Dow Chemical 2012 Annual Report Download - page 93

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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 2012
and 2011 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 2012 2011
In millions Year-end Average Year-end Average
Foreign exchange $1$2$2$2
Interest rate $ 159 $ 166 $ 286 $ 199
Equities $ 12 $ 14 $ 29 $ 20
Commodities $7$8$4$4
Composite $ 159 $ 176 $ 300 $ 220
The Company’s daily VAR for the aggregate of all positions decreased from a composite VAR of $300 million at
December 31, 2011 to a composite VAR of $159 million at December 31, 2012. The decrease in composite VAR is primarily
due to the combined effect of reduced outstanding debt and lower interest rate volatility. The equities VAR declined due to a
decrease in equity volatility despite an increase in the size of the exposure. Despite an increase in net exposure, the foreign
exchange VAR declined due to a decrease in volatility. The commodities VAR is higher due to the increase in both volatility
and exposure.
See Note 10 to the Consolidated Financial Statements for further disclosure regarding market risk.