Derivatives and hedging activities

9 Months Ended

Sep. 30, 2012

Derivatives And Hedging Activities

Derivatives and hedging activities

Derivatives and hedging activities

Risk management objective of using derivatives

OEH enters into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and uncertain cash amounts, the value of which is determined by interest rates. OEH’s derivative financial instruments are used to manage differences in the amount, timing and duration of OEH’s known or expected cash receipts and payments principally related to its investments and borrowings.

Cash flow hedges of interest rate risk

OEH’s objective in using interest rate derivatives is to add certainty and stability to its interest expense and to manage its exposure to interest rate movements. To accomplish this objective, OEH primarily uses interest rate swaps as part of its interest rate risk management strategy. An interest rate swap is a transaction between two parties in which each agrees to exchange, or swap, interest payments where the interest payment amounts are tied to different interest rates or indices for a specified period of time and are based on a notional amount of principal. During the nine months ended September 30, 2012, interest rate swaps were used to hedge the variable cash flows associated with existing variable interest rate debt.

Derivative instruments are recorded on the balance sheet at fair value. The effective portion of changes in the fair value of derivatives designated and qualifying as cash flow hedges is recorded in other comprehensive income/(loss) and is subsequently reclassified into earnings in the period that the hedged forecast transaction affects earnings. The ineffective portion of the change in fair value of the derivatives is recognized directly in earnings.

As of September 30, 2012 and December 31, 2011, OEH had the following outstanding interest rate derivatives stated at their notional amounts that were designated as cash flow hedges of interest rate risk:

	September 30, 2012		December 31, 2011
	’000		’000
Interest Rate Swaps	A$	—	A$	10,800
Interest Rate Swaps	€	143,250	€	148,332
Interest Rate Swaps	$	107,234	$	117,765

Non-derivative financial instruments — net investment hedges

OEH uses certain of its debt denominated in foreign currency to hedge portions of its net investments in foreign operations against adverse movements in exchange rates. OEH’s designates its euro-denominated indebtedness as a net investment hedge of long-term investments in its euro-functional subsidiaries. These contracts are included in non-derivative hedging instruments.  The fair values of non-derivative hedging instruments were $43,741,000 at September 30, 2012 (December 31, 2011 - $45,919,000), both being liabilities of OEH.

Economic hedges of interest rate risk

Derivatives not designated in hedging relationships are used to manage OEH’s exposure to interest rate movements but do not meet the strict hedge accounting requirements of the authoritative guidance. As of September 30, 2012, OEH had interest rate options with a notional amount of €77,250,000 and $54,040,000 (December 31, 2011 - €43,593,750 and $54,880,000).

The table below presents the fair value of OEH’s derivative financial instruments as well as their classification as of September 30, 2012 and December 31, 2011:

	Derivatives Instruments
		Fair value as of		Fair value as of
		September 30, 2012		December 31, 2011
	Balance sheet location	$’000		$’000
Derivatives designated in a cash flow hedging relationship:
Interest Rate Swaps	Other assets	—		—
Interest Rate Swaps	Accrued liabilities	(3,942	)	(3,443	)
Interest Rate Swaps	Other liabilities	(5,214	)	(7,511	)
Total		(9,156	)	(10,954	)
Derivatives not designated as hedging instruments:
Interest Rate Options	Other Assets	10		60
Interest Rate Swaps	Accrued liabilities	—		—
Interest Rate Swaps	Other liabilities	—		—
Total		10		60

The table below (in which “OCI” means other comprehensive income) presents the effect of OEH’s derivative financial instruments on the statements of condensed consolidated operations and the statements of condensed consolidated comprehensive income for the three and nine months ended September 30, 2012 and 2011:

	Three months ended				Nine months ended
	September 30, 2012		September 30, 2011		September 30, 2012		September 30, 2011
	$’000		$’000		$’000		$’000
Interest rate swaps designated as hedging instruments:
Beginning accumulated other comprehensive loss	(7,536	)	(4,867	)	(6,440	)	(8,745	)
Amount of loss recognized in OCI (effective portion)	(2,563	)	(6,801	)	(6,072	)	(6,036	)
Amount of loss reclassified from accumulated OCI into interest income (effective portion)	3,126		3,965		5,126		7,929
Deferred tax on OCI movement	(469	)	1,494		(56	)	643
Change in fair value, net of tax	94		(1,342	)	(1,002	)	2,536
Ending accumulated other comprehensive loss	(7,442	)	(6,209	)	(7,442	)	(6,209	)
Amount of loss recognized in interest expense on derivatives (ineffective portion)	(65	)	(203	)	(218	)	(370	)
Derivatives not designated as hedging instruments:
Amount of (loss)/gain recognized in interest expense	(17	)	479		(50	)	524

At September 30, 2012, the amount recorded in other comprehensive income which is expected to be reclassified to interest expense in the next 12 months is $3,627,454.

Credit-risk-related contingent features

OEH has agreements with each of its derivative counterparties that contain provisions under which, if OEH defaults on any of its indebtedness, OEH could also be declared in default in respect of its derivative obligations.  As of September 30, 2012, the fair value of derivatives in a net liability position, which includes accrued interest and an adjustment for non-performance risk, related to these agreements was $9,156,173.  If OEH breached any of these provisions, it would be required to settle its obligations under the agreements at their termination value of $9,292,196.

Fair value measurements

Derivatives are recorded in the consolidated balance sheet at fair value.  The valuation process for the derivatives uses observable market data provided by third-party sources. Interest rate swaps are valued by using yield curves derived from observable interest rates to project future swap cash flows and then discount these cash flows back to present values. Interest rate caps are valued using a model that projects the probability of various levels of interest rates occurring in the future using observable volatilities. OEH incorporates credit valuation adjustments to reflect both its own and its respective counterparty’s non-performance risk in the fair value measurements.

In the determination of fair value of derivative instruments, a credit valuation adjustment is applied to OEH’s derivative exposures to take into account the risk of the counterparty defaulting with the derivative in an asset position and, when the derivative is in a liability position, the risk that OEH may default. The credit valuation adjustment is calculated by determining the total expected exposure of the derivatives (incorporating both the current and potential future exposure) and then applying each counterparty’s credit spread to the applicable exposure.  For interest rate swaps, OEH’s own credit spread is applied to the counterparty’s exposure to OEH and the counterparty’s credit spread is applied to OEH’s exposure to the counterparty, and then the net credit valuation adjustment is reflected in the determination of the fair value of the derivative instrument.  The credit spreads used as inputs in the fair values calculations represent implied credit default swaps obtained from a third-party credit data provider.  Some of the inputs into the credit valuation adjustment are not observable and, therefore, they are considered to be Level 3 inputs.  Where credit valuation adjustment exceeds 20% of the fair value of the derivatives, Level 3 inputs are assumed to have a significant impact on the fair value of the derivatives in their entirety and the derivative is classified as Level 3.  OEH reviews its fair value hierarchy classifications quarterly.  Transfers between levels are made at the fair value on the actual date of the transfer if the event or change in circumstances that caused the transfer can be identified.

The following tables summarize the valuation of OEH’s financial liabilities by the fair value hierarchy at September 30, 2012 and December 31, 2011:

	September 30, 2012
	Level 1 $’000	Level 2 $’000		Level 3 $’000	Total $’000
Assets at fair value:
Derivative financial instruments	—	10		—	10
Liabilities at fair value:
Derivative financial instruments	—	(9,156	)	—	(9,156	)
Net liabilities	—	(9,146	)	—	(9,146	)

	December 31, 2011
	Level 1 $’000	Level 2 $’000		Level 3 $’000	Total $’000
Assets at fair value:
Derivative financial instruments	—	60		—	60
Liabilities at fair value:
Derivative financial instruments	—	(10,954	)	—	(10,954	)
Net liabilities	—	(10,894	)	—	(10,894	)

There were no transfers in or out of Level 3 for the three and nine months ended September 30, 2012. The tables below present a reconciliation of the beginning and ending balances of derivatives having fair value measurements based on significant unobservable inputs (Level 3) for the three and nine months ended September 30, 2011:

	Beginning balance at	Transfers out of Level 3 $’000		Realized losses included in earnings $’000	Unrealizedgains included in othercomprehensive income $’000	Purchases, sales, issuances or settlements $’000	Ending balance at
	July 1, 2011						September 30, 2011
	$’000						$’000
Derivatives at fair value	215	(289	)	37	—	37	—

	Beginning balance at		Transfers out of Level 3 $’000		Realized losses included in earnings $’000	Unrealizedgains included inothercomprehensive income $’000	Purchases, sales, issuances or settlements $’000	Ending balance at
	January 1, 2011							September 30, 2011
	$’000							$’000
Derivatives at fair value	(277	)	(1,473	)	305	1,140	305	—

The transfers out of Level 3 in 2011 represented new swaps as at December 31, 2010 with a fair value close to zero where the credit valuation adjustment was previously greater than 20% of the fair value.

The amount of total losses for the three and nine months ended September 30, 2012 and 2011 included in earnings that are attributable to the change in unrealized gains or losses relating to those liabilities still held was $Nil (2011 - $Nil) and $Nil (2011 - $Nil), respectively.