Southwest Airlines 2008 Annual Report Download - page 58

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instruments back to the counterparty at full par value
in June 2010. As part of this agreement, the
Company has entered into a line of credit in which it
has received a $91 million loan that is secured by the
auction rate security instruments from that
counterparty. At the time of the first failed auctions
during first quarter 2008, the Company held a total of
$463 million in securities. Since that time, the
Company has been able to sell $252 million of these
instruments at par value, in addition to the $91
million subject to the agreement to be sold at par in
June 2010. The Company is also in discussions with
other counterparties to determine whether mutually
agreeable decisions can be reached regarding the
effective repurchase of its remaining securities.
The Company determines the value of fuel
derivative option contracts utilizing a standard option
pricing model based on inputs that are either readily
available in public markets, can be derived from
information available in publicly quoted markets, or
are quoted by its counterparties. In situations where
the Company obtains inputs via quotes from its
counterparties, it verifies the reasonableness of these
quotes via similar quotes from another counterparty
as of each date for which financial statements are
prepared. The Company has consistently applied
these valuation techniques in all periods presented
and believes it has obtained the most accurate
information available for the types of derivative
contracts it holds. Due to the fact that certain inputs
used in determining estimated fair value of its option
contracts are considered unobservable (primarily
volatility), as defined in SFAS 157, the Company has
categorized these option contracts as Level 3.
As discussed in Note 10 to the consolidated
financial statements, any changes in the fair values of
fuel derivative instruments are subject to the
requirements of SFAS 133. Any changes in fair value
of cash flow hedges that are considered to be
effective, as defined, are offset within “Accumulated
other comprehensive income (loss)” until the period
in which the expected cash flow impacts earnings.
Any changes in the fair value of fuel derivatives that
are ineffective, as defined, or do not qualify for
special hedge accounting, are reflected in earnings
within “Other (gains)/losses, net”, in the period of the
change. Because the Company has extensive
historical experience in valuing the derivative
instruments it holds, and such experience is
continually evaluated against its counterparties each
period when such instruments expire and are settled
for cash, the Company believes it is unlikely that an
independent third party would value the Company’s
derivative contracts at a significantly different
amount than what is reflected in the Company’s
financial statements. In addition, the Company also
has bilateral credit provisions in some of its
counterparty agreements, which provide for parties
(or the Company) to provide cash collateral when the
fair values of fuel derivatives with a single party
exceeds certain threshold levels. Since this cash
collateral is based on the estimated fair value of the
Company’s outstanding fuel derivative contracts, this
provides further validation to the Company’s
estimate of fair values.
Item 7A. Quantitative And Qualitative
Disclosures About Market Risk
The Company has interest rate risk in its floating
rate debt obligations and interest rate swaps,
commodity price risk in jet fuel required to operate
its aircraft fleet, and market risk in the derivatives
used to manage its fuel hedging program. The
Company purchases jet fuel at prevailing market
prices, but seeks to manage market risk through
execution of a documented hedging strategy. The
Company has market sensitive instruments in the
form of fixed rate debt instruments and financial
derivative instruments used to hedge its exposure to
jet fuel price increases. The Company also operates
91 aircraft under operating and capital leases.
However, leases are not considered market sensitive
financial instruments and, therefore, are not included
in the interest rate sensitivity analysis below.
Commitments related to leases are disclosed in Note
8 to the Consolidated Financial Statements. The
Company does not purchase or hold any derivative
financial instruments for trading purposes. See Note
10 to the Consolidated Financial Statements for
information on the Company’s accounting for its
hedging program and for further details on the
Company’s financial derivative instruments.
Fuel hedging
The Company utilizes financial derivative
instruments, on both a short-term and a long-term
basis, as a form of insurance against the potential for
significant increases in fuel prices. The Company
believes there is significant risk in not hedging
against the possibility of such fuel price increases.
39