5. Financial Derivative Instruments

The Company uses derivatives to manage risks associated with certain assets and liabilities arising from the potential adverse impact of fluctuations in global fuel prices, interest rates and foreign currencies.

In May 2013, the Company recognized in its unaudited Consolidated Balance Sheets the financial effect of the net interest owed to the trusts that issued the Company’s enhanced equipment trust certificates. The characteristics of the net interest obligation resulted in the obligation meeting the definition of a derivative instrument under ASC Topic 815, Derivatives and Hedging (ASC 815).

Fuel Risk Management

The Company’s operations are inherently dependent upon the price and availability of aircraft fuel. To manage economic risks associated with fluctuations in aircraft fuel prices, the Company periodically enters into derivative financial instruments. During the three and nine months ended September 30, 2013, the Company primarily used Brent crude oil call options and collars (combinations of purchased call options and sold put options of crude oil). These derivative instruments were not designated as hedges under ASC 815 for hedge accounting treatment. As a result, changes in fair value of these derivative instruments are adjusted through other nonoperating income (expense) in the period of change.

The following table reflects the amount and location of realized and unrealized gains and losses that were recognized during the three and nine months ended September 30, 2013 and 2012, and where those gains and losses were recorded in the unaudited Consolidated Statements of Operations.

	Three months ended September 30,						Nine months ended September 30,
	2013			2012			2013			2012
Fuel derivative contracts	(in thousands)
Losses realized at settlement	$	(3,790	)	$	(1,589	)	$	(11,226	)	$	(4,318	)
Reversal of prior period unrealized amounts	4,278			3,050			5,472			2,324
Unrealized gains (losses) on conracts that will settle in future periods	2,048			5,047			(5,177		)	(501		)
Gains (losses) on fuel derivatives recorded as Nonoperating income (expense)	$	2,536		$	6,508		$	(10,931	)	$	(2,495	)

Interest Rate Risk Management

The Company is exposed to market risk from adverse changes in interest rates associated with its long-term debt obligations. Market risk associated with fixed-rate and variable-rate long-term debt relates to the potential reduction in fair value and negative impact to future earnings, respectively, from an increase in interest rates.

During the quarter ended March 31, 2013, the Company entered into interest rate swap agreements to hedge interest rate risk inherent in debt agreements used to finance aircraft delivered in the quarter ended June 30, 2013. The interest rate swap agreements were designated as cash flow hedges under ASC 815. One of these interest rate swap agreements matured in June 2013, resulting in a gain of $0.7 million recognized in Accumulated Other Comprehensive Income (Loss) (AOCI).

The effective portion of the gain or loss is reported as a component of AOCI and reclassified into earnings in the same period in which interest is accrued. The effective portion of the interest rate swap represents the change in fair value of the hedge that offsets the change in the fair value of the hedged item. To the extent the change in the fair value of the hedge does not perfectly offset the change in the fair value of the hedged item, the ineffective portion of the hedge is immediately recognized in nonoperating income (expense).

The Company did not record any ineffectiveness during the quarter ended September 30, 2013. The Company believes that its derivative contract will continue to be effective in offsetting changes in cash flow attributable to the hedged risk. The Company reclassified net losses from AOCI to interest expense of $0.2 million during the quarter ended September 30, 2013. The Company expects to reclassify a net loss of approximately $0.8 million into earnings over the next 12 months from AOCI based on the values at September 30, 2013.

If the Company terminates a derivative prior to its contractual settlement date, then the cumulative gain or loss recognized in AOCI at the termination date remains in AOCI until the forecasted transaction occurs. In a situation where it becomes probable that a hedged forecasted transaction will not occur, any gains and/or losses that have been recorded to AOCI would be required to be immediately reclassified into earnings. All cash flows associated with purchasing and settling derivatives are classified as operating cash flows in the unaudited Condensed Consolidated Statements of Cash Flows.

Foreign Currency Exchange Rate Risk Management

The Company is subject to foreign currency exchange rate risk due to revenues and expenses denominated in foreign currencies, with the primary exposures being the Japanese Yen and Australian Dollar. To manage exchange rate risk, the Company executes its international revenue and expense transactions in the same foreign currency to the extent practicable.

The Company enters into foreign currency forward contracts, designated as cash flow hedges under ASC 815, to further manage the effects of fluctuating exchange rates. The effective portion of the gain or loss is reported as a component of AOCI and reclassified into earnings in the same period in which the related sales are recognized as passenger revenue. The effective portion of the foreign currency forward contracts represents the change in fair value of the hedge that offsets the change in the fair value of the hedged item. To the extent the change in the fair value of the hedge does not perfectly offset the change in the fair value of the hedged item, the ineffective portion of the hedge is immediately recognized as nonoperating income (expense).

The Company believes that its foreign currency forward contracts will continue to be effective in offsetting changes in cash flow attributable to the hedged risk. The Company reclassified gains from AOCI to passenger revenue of $3.0 million in the quarter ended September 30, 2013. The Company expects to reclassify a net gain of approximately $4.0 million into earnings over the next 12 months from AOCI based on the values at September 30, 2013.

Negative Arbitrage Derivative

In May 2013, the Company created two pass-through trusts, which issued $444.5 million aggregate principal amount of enhanced equipment trust certificates. As of September 30, 2013, the Company has not yet received any of the proceeds raised by the pass-through trusts. However, in accordance with the related agreements, the Company is obligated to pay the interest that accrues on the proceeds and is also entitled to the benefits of the income generated from the same proceeds. The difference between the interest owed to the pass-through trusts and the interest generated from the proceeds introduces an element of variability that could cause the associated cash flows to fluctuate. This variability requires the Company’s obligation to the trusts to be recognized as a derivative in the Company’s unaudited Consolidated Financial Statements. See Note 9 for additional information related to the Company’s enhanced equipment trust certificates.

The following table summarizes the accounting treatment of the Company’s derivative contracts:

			Classification of Unrealized Gains (Losses)
Derivative Type	Accounting Designation	Classification of Gains and Losses	Effective Portion	Ineffective Portion
Interest rate contracts	Designated as cash flow hedges	Interest expense and amortization of debt discounts and issuance costs	AOCI	Nonoperating income (expense)
Foreign currency exchange contracts	Designated as cash flow hedges	Passenger revenue	AOCI	Nonoperating income (expense)
Fuel hedge contracts	Not designated as hedges	Gains (losses) on fuel derivatives	Change in fair value of hedge is recorded in nonoperating income (expense)
Foreign currency exchange contracts	Not designated as hedges	Nonoperating income (expense), Other	Change in fair value of hedge is recorded in nonoperating income (expense)
Negative arbitrage	Not designated as hedges	Nonoperating income (expense), Other	Change in fair value of derivative is recorded in nonoperating income (expense)

The following tables present the gross fair value of asset and liability derivatives that are designated as hedging instruments under ASC 815 and derivatives that are not designated as hedging instruments under ASC 815, as well as the location of the asset and liability balances within the unaudited Consolidated Balance Sheets. The tables also present the gross and net derivative positions as of September 30, 2013 and December 31, 2012.

Derivative position as of September 30, 2013

	Balance Sheet Location	Notional Amount	Final Maturity Date	Gross fair value of assets		Gross fair value of (liabilities)			Net derivative position
		(in thousands)				(in thousands)

Derivatives designated as hedges
Interest rate derivative	Prepaid expenses and other	$67,000 U.S. dollars	April 2023	$	82	$	—		$	82
	Long-term prepayments and other (1)			375		—			375
Foreign currency derivatives	Prepaid expenses and other	12,036,740 Japanese Yen 9,144,358 Korean Won 71,051 Australian Dollars 8,689 New Zealand Dollars	September 2014	4,372		(2,204		)	2,168
	Other liabilities and deferred credits (2)	1,713,861 Japanese Yen 13,204 Australian Dollars	February 2015	58		(197		)	(139		)

Derivatives not designated as hedges
Foreign currency derivatives	Prepaid expenses and other	6,180 Japanese Yen 58 Australian Dollars	September 2014	426		(274		)	152
Fuel derivative contracts	Prepaid expenses and other	91,350 gallons	September 2014	5,573		(589		)	4,984
	Long-term prepayments and other (3)	9,240 gallons	January 2015	1,144		(147		)	997
Negative arbitrage derivative	Other accrued liabilities	$444,540 U.S. dollars	October 2014	—		(12,250		)	(12,250		)
	Other liabilities and deferred credits (4)			—		(615		)	(615		)

(1) Represents the noncurrent portion of the $67 million interest rate derivative with final maturity in April 2023.

(2) Represents the noncurrent portion of the foreign currency derivatives with final maturities in February 2015.

(3) Represents the noncurrent portion of the fuel derivatives with final maturity in January 2015.

(4) Represents the noncurrent portion of the $445 million negative arbitrage derivative with final maturity in October 2014.

Derivative position as of December 31, 2012

Balance Sheet
Location

Notional Amount

Final
Maturity
Date

Gross fair
value of
assets

Gross fair
value of
(liabilities)

Net
derivative
position

(in thousands)

Derivatives not designated as hedges

Fuel derivative contracts

Prepaid expenses and other

126,924 gallons

June 2014

13,094

(397

)

12,697

The following table reflects the impact of cash flow hedges designated for hedge accounting treatment and their location within the unaudited Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2013 and 2012.

	Loss recognized in AOCI on derivatives (effective portion)				(Gain) loss reclassified from AOCI into income (effective portion)					(Gain) loss recognized in nonoperating (income) expense (ineffective portion)
	Three months ended September 30,				Three months ended September 30,					Three months ended September 30,
	2013		2012		2013			2012		2013		2012

Foreign currency derivatives	$	3,960	$	—	$	(3,005	)	$	—	$	—	$	—
Interest rate derivatives	82		—		217			—		—		—

	Gain recognized in AOCI on derivatives (effective portion)					(Gain) loss reclassified from AOCI into income (effective portion)					Gain recognized in nonoperating (income) expense (ineffective portion)
	Nine months ended September 30,					Nine months ended September 30,					Nine months ended September 30,
	2013			2012		2013			2012		2013			2012

Foreign currency derivatives	$	(10,204	)	$	—	$	(6,395	)	$	—	$	(61	)	$	—
Interest rate derivatives	(929		)	—		440			—		—			—

Risk and Collateral

The financial derivative instruments expose the Company to possible credit loss in the event the counterparties to the agreements fail to meet their obligations. To manage such credit risks, the Company (1) selects its counterparties based on past experience and credit ratings, (2) limits its exposure to any single counterparty, and (3) periodically monitors the market position and credit rating of each counterparty. The Company is also subject to market risk in the event these financial instruments become less valuable in the market. However, changes in the fair value of the derivative instruments will generally offset the change in the fair value of the hedged item, limiting the Company’s overall exposure.

ASC 815 requires a reporting entity to elect a policy of whether to offset rights to reclaim cash collateral or obligations to return cash collateral against derivative assets and liabilities executed with the same counterparty, or present such amounts on a gross basis. In the event the price of the underlying financial derivative decreases, counterparties may require the Company to post collateral. The Company’s accounting policy is to present its derivative assets and liabilities on a net basis, including the collateral posted with the counterparty. The Company had no collateral posted with its counterparties as of September 30, 2013 or December 31, 2012.