period of time. The variable-rate received by the FHLBank in its derivatives is the London Interbank Offered Rate (LIBOR).

Application of Interest Rate Swaps

The FHLBank generally uses derivatives as fair value hedges of underlying financial instruments. However, because the FHLBank uses interest rate swaps when they are considered to be the most cost-effective alternative to achieve the FHLBank's financial and risk management objectives, it may enter into interest rate swaps that do not necessarily qualify for hedge accounting (economic hedges). The FHLBank re-evaluates its hedging strategies from time to time and may change the hedging techniques it uses or adopt new strategies.

Types of Hedged Items

The FHLBank documents at inception all relationships between derivatives designated as hedging instruments and the hedged items, its risk management objectives and strategies for undertaking various hedge transactions, and its method of assessing effectiveness. This process includes linking all derivatives that are designated as fair value hedges to assets and liabilities on the Statements of Condition. The FHLBank also formally assesses (both at the hedge's inception and at least quarterly) whether the derivatives that are used in hedging transactions have been effective in offsetting changes in the fair value of the hedged items and whether those derivatives may be expected to remain effective in future periods. The FHLBank currently uses regression analyses to assess the effectiveness of its hedges. The types of assets and liabilities currently hedged with derivatives are:


▪	Consolidated Obligations


▪	Advances


▪	Firm Commitments

Managing Credit Risk on Derivatives

The FHLBank is subject to credit risk due to nonperformance by counterparties to its derivative agreements. The degree of counterparty risk depends on the extent to which master netting arrangements are included in the contracts to mitigate the risk. The FHLBank manages counterparty credit risk through credit analysis, collateral requirements and adherence to the requirements set forth in FHLBank policies and Finance Agency Regulations. The FHLBank requires collateral agreements on all derivatives that establish collateral delivery thresholds. Based on credit analyses and collateral requirements at June 30, 2011, the management of the FHLBank does not anticipate any credit losses on its derivative agreements. See Note 19 for discussion regarding the FHLBank's fair value methodology for derivative assets/liabilities, including the evaluation of the potential for the fair value of these instruments to be affected by counterparty credit risk.

Table 10.1 presents credit risk exposure on derivative instruments, excluding circumstances where a counterparty's pledged collateral to the FHLBank exceeds the FHLBank's net position.

Table 10.1 - Credit Risk Exposure (in thousands)



	June 30, 2011		December 31, 2010
Total net exposure at fair value ⁽¹⁾	$	6,839	$	6,499
Cash collateral	3,300		4,000
Net positive exposure after cash collateral	$	3,539	$	2,499


(1)	Includes net accrued interest receivables of (in thousands) $851 and $1,722 at June 30, 2011 and December 31, 2010.

Certain of the FHLBank's interest rate swap contracts contain provisions that require the FHLBank to post additional collateral with its counterparties if there is deterioration in the FHLBank's credit ratings. The aggregate fair value of all interest rate swaps with credit-risk-related contingent features that were in a liability position at June 30, 2011 was (in thousands) $602,821, for which the FHLBank had posted collateral of (in thousands) $406,122 in the normal course of business, resulting in a net balance of (in thousands) $196,699. If one of the FHLBank's credit ratings had been lowered to the next lower rating, the FHLBank would have been required to deliver up to an additional (in thousands) $116,732 of collateral (at fair value) to its derivatives counterparties at June 30, 2011. None of the FHLBank's credit ratings were lowered during the 12 months ended June 30, 2011. However, on August 8, 2011, Standard & Poor's Rating Services downgraded the long-term credit ratings of the 10 FHLBanks with AAA ratings from AAA to AA+ (the FHLBanks of Chicago and Seattle were already rated AA+). The ratings of the FHLBanks are constrained by the long-term credit rating of the United States of America. On August 5, 2011, Standard & Poor's lowered its long-term credit rating on the United States of America from AAA to AA+ with a negative outlook. The outlook for the 12 FHLBanks is negative. Standard & Poor's actions did not affect the short-term A-1+ ratings of the FHLBanks.

The FHLBank transacts most of its derivatives with large banks and major broker-dealers. Some of these banks and broker-dealers or their affiliates buy, sell, and distribute Consolidated Obligations. The FHLBank is not a derivatives dealer and thus does not trade derivatives for short-term profit.

Financial Statement Effect and Additional Financial Information

The notional amount of derivatives serves as a factor in determining periodic interest payments or cash flows received and paid. The notional amount represents neither the actual amounts exchanged nor the overall exposure of the FHLBank to credit and market risk. The risks of derivatives only can be measured meaningfully on a portfolio basis that takes into account the derivatives, the items being hedged and any offsets between the two.

Table 10.2 summarizes the fair value of derivative instruments. For purposes of this disclosure, the derivative values include the fair value of derivatives and the related accrued interest.

Table 10.2 - Derivative Instruments Fair Value (in thousands)



	June 30, 2011
	Notional Amount of Derivatives		Derivative Assets			Derivative Liabilities
Derivatives designated as fair value hedging instruments:
Interest rate swaps	$	14,206,925	$	92,771		$	(681,024	)
Derivatives not designated as hedging instruments:
Interest rate swaps	2,664,000		1,954			(11,154		)
Forward rate agreements	319,300		603			(1,490		)
Mortgage delivery commitments	360,586		868			(1,372		)
Total derivatives not designated as hedging instruments	3,343,886		3,425			(14,016		)
Total derivatives before netting and collateral adjustments	$	17,550,811	96,196			(695,040		)
Netting adjustments			(89,357		)	89,357
Cash collateral and related accrued interest			(3,300		)	406,122
Total collateral and netting adjustments ⁽¹⁾			(92,657		)	495,479
Derivative assets and derivative liabilities as reported on the Statement of Condition			$	3,539		$	(199,561	)

	December 31, 2010
	Notional Amount of Derivatives		Derivative Assets			Derivative Liabilities
Derivatives designated as fair value hedging instruments:
Interest rate swaps	$	18,694,035	$	112,905		$	(771,864	)
Derivatives not designated as hedging instruments:
Interest rate swaps	1,234,000		4,212			(10,601		)
Forward rate agreements	40,000		—			(124		)
Mortgage delivery commitments	92,274		295			(381		)
Total derivatives not designated as hedging instruments	1,366,274		4,507			(11,106		)
Total derivatives before netting and collateral adjustments	$	20,060,309	117,412			(782,970		)
Netting adjustments			(110,913		)	110,913
Cash collateral and related accrued interest			(4,000		)	444,075
Total collateral and netting adjustments ⁽¹⁾			(114,913		)	554,988
Derivative assets and derivative liabilities as reported on the Statement of Condition			$	2,499		$	(227,982	)


(1)	Amounts represent the effects of legally enforceable master netting agreements that allow the FHLBank to settle positive and negative positions and of cash collateral held or placed with the same counterparties.

Table 10.3 presents the components of net gains (losses) on derivatives and hedging activities as presented in the Statements of Income.

Table 10.3 - Net Gains (Losses) on Derivatives and Hedging Instruments (in thousands)



	Three Months Ended June 30,
	2011			2010
Derivatives and hedged items in fair value hedging relationships:
Interest rate swaps	$	1,671		$	(2,837	)
Derivatives not designated as hedging instruments:
Economic Hedges:
Interest rate swaps	(2,282		)	(3,897		)
Forward rate agreements	(5,077		)	(23		)
Net interest settlements	940			811
Mortgage delivery commitments	4,846			2,872
Total net (losses) related to derivatives not designated as hedging instruments	(1,573		)	(237		)
Net gain (loss) on derivatives and hedging activities	$	98		$	(3,074	)



	Six Months Ended June 30,
	2011			2010
Derivatives and hedged items in fair value hedging relationships:
Interest rate swaps	$	7,517		$	(1,094	)
Derivatives not designated as hedging instruments:
Economic Hedges:
Interest rate swaps	(1,343		)	(5,423		)
Forward rate agreements	(4,048		)	(23		)
Net interest settlements	2,521			1,379
Mortgage delivery commitments	517			4,043
Total net (losses) related to derivatives not designated as hedging instruments	(2,353		)	(24		)
Net gain (loss) on derivatives and hedging activities	$	5,164		$	(1,118	)

Table 10.4 presents by type of hedged item, the gains (losses) on derivatives and the related hedged items in fair value hedging relationships and the impact of those derivatives on the FHLBank's net interest income.

Table 10.4 - Effect of Fair Value Hedge Related Derivative Instruments (in thousands)



	Three Months Ended June 30,
2011	Gain/(Loss) on Derivative			Gain/(Loss) on Hedged Item			Net Fair Value Hedge Ineffectiveness			Effect of Derivatives on Net Interest Income⁽¹⁾
Hedged Item Type:
Advances	$	(21,673	)	$	23,769		$	2,096		$	(93,209	)
Consolidated Bonds	4,548			(4,973		)	(425		)	18,801
	$	(17,125	)	$	18,796		$	1,671		$	(74,408	)
2010
Hedged Item Type:
Advances	$	(93,323	)	$	90,209		$	(3,114	)	$	(113,839	)
Consolidated Bonds	2,582			(2,305		)	277			30,331
	$	(90,741	)	$	87,904		$	(2,837	)	$	(83,508	)



	Six Months Ended June 30,
2011	Gain/(Loss) on Derivative			Gain/(Loss) on Hedged Item			Net Fair Value Hedge Ineffectiveness			Effect of Derivatives on Net Interest Income⁽¹⁾
Hedged Item Type:
Advances	$	81,358		$	(73,671	)	$	7,687		$	(187,457	)
Consolidated Bonds	(10,358		)	10,188			(170		)	40,179
	$	71,000		$	(63,483	)	$	7,517		$	(147,278	)
2010
Hedged Item Type:
Advances	$	(95,537	)	$	93,259		$	(2,278	)	$	(233,088	)
Consolidated Bonds	4,796			(3,612		)	1,184			73,940
	$	(90,741	)	$	89,647		$	(1,094	)	$	(159,148	)


(1)	The net interest on derivatives in fair value hedge relationships is included in the interest income/expense line item of the respective hedged item.