Dow Chemical 2013 Annual Report Download - page 89

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The Dow Chemical Company and Subsidiaries
PART II, Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Dow’s business operations give rise to market risk exposure due to changes in foreign exchange rates, interest rates, commodity
prices and other market factors such as equity prices. To manage such risks effectively, the Company enters into hedging
transactions, pursuant to established guidelines and policies, that enable it to mitigate the adverse effects of financial market
risk. Derivatives used for this purpose are designated as hedges per the accounting guidance related to derivatives and hedging
activities, where appropriate. A secondary objective is to add value by creating additional non-specific exposure within
established limits and policies; derivatives used for this purpose are not designated as hedges. The potential impact of creating
such additional exposures is not material to the Company’s results.
The global nature of Dow’s business requires active participation in the foreign exchange markets. As a result of investments,
production facilities and other operations on a global basis, the Company has assets, liabilities and cash flows in currencies
other than the U.S. dollar. The primary objective of the Company’s foreign exchange risk management is to optimize the U.S.
dollar value of net assets and cash flows, keeping the adverse impact of currency movements to a minimum. To achieve this
objective, the Company hedges on a net exposure basis using foreign currency forward contracts, over-the-counter option
contracts, cross-currency swaps, and nonderivative instruments in foreign currencies. Exposures primarily relate to assets,
liabilities and bonds denominated in foreign currencies, as well as economic exposure, which is derived from the risk that
currency fluctuations could affect the dollar value of future cash flows related to operating activities. The largest exposures are
denominated in European currencies, the Japanese yen and the Canadian dollar, although exposures also exist in other
currencies of Asia Pacific, Latin America, and India, Middle East and Africa.
The main objective of interest rate risk management is to reduce the total funding cost to the Company and to alter the interest
rate exposure to the desired risk profile. Dow uses interest rate swaps, “swaptions,” and exchange-traded instruments to
accomplish this objective. The Company’s primary exposure is to the U.S. dollar yield curve.
Dow has a portfolio of equity securities derived primarily from the investment activities of its insurance subsidiaries. This
exposure is managed in a manner consistent with the Company’s market risk policies and procedures.
Inherent in Dow’s business is exposure to price changes for several commodities. Some exposures can be hedged effectively
through liquid tradable financial instruments. Feedstocks for ethylene production and natural gas constitute the main
commodity exposures. Over-the-counter and exchange traded instruments are used to hedge these risks when feasible.
Dow uses value at risk (“VAR”), stress testing and scenario analysis for risk measurement and control purposes. VAR estimates
the maximum potential loss in fair market values, given a certain move in prices over a certain period of time, using specified
confidence levels. The VAR methodology used by the Company is a historical simulation model which captures co-movements
in market rates across different instruments and market risk exposure categories. The historical simulation model uses a
97.5 percent confidence level and the historical scenario period includes at least six months of historical data. The 2013 and
2012 year-end and average daily VAR for the aggregate of all positions are shown below. These amounts are immaterial
relative to the total equity of the Company:
Total Daily VAR by Exposure Type at December 31 2013 2012
In millions Year-end Average Year-end Average
Commodities $ 1 $ 5 $ 7 $ 8
Equities $ 13 $ 12 $ 12 $ 14
Foreign exchange $ 5 $ 4 $ 1 $ 2
Interest rate $ 167 $ 160 $ 159 $ 166
Composite $ 173 $ 164 $ 159 $ 176
The Company’s daily VAR for the aggregate of all positions increased from a composite VAR of $159 million at December 31,
2012 to a composite VAR of $173 million at December 31, 2013. The increase in interest rate VAR drives the composite VAR
higher and is due to increased interest rate volatility. The commodities VAR decreased due to reduced hedging activity. The
equities VAR increased due to the appreciation in global equity prices resulting in an increased equity exposure. The foreign
exchange VAR increased due to increased hedging activity and volatility.
See Note 10 to the Consolidated Financial Statements for further disclosure regarding market risk.