Southwest Airlines 2013 Annual Report Download - page 114

(a) Individual counterparties with fair value of fuel derivatives <$20 million.
(b) Cash collateral is provided at 100 percent of fair value of fuel derivative contracts.
(c) Thresholds may vary based on changes in credit ratings within investment grade.
(d) The Company has the option of providing cash, letters of credit, or pledging aircraft as collateral. No cash,
letters of credit, or aircraft were pledged as collateral with such counterparties as of December 31, 2013.
(e) The Company has the option of providing cash or letters of credit as collateral. No cash or letters of credit
were pledged as collateral with such counterparties as of December 31, 2013.
11. FAIR VALUE MEASUREMENTS
Accounting standards pertaining to fair value measurements establish a three-tier fair value hierarchy,
which prioritizes the inputs used in measuring fair value. These tiers include: Level 1, defined as observable
inputs such as quoted prices in active markets; Level 2, defined as inputs other than quoted prices in active
markets that are either directly or indirectly observable; and Level 3, defined as unobservable inputs in which
little or no market data exists, therefore requiring an entity to develop its own assumptions.
As of December 31, 2013, the Company held certain items that are required to be measured at fair value on
a recurring basis. These included cash equivalents, short-term investments (primarily treasury bills, commercial
paper, and certificates of deposit), certain noncurrent investments, interest rate derivative contracts, fuel
derivative contracts, and available-for-sale securities. The majority of the Company’s short-term investments
consist of instruments classified as Level 1. However, the Company has certificates of deposit, commercial
paper, and Eurodollar time deposits that are classified as Level 2, due to the fact that the fair value for these
instruments is determined utilizing observable inputs in non-active markets. Noncurrent investments consist of
certain auction rate securities, primarily those collateralized by student loan portfolios, which are guaranteed by
the U.S. Government. Other available-for-sale securities primarily consist of investments associated with the
Company’s excess benefit plan.
The Company’s fuel and interest rate derivative instruments consist of over-the-counter contracts, which
are not traded on a public exchange. Fuel derivative instruments include swaps, as well as different types of
option contracts, whereas interest rate derivatives consist solely of swap agreements. See Note 10 for further
information on the Company’s derivative instruments and hedging activities. The fair values of swap contracts
are determined based on inputs that are readily available in public markets or can be derived from information
available in publicly quoted markets. Therefore, the Company has categorized these swap contracts as Level 2.
The Company’s Treasury Department, which reports to the Chief Financial Officer, determines the value of
option contracts utilizing an 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 provided by financial
institutions that trade these contracts. The option pricing model used by the Company is an industry standard
model for valuing options and is the same model used by the broker/dealer community (i.e., the Company’s
counterparties). The inputs to this option pricing model are the option strike price, underlying price, risk free rate
of interest, time to expiration, and volatility. Because certain inputs used to determine the fair value of option
contracts are unobservable (principally implied volatility), the Company has categorized these option contracts as
Level 3. Volatility information is obtained from external sources, but is analyzed by the Company for
reasonableness and compared to similar information received from other external sources. The fair value of
option contracts considers both the intrinsic value and any remaining time value associated with those derivatives
that have not yet settled. The Company also considers counterparty credit risk and its own credit risk in its
determination of all estimated fair values. To validate the reasonableness of the Company’s option pricing model,
on a monthly basis, the Company compares its option valuations to third party valuations. If any significant
differences were to be noted, they would be researched in order to determine the reason. However, historically,
no significant differences have been noted. 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.
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