Note 9. Fair Value Measurements and Derivative Instruments

Fair Value Measurements

We use quoted prices in active markets when available to determine the fair value of our financial instruments. The estimated fair value of our financial instruments that are not measured at fair value on a recurring basis are as follows (in thousands):


	At June 30, 2011		At December 31, 2010

Long-term debt (including current portion of long-term debt)	$	8,858,400	$	8,775,875

Long-Term Debt

The fair values of our senior notes and senior debentures were estimated by obtaining quoted market prices. The fair values of all other debt were estimated using the present value of expected future cash flows which incorporates our risk profile.

Other Financial Instruments

The carrying amounts of cash and cash equivalents, accounts receivable, accounts payable, accrued interest and accrued expenses approximate fair value at June 30, 2011 and December 31, 2010.

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 June 30, 2011 Using								Fair Value Measurements at December 31, 2010 Using
Description	Total		Level 1¹		Level 2²		Level 3³		Total		Level 1¹		Level 2²		Level 3³

Assets:

Derivative financial instruments⁴	$	447,469		—		447,469		—	$	195,944		—		195,944		—

Investments⁵	$	7,833		7,833		—		—	$	7,974		7,974		—		—


Total Assets	$	455,302	$	7,833	$	447,469	$	—	$	203,918	$	7,974	$	195,944	$	—


Liabilities:
Derivative financial instruments⁶	$	2,038		—	$	2,038		—	$	88,491		—		88,491		—


Total Liabilities	$	2,038	$	—	$	2,038	$	—	$	88,491	$	—	$	88,491	$	—

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.

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, cross currency 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 exchange rates, fuel types, fuel curves, interest rate yield curves, creditworthiness of the counterparty and the Company. 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.

3.	Inputs that are unobservable for the asset or liability. The Company did not use any Level 3 inputs as of June 30, 2011 and December 31, 2010.

4.	Consists of foreign currency forward contracts, interest rate, cross currency, fuel swaps and 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 fuel swaps and foreign currency forward contracts. Please refer to the “Fair Value of Derivative Instruments” table for breakdown by instrument type.

We do not have financial instruments measured at fair value within the third level of the fair value hierarchy as of June 30, 2011. During the fourth quarter of 2010, we changed our valuation technique for fuel call options to a market approach method which employs inputs that are observable. The fair value for fuel call options 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. We believe that Level 2 categorization is appropriate due to an increase in the observability and transparency of significant inputs. Previously, we derived the fair value of our fuel call options using standard option pricing models with inputs based on the options’ contract terms and data either readily available or formulated from public market information. The fuel call options were categorized as Level 3 as of June 30, 2010, because certain inputs, principally volatility, were unobservable.

The following table presents a reconciliation of the Company’s fuel call options’ beginning and ending balances as of June 30, 2010 (in thousands):


Quarter Ended June 30, 2010	Fair Value Measurements Using Significant Unobservable Inputs (Level 3)			Six Months Ended June 30, 2010	Fair Value Measurements Using Significant Unobservable Inputs (Level 3)
	Fuel Call Options				Fuel Call Options

Balance at April 1, 2010	$	20,543		Balance at January 1, 2010	$	9,998
Total gains or losses (realized /unrealized)				Total gains or losses (realized /unrealized)
Included in other income (expense)		(4,249	)	Included in other income (expense)		(7,347	)
Purchases		10,896		Purchases		24,539
Transfers in and/or out of Level 3		—		Transfers in and/or out of Level 3		—

Balance at June 30, 2010	$	27,190		Balance at June 30, 2010	$	27,190

The amount of total gains or losses for the period included in other (expense) income attributable to the change in unrealized gains or losses relating to assets still held at the reporting date	$	(4,249	)	The amount of total gains or losses for the period included in other (expense) income attributable to the change in unrealized gains or losses relating to assets still held at the reporting date	$	(7,347	)

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 June 30, 2011, December 31, 2010 or June 30, 2010, 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 limit our exposure to an individual counterparty. Credit risk, including but not limited to counterparty nonperformance under derivative instruments, our revolving credit facilities and new ship progress payment guarantees, is not considered significant, as we primarily conduct business with large, well-established financial institutions and insurance companies 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 contracts, fuel call options, interest rate and fuel swap agreements that are in-the-money are 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. We normally require that reimbursement of our new ship progress payments to shipyards be guaranteed by either the respective export credit agency, a financial institution or an insurance company in the event of default by the shipyard.

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. 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 income (loss) 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 our foreign operations and investments are recognized as a component of accumulated other comprehensive income (loss) 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 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 operations.

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.

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 June 30, 2011, approximately 47% of our long-term debt was effectively fixed and approximately 53% was floating as compared to 49% and 51% as of December 31, 2010, respectively. We use interest rate swap agreements to modify our exposure to interest rate movements and to manage our interest expense. We assess the risk that changes in interest rates will have either on the fair value of debt obligations or on the amount of future interest payments by monitoring changes in interest rate exposures and by evaluating hedging opportunities.

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 June 30, 2011 and December 31, 2010 we maintained interest rate swap agreements that effectively changed $350.0 million of debt with a fixed rate of 7.25% to a LIBOR-based floating rate equal to LIBOR plus 1.72%, for an interest rate that is currently approximately 2.12%. These interest rate swap agreements are accounted for as fair value hedges.

The notional amount of outstanding debt related to interest rate swaps as of June 30, 2011 and as of December 31, 2010 was $350.0 million.

Foreign Currency Exchange Rate Risk

Derivative Instruments

Our primary exposure to foreign currency exchange rate risk relates to our ship construction firm commitments denominated in euros, a portion of our euro-denominated debt, and to a lesser extent, transactions arising from our international operations that are denominated in currencies other than the United States dollar. We enter into euro-denominated forward contracts and cross currency swap agreements to manage portions of the exposure to movements in foreign currency exchange rates. Approximately 2.9% of the aggregate cost of the ships was exposed to fluctuations in the euro exchange rate at June 30, 2011. Approximately 2.2% of the aggregate cost of the ships was exposed to fluctuations in the euro exchange rate at December 31, 2010. The majority of our foreign exchange contracts and our cross currency swap agreements are accounted for as fair value or cash flow hedges depending on the designation of the related hedge.

During the second quarter of 2011, we recognized a gain of approximately $5.0 million related to certain derivative instruments associated with our ship construction firm commitments denominated in euros that no longer qualified for hedge accounting treatment because it was probable that the original forecasted transaction would not occur by the end of the originally specified time period. The gain represents the derivative gain, net of ineffectiveness, previously reported in accumulated other comprehensive income. This amount is reported in other income (expense) in our consolidated statements of operations.

The notional amount of outstanding foreign exchange contracts including our cross currency swap agreements as of June 30, 2011 and December 31, 2010 was $2.7 billion and $2.5 billion, respectively.

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. As of June 30, 2011 and December 31, 2010, we have assigned debt of approximately €452.7 million and €469.3 million, or approximately $656.5 million and $628.2 million, respectively, as a hedge of our net investment in Pullmantur and TUI Cruises.

Fuel Price Risk

Our exposure to market risk for changes in fuel prices relates 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.

As of June 30, 2011 and December 31, 2010, we have entered into the following fuel swap agreements:


	Fuel Swap Agreements
	As of June 30, 2011			As of December 31, 2010
	(metric tons)
2011		436,000			766,000
2012		738,000			738,000
2013		644,000			300,000
2014		418,000			—
2015		284,000			—

	Fuel Swap Agreements
Projected fuel purchases for year:	As of June 30, 2011			As of December 31, 2010
	(% hedged)
2011		55	%		58	%
2012		55	%		55	%
2013		47	%		22	%
2014		30	%		—
2015		20	%		—

Additionally, as of June 30, 2011, we have entered into fuel call options on a total of 1.7 million barrels which mature between 2012 and 2013 in order to provide protection in the event fuel prices exceed the options’ exercise prices. This compares to fuel call options of 6.6 million barrels, maturing between 2011 and 2013, held as of December 31, 2010. During the second quarter of 2011, we terminated 100% of our fuel call options maturing in 2011 and 68% of our fuel call options maturing in 2012 in order to monetize previously recorded gains pertaining to the fuel call options’ fair value prior to their expiration. Upon termination of these options, we recognized a gain of approximately $7.2 million and received net cash proceeds of approximately $27.8 million which are reflected as cash flows from investing activities. We accounted for the settlement of these fuel call options by recording the cash received and removing the fair value of the instrument from our balance sheet. As of June 30, 2011, the fuel call options represented 8% of our projected 2012 fuel requirements and 11% of our projected 2013 fuel requirements. As of December 31, 2010, the fuel call options represented 41% of our projected 2011 fuel requirements, 25% of our projected 2012 fuel requirements and 11% of our projected 2013 fuel requirements.

Our fuel swap agreements are accounted for as cash flow hedges. Because our fuel call options are not designated as hedging instruments, changes in the fair value of our fuel call options are recognized in earnings immediately and reported in other income (expense) in our consolidated statements of operations.

At June 30, 2011 and December 31, 2010, $130.3 million and $83.6 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 other accumulated comprehensive income (loss) within the next twelve months. Reclassification is expected to occur as the 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
	Balance Sheet Location	As of June 30, 2011		As of December 31, 2010		Balance Sheet Location	As of June 30, 2011		As of December 31, 2010
	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	$	57,871	$	56,497	Other long- term liabilities	$	—	$	—
Cross currency swaps	Other Assets		51,595		13,017	Other long- term liabilities		—		—
Foreign currency forward contracts	Derivative Financial Instruments		13,645		—	Accrued expenses and other liabilities		644		68,374
Foreign currency forward contracts	Other Assets		69,941		8,058	Other long- term liabilities		607		19,630
Fuel swaps	Derivative Financial Instruments		117,190		49,297	Accrued expenses and other liabilities		—		—
Fuel swaps	Other Assets		104,783		37,362	Other long- term liabilities		787		487


Total derivatives designated as hedging instruments under ASC 815-20		$	415,025	$	164,231		$	2,038	$	88,491


Derivatives not designated as hedging instruments under ASC 815-20

Foreign currency forward contracts	Other Assets		4,519		—	Other long- term liabilities		—		—
Fuel call options	Derivative Financial Instruments		—		7,194	Accrued expenses and other liabilities		—		—
Fuel call options	Other Assets		27,925		24,519	Other long- term liabilities		—		—


Total derivatives not designated as hedging instruments under ASC 815-20		$	32,444	$	31,713		$	—	$	—

Total derivatives		$	447,469	$	195,944		$	2,038	$	88,491

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

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


Non-derivative instrument designated as hedging instrument under ASC 815-20	Balance Sheet Location	Carrying Value
		As of June 30, 2011		As of December 31, 2010
In thousands
Foreign currency debt	Long-term debt	$	656,509	$	628,172

		$	656,509	$	628,172

The effect of derivative instruments qualifying and designated as hedging instruments and the related hedged items in fair value hedges on the consolidated statement of operations was as follows:


Derivatives and related Hedged Items under ASC 815-20 Fair Value Hedging Relationships	Location of Gain (Loss) Recognized in Income on Derivative and Hedged Item	Amount of Gain (Loss) Recognized in Income on Derivative											Amount of Gain (Loss) Recognized in Income on Hedged Item
		Quarter Ended June 30, 2011			Quarter Ended June 30, 2010			Six Months Ended June 30, 2011		Six Months Ended June 30, 2010			Quarter Ended June 30, 2011			Quarter Ended June 30, 2010			Six Months Ended June 30, 2011			Six Months Ended June 30, 2010
In thousands

Interest rate swaps	Interest expense, net of interest capitalized	$	4,444		$	12,919		$	8,881	$	28,812		$	7,971		$	—		$	15,594		$	—

Cross currency swaps	Interest expense, net of interest capitalized		—			208			—		987			—			—			—			—

Interest rate swaps	Other income (expense)		7,333			6,280			1,374		27,018			(6,933	)		(4,763	)		(1,043	)		(26,160	)

Cross currency swaps	Other income (expense)		—			(22,238	)		—		(42,284	)		—			23,640			—			47,715

Foreign currency forward contracts	Other income (expense)		(10	)		(49,908	)		22,901		(109,853	)		(28	)		52,424			(23,720	)		113,133

		$	11,767		$	(52,739	)	$	33,156	$	(95,320	)	$	1,010		$	71,301		$	(9,169	)	$	134,688

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 815-20 Cash Flow Hedging Relationships	Amount of Gain (Loss) Recognized in OCI on Derivative (Effective Portion)											Location of Gain (Loss) Reclassified from	Amount of Gain (Loss) Reclassified from Accumulated OCI into Income (Effective Portion)
	Quarter Ended June 30, 2011		Quarter Ended June 30, 2010			Six Months Ended June 30, 2011			Six Months Ended June 30, 2010			Accumulated OCI into Income (Effective Portion)	Quarter Ended June 30, 2011			Quarter Ended June 30, 2010			Six Months Ended June 30, 2011			Six Months Ended June 30, 2010
In thousands
Cross currency swaps		13,691		(30,911	)		38,578			(30,911	)	Other income (expense)		13,760			(19,200	)		44,720			(19,200	)
Foreign currency forward contracts		44,307		(157,090	)		112,156			(259,399	)	Depreciation and amortization expenses		(175	)		54			(349	)		108
Foreign currency forward contracts		—		—			(12,375	)		—		Other income (expense)		(71	)		262			191			525
Fuel swaps		14,464		(68,867	)		193,479			(72,233	)	Fuel		42,427			3,586			78,501			9,510



	$	72,462	$	(256,868	)	$	331,838		$	(362,543	)		$	55,941		$	(15,298	)	$	123,063		$	(9,057	)


Derivatives under ASC 815-20 Cash Flow Hedging Relationships	Location of Gain (Loss) Recognized in Income on Derivative (Ineffective Portion and Amount	Amount of Gain (Loss) Recognized in Income on Derivative (Ineffective Portion and Amount Excluded from Effectiveness testing)
	Excluded from Effectiveness Testing)	Quarter Ended June 30, 2011		Quarter Ended June 30, 2010		Six Months Ended June 30, 2011		Six Months Ended June 30, 2010
In thousands
Cross currency swaps	Other income (expense)		—		—		—		—

Foreign currency forward contracts	Other income (expense)		1,661		414		2,689		240

Foreign currency forward contracts	Other income (expense)		—		—		—		—

Fuel swaps	Other income (expense)		1,685		(185)		6,769		270


		$	3,346	$	229	$	9,458	$	510

At June 30, 2011, we have hedged the variability in future cash flows for certain forecasted fuel transactions occurring through 2015.

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


Non-derivatives instruments under ASC 815-20 Net Investment Hedging Relationships	Amount of Gain (Loss) Recognized in OCI (Effective Portion)								Location of Gain (Loss) in Income (Ineffective	Amount of Gain (Loss) Recognized in Income (Ineffective Portion and Amount Excluded from Effectiveness Testing)
	Quarter Ended June 30, 2011		Quarter Ended June 30, 2010		Six Months Ended June 30, 2011		Six Months Ended June 30, 2010		Portion and Amount Excluded from Effectiveness Testing)	Quarter Ended June 30, 2011		Quarter Ended June 30, 2010		Six Months Ended June 30, 2011		Six Months Ended June 30, 2010
In thousands
Foreign Currency Debt	$	(17,294)	$	60,887	$	(54,502)	$	102,274	Other income (expense)	$	—	$	—	$	—	$	—

	$	(17,294)	$	60,887	$	(54,502)	$	102,274		$	—	$	—	$	—	$	—

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


Derivatives Not Designated as Hedging Instruments under ASC 815-20	Location of Gain (Loss) Recognized in	Amount of Gain (Loss) Recognized in Income on Derivative
	Income on Derivative	Quarter Ended June 30, 2011		Quarter Ended June 30, 2010		Six Months Ended June 30, 2011		Six Months Ended June 30, 2010
In thousands
Foreign exchange contracts	Other income (expense)	$	4,697	$	3	$	4,697	$	(54)

Fuel call options	Other income (expense)		642		(4,250)		24,795		(7,348)

		$	5,339	$	(4,247)	$	29,492	$	(7,402)

Credit Related Contingent Features

Starting in 2012, 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 instrument 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 Ba2 with a stable outlook by Moody’s. Only our interest rate instruments have a term of at least five years. These interest rate instruments will not reach their fifth anniversary until July 2012. Therefore, as of June 30, 2011, we are not required to post any collateral for our derivative instruments. We do not have interest rate derivative instruments which are in a net liability position as of June 30, 2011.