Derivative Financial Instruments

The Company uses derivative financial instruments primarily to manage interest rate risk and foreign currency exchange risk.

Interest Rate Risk

The Company is exposed to interest rate risk in the form of basis risk and repricing risk because the interest rate characteristics of the Company's assets do not match the interest rate characteristics of the funding for those assets. The Company has adopted a policy of periodically reviewing the mismatch related to the interest rate characteristics of its assets and liabilities together with the Company's outlook as to current and future market conditions. Based on those factors, the Company uses derivative instruments as part of its overall risk management strategy. Derivative instruments used as part of the Company's interest rate risk management strategy currently include basis swaps and interest rate swaps.

Basis Swaps

Interest earned on the majority of the Company's FFELP student loan assets is indexed to the one-month LIBOR rate. Meanwhile, the Company funds a majority of its FFELP loan assets with three-month LIBOR indexed floating rate securities. The different interest rate characteristics of the Company's loan assets and liabilities funding these assets results in basis risk.

The Company also faces repricing risk due to the timing of the interest rate resets on its liabilities, which may occur as infrequently as once a quarter, in contrast to the timing of the interest rate resets on its assets, which generally occur daily. As of December 31, 2017, the Company had $20.0 billion, $1.1 billion, and $0.6 billion of FFELP loans indexed to the one-month LIBOR rate, three-month commercial paper rate, and the three-month treasury bill rate, respectively, the indices for which reset daily, and $11.7 billion of debt indexed to three-month LIBOR, the indices for which reset quarterly, and $8.6 billion of debt indexed to one-month LIBOR, the indices for which reset monthly.

The Company has used derivative instruments to hedge its basis risk and repricing risk. The Company has entered into basis swaps in which the Company receives three-month LIBOR set discretely in advance and pays one-month LIBOR plus or minus a spread as defined in the agreements (the 1:3 Basis Swaps).

The following table summarizes the Company’s 1:3 Basis Swaps outstanding:



	As of December 31,
	2017		2016
Maturity	Notional amount		Notional amount
2018	$	4,250,000	—
2019	3,500,000		—
2022	1,000,000		—
2024	250,000		—
2026	1,150,000		1,150,000
2027	375,000		—
2028	325,000		325,000
2029	100,000		—
2031	300,000		300,000
	$	11,250,000	1,775,000

The weighted average rate paid by the Company on the 1:3 Basis Swaps as of December 31, 2017 and 2016, was one-month LIBOR plus 12.5 basis points and 10.1 basis points, respectively.

Interest rate swaps – floor income hedges

FFELP loans originated prior to April 1, 2006 generally earn interest at the higher of the borrower rate, which is fixed over a period of time, or a floating rate based on the Special Allowance Payments ("SAP") formula set by the Department. The SAP rate is based on an applicable index plus a fixed spread that depends on loan type, origination date, and repayment status. The Company generally finances its student loan portfolio with variable rate debt. In low and/or certain declining interest rate environments, when the fixed borrower rate is higher than the SAP rate, these student loans earn at a fixed rate while the interest on the variable rate debt typically continues to reflect the low and/or declining interest rates. In these interest rate environments, the Company may earn additional spread income that it refers to as floor income.

Depending on the type of loan and when it was originated, the borrower rate is either fixed to term or is reset to an annual rate each July 1. As a result, for loans where the borrower rate is fixed to term, the Company may earn floor income for an extended period of time, which the Company refers to as fixed rate floor income, and for those loans where the borrower rate is reset annually on July 1, the Company may earn floor income to the next reset date, which the Company refers to as variable rate floor income. All FFELP loans first originated on or after April 1, 2006 effectively earn at the SAP rate, since lenders are required to rebate fixed rate floor income and variable rate floor income for these loans to the Department.

Absent the use of derivative instruments, a rise in interest rates may reduce the amount of floor income received and this may have an impact on earnings due to interest margin compression caused by increasing financing costs, until such time as the federally insured loans earn interest at a variable rate in accordance with their SAP formulas. In higher interest rate environments, where the interest rate rises above the borrower rate and fixed rate loans effectively become variable rate loans, the impact of the rate fluctuations is reduced.

As of December 31, 2017 and 2016, the Company had $4.8 billion and $8.4 billion, respectively, of FFELP student loan assets that were earning fixed rate floor income, of which the weighted average estimated variable conversion rate for these loans, which is the estimated short-term interest rate at which loans would convert to a variable rate, was 3.17% and 2.42%, respectively.

The following tables summarize the outstanding derivative instruments used by the Company to economically hedge loans earning fixed rate floor income.



	As of December 31, 2017				As of December 31, 2016
Maturity	Notional amount		Weighted average fixed rate paid by the Company (a)		Notional amount		Weighted average fixed rate paid by the Company (a)
Maturity	Notional amount		Weighted average fixed rate paid by the Company (a)		Notional amount		Weighted average fixed rate paid by the Company (a)
2017	$	—	—	%	$	750,000	0.99	%
2018	1,350,000		1.07		1,350,000		1.07
2019	3,250,000		0.97		3,250,000		0.97
2020	1,500,000		1.01		1,500,000		1.01
2023	750,000		2.28		—		—
2024	300,000		2.28		—		—
2025	100,000		2.32		100,000		2.32
2027	50,000		2.32		—		—
	$	7,300,000	1.21	%	$	6,950,000	1.02	%


(a)	For all interest rate derivatives, the Company receives discrete three-month LIBOR.

On August 20, 2014, the Company paid $9.1 million for an interest rate swap option to economically hedge loans earning fixed rate floor income. The interest rate swap option gives the Company the right, but not the obligation, to enter into a $250.0 million notional interest rate swap in which the Company would pay a fixed amount of 3.30% and receive discrete one-month LIBOR. If the interest rate swap option is exercised, the swap would become effective in 2019 and mature in 2024.

Interest Rate Caps

In June 2015, in conjunction with the entry into a $275.0 million private education loan warehouse facility, the Company paid $2.9 million for two interest rate cap contracts with a total notional amount of $275.0 million. The first interest rate cap has a notional amount of $125.0 million and a one-month LIBOR strike rate of 2.50%, and the second interest rate cap has a notional amount of $150.0 million and a one-month LIBOR strike rate of 4.99%. In the event that the one-month LIBOR rate rises above the applicable strike rate, the Company would receive monthly payments related to the spread difference. Both interest rate cap contracts have a maturity date of July 15, 2020. The private education loan warehouse facility was terminated by the Company on December 21, 2016. During the first quarter of 2017, the Company received $913,000 to terminate the interest rate cap contracts that were held in the private education loan warehouse legal entity and paid $929,000 to enter into new interest rate cap contracts with identical terms at Nelnet, Inc. (the parent company). The Company currently intends to keep these derivatives outstanding to partially mitigate a rise in interest rates and its impact on earnings related to its student loan portfolio earning a fixed rate.

Interest rate swaps – unsecured debt hedges

As of December 31, 2017 and 2016, the Company had $20.4 million and $50.2 million, respectively, of unsecured Hybrid Securities outstanding. The interest rate on the Hybrid Securities through September 29, 2036 is equal to three-month LIBOR plus 3.375%, payable quarterly. As of December 31, 2017 and 2016, the Company had the following derivatives outstanding that are used to effectively convert the variable interest rate on a portion of the Hybrid Securities to a fixed rate of 7.66%.


(a)	For all interest rate derivatives, the Company receives discrete three-month LIBOR.

Foreign Currency Exchange Risk

In 2006, the Company issued €352.7 million of student loan asset-backed Euro Notes (the "Euro Notes") with an interest rate based on a spread to the EURIBOR index. On October 25, 2017, the Company completed a remarketing of the Euro Notes which reset principal amount outstanding on the Euro Notes to $450.0 million U.S. dollars with an interest rate based on the 3-month LIBOR index. As a result of the Euro Notes, the Company was exposed to market risk related to fluctuations in foreign currency exchange rates between the U.S. dollar and Euro. The principal and accrued interest on these notes were re-measured at each reporting period and recorded in the Company’s consolidated balance sheet in U.S. dollars based on the foreign currency exchange rate on that date. Changes in the principal and accrued interest amounts as a result of foreign currency exchange rate fluctuations were included in the Company’s consolidated statements of income.

The Company entered into a cross-currency interest rate swap in connection with the issuance of the Euro Notes. On October 25, 2017, the Company terminated the cross-currency swap when the Euro Notes were remarketed. Under the terms of the cross-currency interest rate swap, the Company received from the counterparty a spread to the EURIBOR index based on a notional amount of €352.7 million and paid a spread to the LIBOR index based on a notional amount of $450.0 million.

The following table shows the income statement impact as a result of the re-measurement of the Euro Notes and the change in the fair value of the related derivative instruments.



	Year ended December 31,
	2017			2016		2015
Re-measurement of Euro Notes	$	(45,600	)	11,849		43,801
Change in fair value of cross currency interest rate swap	34,208			(1,954	)	(45,195	)
Total impact to consolidated statements of income - (expense) income (a)	$	(11,392	)	9,895		(1,394	)


(a)	The financial statement impact of the above items is included in "Derivative market value and foreign currency adjustments and derivative settlements, net" in the Company's consolidated statements of income.

Management structured the cross-currency interest rate swap to economically hedge the Euro Notes to effectively convert the Euro Notes to U.S. dollars and pay a spread on these notes based on the LIBOR index. However, the cross-currency interest rate swap did not qualify for hedge accounting. The re-measurement of the Euro-denominated bonds generally correlated with the change in the fair value of the corresponding cross-currency interest rate swap. However, the Company experienced unrealized gains and losses between these financial instruments due to the principal and accrued interest on the Euro Notes being re-measured to U.S. dollars at each reporting date based on the foreign currency exchange rate on that date, while the cross-currency interest rate swap was measured at fair value at each reporting date with the change in fair value recognized in the current period earnings.

Consolidated Financial Statement Impact Related to Derivatives

Balance Sheet

The following table summarizes the fair value of the Company’s derivatives as reflected on the consolidated balance sheets.



	Fair value of asset derivatives			Fair value of liability derivatives
	As of		As of	As of	As of
	December 31, 2017		December 31, 2016	December 31, 2017	December 31, 2016
1:3 basis swaps	$	—	—	—	2,624
Interest rate swaps - floor income hedges	—		81,159	—	256
Interest rate swap option - floor income hedge	543		2,977	—	—
Interest rate caps	275		1,152	—	—
Interest rate swaps - hybrid debt hedges	—		—	7,063	7,341
Cross-currency interest rate swap	—		—	—	67,605
Other	—		2,243	—	—
Total	$	818	87,531	7,063	77,826

During the year ended December 31, 2017 the Company terminated certain derivatives for net payments of $30.4 million, including proceeds of $2.1 million and $0.9 million on the termination of 1:3 basis swaps and interest rate caps, respectively, and payments of $33.4 million on the termination of cross-currency interest rate swap. During the year ended December 31, 2016, the Company terminated certain derivatives for net proceeds of $4.0 million, including proceeds of $0.6 million and $3.4 million from the termination of 1:3 basis swaps and interest rate swaps used to hedge loans earning fixed rate floor income, respectively.

Offsetting of Derivative Assets/Liabilities

The following tables include the gross amounts related to the Company's derivative portfolio recognized in the consolidated balance sheets, reconciled to the net amount when excluding derivatives subject to enforceable master netting arrangements and cash collateral received/pledged:



			Gross amounts not offset in the consolidated balance sheets
Derivative assets	Gross amounts of recognized assets presented in the consolidated balance sheets		Derivatives subject to enforceable master netting arrangement		Cash collateral pledged	Net asset (liability)
Balance as of December 31, 2017	$	818	—		—	818
Balance as of December 31, 2016	87,531		(2,880	)	475	85,126



				Gross amounts not offset in the consolidated balance sheets
Derivative liabilities	Gross amounts of recognized liabilities presented in the consolidated balance sheets			Derivatives subject to enforceable master netting arrangement	Cash collateral pledged	Net asset (liability)
Balance as of December 31, 2017	$	(7,063	)	—	8,520	1,457
Balance as of December 31, 2016	(77,826		)	2,880	7,292	(67,654	)

Income Statement

The following table summarizes the components of "derivative market value and foreign currency transaction adjustments and derivative settlements, net" included in the consolidated statements of income.



	Year ended December 31,
	2017			2016		2015
Settlements:
1:3 basis swaps	$	(3,069	)	1,493		1,058
Interest rate swaps - floor income hedges	10,838			(17,643	)	(23,041	)
Interest rate swaps - hybrid debt hedges	(781		)	(915	)	(1,012	)
Cross-currency interest rate swap	(6,321		)	(4,884	)	(1,255	)
Total settlements - income (expense)	667			(21,949	)	(24,250	)
Change in fair value:
1:3 basis swaps	(8,224		)	(2,938	)	12,292
Interest rate swaps - floor income hedges	3,585			64,111		20,103
Interest rate swap option - floor income hedge	(2,433		)	(281	)	(2,420	)
Interest rate caps	(893		)	(419	)	(1,365	)
Interest rate swaps - hybrid debt hedges	279			304		(295	)
Cross-currency interest rate swap	34,208			(1,954	)	(45,195	)
Other	(143		)	1,072		1,730
Total change in fair value - income (expense)	26,379			59,895		(15,150	)
Re-measurement of Euro Notes (foreign currency transaction adjustment) - income (expense)	(45,600		)	11,849		43,801
Derivative market value and foreign currency transaction adjustments and derivative settlements, net - income (expense)	$	(18,554	)	49,795		4,401

Derivative Instruments - Credit and Market Risk

New clearing requirements reduce counterparty risk associated with over-the-counter derivatives executed by the Company after June 10, 2013. For non-centrally cleared derivatives, the Company is exposed to credit risk.

When the fair value of a non-centrally cleared derivative is positive (an asset in the Company's consolidated balance sheet), this generally indicates that the counterparty would owe the Company if the derivative was settled. If the counterparty fails to perform, credit risk with such counterparty is equal to the extent of the fair value gain in the derivative less any collateral held by the Company. If the Company was unable to collect from a counterparty, it would have a loss equal to the amount the derivative is recorded in the consolidated balance sheet.

The Company considers counterparties' credit risk when determining the fair value of derivative positions on its exposure net of collateral. However, the Company does not use the collateral to offset fair value amounts recognized for derivative instruments in the financial statements.

When the fair value of a non-centrally cleared derivative is negative (a liability in the Company's consolidated balance sheet), the Company would owe the counterparty if the derivative was settled and, therefore, has no immediate credit risk. If the negative fair value of derivatives with a counterparty exceeds a specified threshold, the Company may have to make a collateral deposit with the counterparty. The threshold at which the Company may be required to post collateral is dependent upon the Company's unsecured credit rating. The Company believes any downgrades from its current unsecured credit rating (Standard & Poor's: BBB- (stable outlook), Moody's: Ba1 (stable outlook), and DBRS: BBB (low) (stable outlook)), would not result in additional collateral requirements of a material nature. In addition, no counterparty has the right to terminate its contracts in the event of downgrades from the current ratings.

Interest rate movements have an impact on the amount of collateral the Company is required to deposit with its derivative instrument counterparties and variation margin payments to its third-party clearinghouse. The Company attempts to manage market risk associated with interest rates by establishing and monitoring limits as to the types and degree of risk that may be undertaken. The Company's derivative portfolio and hedging strategy is reviewed periodically by its internal risk committee and board of directors' Risk and Finance Committee. With the Company's current derivative portfolio, the Company does not currently anticipate any movement in interest rates having a material impact on its liquidity or capital resources, nor expects future movements in interest rates to have a material impact on its ability to meet potential collateral deposits with its counterparties and variation margin payments to its third-party clearinghouse. Due to the existing low interest rate environment, the Company's exposure to downward movements in interest rates on its interest rate swaps is limited. In addition, the historical high correlation between one-month and three-month LIBOR limits the Company's exposure to interest rate movements on the 1:3 Basis Swaps.

Notional amount

Weighted average fixed rate paid by the Company (a)