Southwest Airlines 2007 Annual Report Download - page 53

The fair values of the derivative instruments, depending
on the type of instrument, were determined by use of
present value methods or standard option value models
with assumptions about commodity prices based on those
observed in underlying markets. An immediate ten-per-
cent increase or decrease in underlying fuel-related com-
modity prices from the December 31, 2007, prices would
correspondingly change the fair value of the commodity
derivative instruments in place by up to $658 million.
Changes in the related commodity derivative instrument
cash flows may change by more or less than this amount
based upon further fluctuations in futures prices as well as
related income tax effects. This sensitivity analysis uses
industry standard valuation models and holds all inputs
constant at December 31, 2007, levels, except underlying
futures prices.
Outstanding financial derivative instruments expose
the Company to credit loss in the event of nonperfor-
mance by the counterparties to the agreements. However,
the Company does not expect any of the counterparties to
fail to meet its obligations. The credit exposure related to
these financial instruments is represented by the fair value
of contracts with a positive fair value at the reporting date.
To manage credit risk, the Company selects and will
periodically review counterparties based on credit ratings,
limits its exposure to a single counterparty, and monitors
the market position of the program and its relative market
position with each counterparty. At December 31, 2007,
the Company had agreements with nine counterparties
containing early termination rights and/or bilateral col-
lateral provisions whereby security is required if market
risk exposure exceeds a specified threshold amount or
credit ratings fall below certain levels. At December 31,
2007, the Company held $2.0 billion in cash collateral
deposits under these bilateral collateral provisions. These
collateral deposits serve to decrease, but not totally elim-
inate, the credit risk associated with the Company’s
hedging program. The deposits are included in “Accrued
liabilities” on the Consolidated Balance Sheet. See also
Note 10 to the Consolidated Financial Statements.
Financial Market Risk
The vast majority of the Company’s assets are air-
craft, which are long-lived. The Company’s strategy is to
maintain a conservative balance sheet and grow capacity
steadily and profitably. While the Company uses financial
leverage, it has maintained a strong balance sheet and an
“A” credit rating on its senior unsecured fixed-rate debt
with Standard & Poor’s and Fitch ratings agencies, and a
“Baa1” credit rating with Moody’s rating agency as of
December 31, 2007. In January 2008, Fitch announced a
cut in the Company’s senior unsecured debt rating to
“A⫺”. The Company’s 1999 and 2004 French Credit
Agreements do not give rise to significant fair value risk
but do give rise to interest rate risk because these bor-
rowings are floating-rate debt. In addition, as disclosed in
Note 10 to the Consolidated Financial Statements, the
Company has converted certain of its long-term debt to
floating rate debt by entering into interest rate swap
agreements. This includes the Company’s $385 million
6.5% senior unsecured notes due 2012, the $350 million
5.25% senior unsecured notes due 2014, the $300 million
5.125% senior unsecured notes due 2017, and the
$100 million 7.375% senior unsecured debentures due
2027. Although there is interest rate risk associated with
these floating rate borrowings, the risk for the 1999 and
2004 French Credit Agreements is somewhat mitigated
by the fact that the Company may prepay this debt under
certain conditions. See Notes 6 and 7 to the Consolidated
Financial Statements for more information on the mate-
rial terms of the Company’s short-term and long-term
debt.
Excluding the notes or debentures that were con-
verted to a floating rate as previously noted, the Compa-
ny’s only fixed-rate senior unsecured notes at
December 31, 2007 were its $300 million notes due
2016. These senior unsecured notes have a fixed-rate of
5.75 percent, which is comparable to average rates pre-
vailing for similar debt instruments over the last ten years.
The Company’s outstanding $500 million EETCs, which
are secured by 16 Boeing 737-700 aircraft, had an
effective fixed-rate of 6.24 percent. The carrying value
of the Company’s floating rate debt totaled $1.3 billion,
and this debt had a weighted-average maturity of 6.1 years
at floating rates averaging 5.68 percent for the twelve
months ended December 31, 2007. In total, the Com-
pany’s fixed rate debt and floating rate debt represented
6.5 percent and 10.3 percent, respectively, of total non-
current assets at December 31, 2007.
The Company also has some risk associated with
changing interest rates due to the short-term nature of its
invested cash, which totaled $2.2 billion, and short-term
investments, which totaled $566 million, at December 31,
2007. However, the Company generally does not retain
the interest earnings on the $2.0 billion in cash collateral
deposits from counterparties associated with the Compa-
ny’s fuel derivative instruments. See Notes 1 and 10 to the
Consolidated Financial Statements for further informa-
tion. The Company invests available cash in certificates of
deposit, highly rated money market instruments, invest-
ment grade commercial paper, auction rate securities, and
other highly rated financial instruments. Because of the
short-term nature of these investments, the returns
earned parallel closely with short-term floating interest
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