Black & Decker 2011 Annual Report Download - page 44

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MARKET RISK
Market risk is the potential economic loss that may result from adverse changes in the fair value of financial instruments, currencies,
commodities and other items traded in global markets. The Company is exposed to market risk from changes in foreign currency
exchange rates, interest rates, stock prices, and commodity prices.
Exposure to foreign currency risk results because the Company, through its global businesses, enters into transactions and makes
investments denominated in multiple currencies. The Company’s predominant exposures are in European, Canadian, British,
Australian, and Asian currencies, including the Chinese Renminbi (“RMB”) and the Taiwan Dollar. Certain cross-currency trade
flows arising from sales and procurement activities as well as affiliate cross-border activity are consolidated and netted prior to
obtaining risk protection through the use of various derivative financial instruments which may include: purchased basket options;
purchased options; collars, cross currency swaps and currency forwards. The Company is thus able to capitalize on its global
positioning by taking advantage of naturally offsetting exposures and portfolio efficiencies to reduce the cost of purchasing derivative
protection. At times, the Company also enters into forward exchange contracts and purchased options to reduce the earnings and cash
flow impact of non-functional currency denominated receivables and payables, predominately for affiliate transactions. Gains and
losses from these hedging instruments offset the gains or losses on the underlying net exposures, assets and liabilities being hedged.
Management determines the nature and extent of currency hedging activities, and in certain cases, may elect to allow certain currency
exposures to remain un-hedged. The Company has also entered into cross-currency swaps and forward contracts, to provide a partial
hedge of the net investments in certain subsidiaries and better match the cash flows of operations to debt service requirements.
Management estimates the foreign currency impact from these financial instruments at the end of 2011 would have been
approximately a $69 million pre-tax loss based on a hypothetical 10% adverse movement in all net derivative currency positions; this
effect would occur from depreciation of the foreign currencies relative to the U.S. dollar. The Company follows risk management
policies in executing derivative financial instrument transactions, and does not use such instruments for speculative purposes. The
Company does not hedge the translation of its non-U.S. dollar earnings in foreign subsidiaries.
As mentioned above, the Company routinely has cross-border trade and affiliate flows that cause a “transactional” impact on earnings
from foreign exchange rate movements. The Company is also exposed to currency fluctuation volatility from the translation of foreign
earnings into U.S. dollars. It is more difficult to quantify the transactional effects from currency fluctuations than the translational
effects. Aside from the use of derivative instruments which may be used to mitigate some of the exposure, transactional effects can
potentially be influenced by actions the Company may take; for example, if an exposure occurs from a European entity sourcing
product from a U.S. supplier it may be possible to change to a European supplier. Management estimates the combined translational
and transactional impact of a 10% overall movement in exchange rates is approximately $101 million, or $0.59 per diluted share. The
effect of foreign currency translation on diluted earnings per share from continuing operations was approximately $0.17 favorable in
2011, $0.14 favorable in 2010, and $0.04 unfavorable in 2009.
The Company’s exposure to interest rate risk results from its outstanding debt and derivative obligations, short-term investments, and
derivative financial instruments employed in the management of its debt portfolio. The debt portfolio including both trade and affiliate
debt, is managed to achieve capital structure targets and reduce the overall cost of borrowing by using a combination of fixed and
floating rate debt as well as interest rate swaps, and cross-currency swaps.
The Company’s primary exposure to interest rate risk comes from its floating rate debt and derivatives in the U.S. and is fairly
represented by changes in LIBOR rates. At December 31, 2011, the impact of a hypothetical 10% increase in the interest rates
associated with the Company’s floating rate derivative and debt instruments would have an immaterial effect on the Company’s
financial position and results of operations.
The Company has exposure to commodity prices in many businesses, particularly brass, nickel, resin, aluminum, copper, zinc, steel,
and energy used in the production of finished goods. Generally, commodity price exposures are not hedged with derivative financial
instruments, but instead are actively managed through customer product and service pricing actions, procurement-driven cost
reduction initiatives and other productivity improvement projects. The Company experienced inflation, primarily commodity related,
of approximately $236 million and $70 million in 2011 and 2010 respectively, while it experienced mild deflation in 2009. Price
erosion has also occurred in 2011 and 2010, in addition to inflation, with the cumulative unfavorable impact exceeding $320 million.
The impact of inflation is expected to continue in 2012, with cost and pricing actions being aggressively pursued to offset any adverse
impact on operations.
Fluctuations in the fair value of the Company’s common stock affect domestic retirement plan expense as discussed in the ESOP
section of MD&A. Additionally, the Company has $30 million of liabilities as of December 31, 2011 pertaining to unfunded defined
contribution plans for certain U.S. employees for which there is mark-to-market exposure.