Southwest Airlines 2007 Annual Report Download - page 50

documentation that is required at the time each hedge is
designated by the Company. As required by SFAS 133,
the Company assesses the effectiveness of each of its
individual hedges on a quarterly basis. The Company also
examines the effectiveness of its entire hedging program
on a quarterly basis utilizing statistical analysis. This
analysis involves utilizing regression and other statistical
analyses that compare changes in the price of jet fuel to
changes in the prices of the commodities used for hedging
purposes.
The Company continually looks for better and more
accurate methodologies in forecasting future cash flows
relating to its jet fuel hedging program. These estimates
are an important component used in the measurement of
effectiveness for the Company’s fuel hedges, as required
by SFAS 133. During first quarter 2006, the Company
did revise its method for forecasting these future cash
flows. Prior to 2006, the Company had estimated future
cash flows using actual market forward prices of a single
like commodity and adjusting for historical differences
from the Company’s actual jet fuel purchase prices. The
Company implemented an improved model for forecast-
ing forward jet fuel prices during 2006, due to the fact
that different types of commodities are statistically better
predictors of forward jet fuel prices, depending on specific
geographic locations in which the Company hedges. In
accordance with SFAS 133, the Company then adjusts for
certain items, such as transportation costs, that are stated
in fuel purchasing contracts with its vendors, in order to
estimate the actual price paid for jet fuel associated with
each hedge. This improved methodology for estimating
future cash flows (i.e., jet fuel prices) was applied pro-
spectively, in accordance with the Company’s interpre-
tation of SFAS 133. The Company did not, however,
change its method for either assessing or measuring
hedge ineffectiveness. As a result of this new method
for forecasting future jet fuel prices, the Company
believes its hedges are more likely to be effective over
the long-term.
The Company also utilizes financial derivative
instruments in the form of interest rate swap agreements.
The primary objective for the Company’s use of interest
rate hedges is to reduce the volatility of net interest
income by better matching the repricing of its assets
and liabilities. The Company currently holds interest rate
swap agreements related to its $385 million 6.5% senior
unsecured notes due 2012, its $350 million 5.25% senior
unsecured notes due 2014, its $300 million 5.125% senior
unsecured notes due 2017, and its $100 million
7.375% senior unsecured debentures due 2027. The
interest rate swaps associated with the $300 million
5.125% notes and $100 million 7.375% debentures were
entered into during 2007.
The floating rate paid under the swap associated
with the $385 million 6.5% senior unsecured notes due
2012 is set in arrears. The Company pays the London
InterBank Offered Rate (LIBOR) plus a margin every six
months and receives 6.5 percent every six months on a
notional amount of $385 million until 2012. The average
floating rate paid under this agreement during 2007 is
estimated to be 7.31 percent based on actual and forward
rates at December 31, 2007. The floating rate for the
swap agreement relating to its $350 million 5.25% senior
unsecured notes due 2014 is set at the beginning of each
six month period. Under this agreement, the Company
pays LIBOR plus a margin every six months and receives
5.25 percent every six months on a notional amount of
$350 million until 2014. The average floating rate paid
under this agreement during 2007 was 6.02 percent. For
both the swap agreements associated with the $300 mil-
lion 5.125% notes and $100 million 7.375% debentures,
the Company pays the LIBOR plus a margin every six
months on the notional amount of the debt, and receives
the fixed stated rate of the notes or debentures every six
months until the date the notes or debentures become
due. The average floating rate paid during 2007 under the
agreement associated with the $300 million 5.125% notes
due 2016 was 4.64 percent. The average floating rate paid
during 2007 under the agreement associated with the
$100 million 7.375% debentures due 2027 was
6.73 percent.
The Company’s interest rate swap agreements qual-
ify as fair value hedges, as defined by SFAS 133. In
addition, these interest rate swap agreements qualify for
the “shortcut” method of accounting for hedges, as
defined by SFAS 133. Under the “shortcut” method,
the hedges are assumed to be perfectly effective, and, thus,
there is no ineffectiveness to be recorded in earnings. The
fair values of the interest rate swap agreements, which are
adjusted regularly, is recorded in the Consolidated Bal-
ance Sheet, as necessary, with a corresponding adjust-
ment to the carrying value of the long-term debt. The
total fair value of the interest rate swap agreements,
excluding accrued interest, at December 31, 2007, was
an asset of approximately $16 million. The total fair value
of the swap agreements held at December 31, 2006, was a
liability of $30 million. The long-term portion of these
amounts is recorded in “Other deferred liabilities” in the
Consolidated Balance Sheet for each respective year. In
accordance with fair value hedging, the offsetting entry is
an adjustment to decrease the carrying value of long-term
debt. See Note 10 to the Consolidated Financial
Statements.
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