Note 10. Fair Value Measurements and Derivative Instruments

Fair Value Measurements

The estimated fair value of our financial instruments that are not measured at fair value on a recurring basis, categorized based upon the fair value hierarchy, are as follows (in thousands):

	Fair Value Measurements At March 31, 2013 Using								Fair Value Measurements at December 31, 2012 Using


Description	Total		Level 11		Level 22		Level 33		Total		Level 11		Level 22		Level 33

Assets:
Cash and cash equivalents4	$	215,888	215,888		–		–		$	194,855	194,855		–		–

Total Assets	$	215,888	$	215,888	$	–	$	–	$	194,855	$	194,855	$	–	$	–


Liabilities:
Long-term debt (including current portion of long-term debt)5	$	8,795,336	3,845,459		4,949,877		–		$	8,859,310	3,917,398		4,941,912		–

Total Liabilities	$	8,795,336	$	3,845,459	$	4,949,877	$	–	$	8,859,310	$	3,917,398	$	4,941,912	$	–

	1.	Inputs based on quoted prices (unadjusted) in active markets for identical assets or liabilities that we have the ability to access. Valuation of these items does not entail a significant amount of judgment.
	2.	Inputs other than quoted prices included within Level 1 that are observable for the liability, either directly or indirectly. For unsecured revolving credit facilities and unsecured term loans, fair value is determined utilizing the income valuation approach. This valuation model takes into account the contract terms of our debt such as the debt maturity and the interest rate on the debt. The valuation model also takes into account our creditworthiness based on publicly available credit default swap rates.
	3.	Inputs that are unobservable. The Company did not use any Level 3 inputs as of March 31, 2013 and December 31, 2012.
	4.	Consists of cash and marketable securities with original maturities of less than 90 days.

Consists of unsecured revolving credit facilities, unsecured senior notes, senior debentures and unsecured term loans. Does not include our capital lease obligations.

Other Financial Instruments

The carrying amounts of accounts receivable, accounts payable, accrued interest and accrued expenses approximate fair value at March 31, 2013 and December 31, 2012.

Assets and liabilities that are recorded at fair value have been categorized based upon the fair value hierarchy. The following table presents information about the Company’s financial instruments recorded at fair value on a recurring basis (in thousands):

	Fair Value Measurements at March 31, 2013 Using								Fair Value Measurements at December 31, 2012 Using


Description	Total		Level 11		Level 22		Level 33		Total		Level 11		Level 22		Level 33

Assets:
Derivative financial instruments4	$	85,427	—		85,427		—		$	96,489	-—		96,489		—
Investments5	$	6,218	6,218		—		—		$	6,231	6,231		—		—

Total Assets	$	91,645	$	6,218	$	85,427	$	—	$	102,720	$	6,231	$	96,489	$	—

Liabilities:
Derivative financial instruments6	$	97,362	—		97,362		—		$	85,119	—		85,119		—

Total Liabilities	$	97,362	$	—	$	97,362	$	—	$	85,119	$	—	$	85,119	$	—

	1.	Inputs based on quoted prices (unadjusted) in active markets for identical assets or liabilities that we have the ability to access. Valuation of these items does not entail a significant amount of judgment.
	2.	Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. For foreign currency forward contracts, interest rate swaps, cross currency swaps and fuel swaps, fair value is derived using valuation models that utilize the income valuation approach. These valuation models take into account the contract terms, such as maturity, as well as other inputs, such as foreign exchange rates and curves, fuel types, fuel curves and interest rate yield curves. For fuel call options, fair value is determined by using the prevailing market price for the instruments consisting of published price quotes for similar assets based on recent transactions in an active market. Fair value for foreign currency collar options is determined by using standard option pricing models with inputs based on the options’ contract terms, such as exercise price and maturity, and readily available public market data, such as foreign exchange curves, foreign exchange volatility levels and discount rates. All derivative instrument fair values take into account the creditworthiness of the counterparty and the Company.
	3.	Inputs that are unobservable. The Company did not use any Level 3 inputs as of March 31, 2013 and December 31, 2012.
	4.	Consists of foreign currency forward contracts, interest rate swaps, fuel swaps and purchased fuel call options. Please refer to the “Fair Value of Derivative Instruments” table for breakdown by instrument type.
	5.	Consists of exchange-traded equity securities and mutual funds.
	6.	Consists of interest rate swaps, fuel swaps, foreign currency forward contracts and sold fuel call options. Please refer to the “Fair Value of Derivative Instruments” table for breakdown by instrument type.

The reported fair values are based on a variety of factors and assumptions. Accordingly, the fair values may not represent actual values of the financial instruments that could have been realized as of March 31, 2013 or December 31, 2012, or that will be realized in the future, and do not include expenses that could be incurred in an actual sale or settlement.

Concentrations of Credit Risk

We monitor our credit risk associated with financial and other institutions with which we conduct significant business and, to minimize these risks, we select counterparties with credit risks acceptable to us and we seek to limit our exposure to an individual counterparty. Credit risk, including but not limited to counterparty nonperformance under derivative instruments, our credit facilities and new ship progress payment guarantees, is not considered significant, as we primarily conduct business with large, well-established financial institutions, insurance companies and export credit agencies with which we have long-term relationships and which have credit risks acceptable to us or where the credit risk is spread out among a large number of counterparties. In addition, our exposure under foreign currency forward contracts, foreign currency collar options, fuel call options, interest rate and fuel swap agreements was approximately $45.2 million and $60.8 million as of March 31, 2013 and December 31, 2012, respectively, and was limited to the cost of replacing the contracts in the event of non-performance by the counterparties to the contracts, all of which are currently our lending banks. We do not anticipate nonperformance by any of our significant counterparties. In addition, we have established guidelines regarding credit ratings and instrument maturities that we follow to maintain safety and liquidity. We do not normally require collateral or other security to support credit relationships; however, in certain circumstances this option is available to us.

Derivative Instruments

We are exposed to market risk attributable to changes in interest rates, foreign currency exchange rates and fuel prices. We manage these risks through a combination of our normal operating and financing activities and through the use of derivative financial instruments pursuant to our hedging practices and policies. The financial impact of these hedging instruments is primarily offset by corresponding changes in the underlying exposures being hedged. We achieve this by closely matching the amount, term and conditions of the derivative instrument with the underlying risk being hedged. Although certain of our derivative financial instruments do not qualify or are not accounted for under hedge accounting, we do not hold or issue derivative financial instruments for trading or other speculative purposes. We monitor our derivative positions using techniques including market valuations and sensitivity analyses.

We enter into various forward, swap and option contracts to manage our interest rate exposure and to limit our exposure to fluctuations in foreign currency exchange rates and fuel prices. These instruments are recorded on the balance sheet at their fair value and the vast majority are designated as hedges. We also have non-derivative financial instruments designated as hedges of our net investment in our foreign operations and investments.

At inception of the hedge relationship, a derivative instrument that hedges the exposure to changes in the fair value of a firm commitment or a recognized asset or liability is designated as a fair value hedge. A derivative instrument that hedges a forecasted transaction or the variability of cash flows related to a recognized asset or liability is designated as a cash flow hedge.

Changes in the fair value of derivatives that are designated as fair value hedges are offset against changes in the fair value of the underlying hedged assets, liabilities or firm commitments. Gains and losses on derivatives that are designated as cash flow hedges are recorded as a component of accumulated other comprehensive (loss) income until the underlying hedged transactions are recognized in earnings. The foreign currency transaction gain or loss of our non-derivative financial instruments designated as hedges of our net investment in foreign operations and investments are recognized as a component of accumulated other comprehensive (loss) income along with the associated foreign currency translation adjustment of the foreign operation.

On an ongoing basis, we assess whether derivatives used in hedging transactions are “highly effective” in offsetting changes in the fair value or cash flow of hedged items. We use the long-haul method to assess hedge effectiveness using regression analysis for each hedge relationship under our interest rate, foreign currency and fuel hedging programs. We apply the same methodology on a consistent basis for assessing hedge effectiveness to all hedges within each hedging program (i.e. interest rate, foreign currency and fuel). We perform regression analyses over an observation period commensurate with the contractual life of the derivative instrument, up to three years for interest rate and foreign currency relationships and four years for fuel relationships. High effectiveness is achieved when a statistically valid relationship reflects a high degree of offset and correlation between the changes in the fair values of the derivative instrument and the hedged item. The determination of ineffectiveness is based on the amount of dollar offset between the change in fair value of the derivative instrument and the change in fair value of the hedged item at the end of the reporting period. If it is determined that a derivative is not highly effective as a hedge or hedge accounting is discontinued, any change in fair value of the derivative since the last date at which it was determined to be effective is recognized in earnings. In addition, the ineffective portion of our highly effective hedges is recognized in earnings immediately and reported in other income (expense) in our consolidated statements of comprehensive income (loss).

Cash flows from derivative instruments that are designated as fair value or cash flow hedges are classified in the same category as the cash flows from the underlying hedged items. In the event that hedge accounting is discontinued, cash flows subsequent to the date of discontinuance are classified within investing activities. Cash flows from derivative instruments not designated as hedging instruments are classified as investing activities.

We consider the classification of the underlying hedged item’s cash flows in determining the classification for the designated derivative instrument’s cash flows. We classify derivative instrument cash flows from hedges of benchmark interest rate or hedges of fuel expense as operating activities due to the nature of the hedged item. Likewise, we classify derivative instrument cash flows from hedges of foreign currency risk on our newbuild ship payments as investing activities. Cash flows from derivative instruments not designated under hedge accounting, such as our fuel call options, are reported as investing activities.

Interest Rate Risk

Our exposure to market risk for changes in interest rates relates to our long-term debt obligations including future interest payments. At March 31, 2013, approximately 45.5% of our long-term debt was effectively fixed as compared to 45.8% as of December 31, 2012. We use interest rate swap agreements to modify our exposure to interest rate movements and to manage our interest expense.

Market risk associated with our long-term fixed rate debt is the potential increase in fair value resulting from a decrease in interest rates. We use interest rate swap agreements that effectively convert a portion of our fixed-rate debt to a floating-rate basis to manage this risk. At March 31, 2013 and December 31, 2012, we maintained interest rate swap agreements on the $420.0 million fixed rate portion of our Oasis of the Seas unsecured amortizing term loan. The interest rate swap agreements effectively changed the interest rate on the balance of the unsecured term loan, which was $315.0 million as of March 31, 2013, from a fixed rate of 5.41% to a LIBOR-based floating rate equal to LIBOR plus 3.87%, currently approximately 4.42%. These interest rate swap agreements are accounted for as fair value hedges.

Market risk associated with our long-term floating rate debt is the potential increase in interest expense from an increase in interest rates. We use interest rate swap agreements that effectively convert a portion of our floating-rate debt to a fixed-rate basis to manage this risk. At March 31, 2013 and December 31, 2012, we maintained forward-starting interest rate swap agreements that hedge the anticipated unsecured amortizing term loans that will finance our purchase of Quantum of the Seas and Anthem of the Seas. Forward-starting interest rate swaps hedging the Quantum of the Seas loan will effectively convert the interest rate for $735.0 million of the anticipated loan balance from LIBOR plus 1.30% to a fixed rate of 3.74% (inclusive of margin) beginning in October 2014. Forward-starting interest rate swaps hedging the Anthem of the Seas loan will effectively convert the interest rate for $725.0 million of the anticipated loan balance from LIBOR plus 1.30% to a fixed rate of 3.86% (inclusive of margin) beginning in April 2015. These interest rate swap agreements are accounted for as cash flow hedges.

In addition, at March 31, 2013 and December 31, 2012, we maintained forward-starting interest rate swap agreements that beginning April 2013 effectively converted the interest rate on a portion of the Celebrity Reflection unsecured amortizing term loan balance of approximately $627.2 million from LIBOR plus 0.40% to a fixed rate (including applicable margin) of 2.85% through the term of the loan. These interest rate swap agreements are accounted for as cash flow hedges. These forward-starting interest rate swap agreements became effective on April 8, 2013.

The notional amount of interest rate swap agreements related to outstanding debt and on our current unfunded financing arrangements as of March 31, 2013 and December 31, 2012 was $2.4 billion.

Foreign Currency Exchange Rate Risk

Derivative Instruments

Our primary exposure to foreign currency exchange rate risk relates to our ship construction contracts denominated in euros and our growing international business operations. We enter into foreign currency forward contracts, collar options and cross currency swap agreements to manage portions of the exposure to movements in foreign currency exchange rates. As of March 31, 2013, the aggregate cost of our ships on order was approximately $3.5 billion, of which we had deposited $202.9 million as of such date. Approximately 46.7% and 49.7% of the aggregate cost of the ships under construction was exposed to fluctuations in the euro exchange rate at March 31, 2013 and December 31, 2012, respectively. The majority of our foreign currency forward contracts, collar options and cross currency swap agreements are accounted for as cash flow or fair value hedges depending on the designation of the related hedge.

During 2012, we entered into foreign currency collar options to hedge a portion of our foreign currency exposure on the construction contract price for Anthem of the Seas. These foreign currency collar options are accounted for as cash flow hedges and mature in April 2015.

On a regular basis, we enter into foreign currency forward contracts to minimize the volatility resulting from the remeasurement of net monetary assets and liabilities denominated in a currency other than our functional currency or the functional currencies of our foreign subsidiaries. During the first quarter of 2013, we maintained an average of approximately $393.9 million of these foreign currency forward contracts. These instruments are not designated as hedging instruments. Changes in the fair value of the foreign currency forward contracts, of approximately $(8.6) million and $8.2 million, as of March 31, 2013 and March 31, 2012, respectively, were recognized in earnings within other income (expense) in our consolidated statements of comprehensive income (loss).

The notional amount of outstanding foreign exchange contracts including our forward contracts, cross currency swap agreements and collar options as of March 31, 2013 and December 31, 2012 was $1.2 billion.

Non-Derivative Instruments

We consider our investments in our foreign operations to be denominated in relatively stable currencies and of a long-term nature. We partially address the exposure of our investments in foreign operations by denominating a portion of our debt in our subsidiaries’ and investments’ functional currencies and designating it as a hedge of these subsidiaries and investments. We had assigned debt as a hedge of our net investments in Pullmantur and TUI Cruises of approximately €389.4 million and €481.7 million, or approximately $500.0 million and $635.1 million, as of March 31, 2013 and December 31, 2012, respectively.

Fuel Price Risk

Our exposure to market risk for changes in fuel prices relates primarily to the consumption of fuel on our ships. We use fuel swap agreements and fuel call options to mitigate the financial impact of fluctuations in fuel prices.

Our fuel swap agreements are accounted for as cash flow hedges. At March 31, 2013, we have hedged the variability in future cash flows for certain forecasted fuel transactions occurring through 2016. As of March 31, 2013 and December 31, 2012, we had entered into the following fuel swap agreements:

	Fuel Swap Agreements
	As of March 31, 2013	As of December 31, 2012
	(metric tons)
2013	757,000	755,000
2014	699,000	635,000
2015	435,000	363,000
2016	149,000	104,000

	Fuel Swap Agreements
Projected fuel purchases for year:	As of March 31, 2013	As of December 31, 2012
	(% hedged)
2013	55%	55%
2014	50%	45%
2015	30%	25%
2016	10%	7%

At March 31, 2013 and December 31, 2012, $43.8 million and $47.2 million, respectively, of estimated unrealized net gains associated with our cash flow hedges pertaining to fuel swap agreements were expected to be reclassified to earnings from accumulated other comprehensive loss within the next twelve months. Reclassification is expected to occur as a result of fuel consumption associated with our hedged forecasted fuel purchases.

The fair value and line item caption of derivative instruments recorded were as follows:

	Fair Value of Derivative Instruments
	Asset Derivatives					Liability Derivatives
		As of March 31, 2013		As of December 31, 2012			As of March 31, 2013		As of December 31, 2012
	Balance Sheet Location	Fair Value		Fair Value		Balance Sheet Location	Fair Value		Fair Value
In thousands
Derivatives designated as hedging instruments under ASC 815-201
Interest rate swaps	Other Assets	$	3,532	$	5,099	Other long-term liabilities	$	42,729	$	55,471
Foreign currency forward contracts	Derivative Financial Instruments	-		951		Accrued expenses and other liabilities	3,967		338
Foreign currency forward contracts	Other Assets	6,446		11,564		Other long-term liabilities	6,383		1,000
Foreign currency collar options	Other Assets	-		8,974		Other long-term liabilities	5,987		-
Fuel swaps	Derivative Financial Instruments	45,124		48,624		Accrued expenses and other liabilities	849		1,761
Fuel swaps	Other Assets	8,110		8,585		Other long-term liabilities	8,372		6,369
Total derivatives designated as hedging instruments under 815-20		63,212		83,797			68,287		64,939

Derivatives not designated as hedging instruments under ASC 815-20
Foreign currency forward contracts	Other Assets	$	15,519	$	4,440	Other long-term liabilities	$	22,493	$	11,475
Fuel swaps	Derivative Financial Instruments	-		-		Accrued expenses and other liabilities	-		475
Fuel call options	Derivative Financial Instruments	6,696		8,252		Accrued expenses and other liabilities	6,582		8,230
Fuel call options	Other Assets	-		-		Other long-term liabilities	-		-
Total derivatives not designated as hedging instruments under 815-20		22,215		12,692			29,075		20,180
Total derivatives		$	85,427	$	96,489		$	97,362	$	85,119

1 Accounting Standard Codification 815-20 “Derivatives and Hedging”.

The carrying value and line item caption of non-derivative instruments recorded was as follows:

		Carrying Value
Non-derivative instrument designated as hedging instrument under ASC 815-20	Balance Sheet Location	As of March 31, 2013		As of December 31, 2012
In thousands
Foreign currency debt	Current portion of long-term debt	$	363,501	$	17,516
Foreign currency debt	Long-term debt	136,482		617,593
		$	499,983	$	635,109

The effect of derivative instruments qualifying and designated as hedging instruments and the related hedged items in fair value hedges on the consolidated statements of comprehensive income (loss) was as follows:

Derivatives and related Hedged Items	Location	Amount of Gain (Loss) Recognized in Income on Derivative				Amount of Gain (Loss) Recognized in Income on Hedged Item
under ASC 815-20 Fair Value Hedging Relationships	of Gain (Loss) Recognized in Income on Derivative and Hedged Item	Quarter Ended March 31, 2013		Quarter Ended March 31, 2012		Quarter Ended March 31, 2013		Quarter Ended March 31, 2012
In thousands
Interest rate swaps	Interest expense, net of interest capitalized	$	779	$	4,982	$	9,276	$	7,260
Interest rate swaps	Other income (expense)	(1,569)		(4,543)		1,412		3,714
		$	(790)	$	439	$	10,688	$	10,974

The effect of derivative instruments qualifying and designated as hedging instruments in cash flow hedges on the consolidated financial statements was as follows:

Derivatives under ASC	Amount of Gain (Loss) Recognized in OCI on Derivative (Effective Portion)				Location of Gain (Loss) Reclassified from Accumulated	Amount of Gain (Loss) Reclassified from Accumulated OCI into Income (Effective Portion)				Location of Gain (Loss) Recognized in Income on Derivative (Ineffective	Amount of Gain (Loss) Recognized in Income on Derivative (Ineffective Portion and Amount Excluded from Effectiveness testing)
815-20 Cash Flow Hedging Relationships	Quarter Ended March 31, 2013		Quarter Ended March 31, 2012		OCI into Income (Effective Portion)	Quarter Ended March 31, 2013		Quarter Ended March 31, 2012		Portion and Amount Excluded from Effectiveness Testing)	Quarter Ended March 31, 2013		Quarter Ended March 31, 2012
In thousands
Cross currency swaps	$	–	$	(3,587)	Other income (expense)	$	–	$	(2,921)	Other income (expense)	$	–	$	–
Cross currency swaps	–		–		Interest Expense, net of interest capitalized	(871)		–		Other income (expense)	–		–
Interest rate swaps	12,688		4,554		Other income (expense)	–		–		Other income (expense)	54		1
Foreign currency forward contracts	(15,082)		17,708		Depreciation and amortization expenses	(449)		(196)		Other income (expense)	(5)		7
Foreign currency forward contracts	–		–		Other income (expense)	(238)		(238)		Other income (expense)	–		–
Foreign currency collar options	(14,961)		–		Depreciation and amortization expenses	–		–		Other income (expense)	–		–
Fuel swaps	10,025		161,267		Fuel	16,828		35,827		Other income (expense)	(720)		529
	$	(7,330)	$	179,942		$	15,270	$	32,472		$	(671)	$	537

The effect of non-derivative instruments qualifying and designated as hedging instruments in net investment hedges on the consolidated financial statements was as follows:

	Amount of Gain (Loss) Recognized in OCI (Effective)				Location of Gain (Loss) in Income (Ineffective Portion and Amount	Amount of Gain (Loss) Recognized in Income (Ineffective Portion and Amount Excluded from Effectiveness Testing)
Non-derivative instruments under ASC 815-20 Net Investment Hedging Relationships	Quarter Ended March 31, 2013		Quarter Ended March 31, 2012		Excluded from Effectiveness Testing)	Quarter Ended March 31, 2013		Quarter Ended March 31, 2012
In thousands
Foreign Currency Debt	$	12,732	$	(20,770)	Other income (expense)	$	-	$	-
	$	12,732	$	(20,770)		$	-	$	-

The effect of derivatives not designated as hedging instruments on the consolidated financial statements was as follows:

	Location of Gain (Loss)	Amount of Gain (Loss) Recognized in Income on Derivative
Derivatives Not Designated as Hedging Instruments under ASC 815-20	Recognized in Income on Derivative	Quarter Ended March 31, 2013		Quarter Ended March 31, 2012
In thousands
Foreign currency forward contracts	Other income (expense)	$	(8,611)	$	8,373
Fuel swaps	Other income (expense)	109		-
Fuel call options	Other income (expense)	158		2,682
		$	(8,344)	$	11,055

Credit Related Contingent Features

Our current interest rate derivative instruments may require us to post collateral if our Standard & Poor’s and Moody’s credit ratings remain below specified levels. Specifically, if on the fifth anniversary of entering into a derivative transaction and on all succeeding fifth-year anniversaries our credit ratings for our senior unsecured debt were to be below BBB- by Standard & Poor’s and Baa3 by Moody’s, then each counterparty to such derivative transaction with whom we are in a net liability position that exceeds the applicable minimum call amount may demand that we post collateral in an amount equal to the net liability position. The amount of collateral required to be posted following such event will change each time our net liability position increases or decreases by more than the applicable minimum call amount. If our credit rating for our senior debt is subsequently equal to, or above BBB- by Standard & Poor’s or Baa3 by Moody’s, then any collateral posted at such time will be released to us and we will no longer be required to post collateral unless we meet the collateral trigger requirement at the next fifth-year anniversary. Currently, our senior unsecured debt credit rating is BB with a stable outlook by Standard & Poor’s and Ba1 with a stable outlook by Moody’s. We currently have four interest rate derivative hedges that have a term of at least five years. The aggregate fair values of all derivative instruments with such credit-related contingent features in net liability positions as of March 31, 2013 and December 31, 2012 were $42.7 million and $55.5 million, respectively, which do not include the impact of any such derivatives in net asset positions. The earliest that any of the four interest rate derivative hedges will reach their fifth anniversary is November 2016. Therefore, as of March 31, 2013, we were not required to post collateral for any of our derivative transactions.