Financial Instruments

Financial Instruments

Financial Instruments

Exposure to various risks arises in the normal course of the Group‘s business. Companies held by Icelandair Group hf. operate on international markets and therefore the Company is subject to risks of fluctuation in currency, interest rates and fuel prices.

Foreign currency risk

The Group seeks to reduce its foreign exchange exposure arising from transactions in various currencies through a policy of matching, as far as possible, receipts and payments in each individual currency. Nevertheless, the US D cash inflow falls short of dollar outflow by around US D 100 million due to fuel costs and capital related payments which are to a large extent denominated in US D. This shortage is financed by a surplus of European currencies, most importantly EUR but also ISK and SE K. The Group follows a hedging policy of 40- 90%, 12 months in advance and uses a portfolio of instruments, mainly collar options, but also barrier options and forwards.

Interest rate risk

The largest share of outstanding loans are directly related to aircraft financing and denominated in US D. That is a consequence of the fact that the most liquid market for commercial aircraft denominates prices in US D. The Group follows a policy of hedging 40-70% of interest rate exposure of long-term financing, 3-5 years in advance. Currently, only the aircraft loans are hedged against interest rate fluctuations with swap contracts, where the 6 month floating rate is exchanged for fixed interest rates. Forward rate agreements and options have occasionally also been used to that end. The contracts amount up to US D 100 million and are currently considerably favourable, as the floating rate has been increasing in recent years. The average fixed interest rate is 3.59% compared to the 6 month floating rate, mid year 2006 of 5.11%.

Fuel price risk

The jet fuel price has proved to be increasingly volatile in recent years. Not only has the price development been characterized by a steep upward trend, generated by excessive world demand, but also periodic cycles. Moreover, swap prices have for the past two years followed a positive curvature as opposed to the “backwardation”, which used to be the case. In 2006, the monthly average of jet fuel prices reached a record level of US D 735 per tonne in July with swaps trading at US D 850 per tonne, but in August oil prices fell by 20% reaching a low in November. Due to the volatility and expensive swaps, the Group exchanged the traditional instruments of swaps and collars for capped swaps and related types of options to acquire improved prices and reduce the downside risk. The Group follows a policy of 40-80% hedging ratio, 12-18 months in advance and has recently maintained its ratio closer to the lower boundaries to benefit from lower prices.

Liquidity risk

It is the Company‘s policy to keep the equivalent of 20-25% of the Group’s estimated annual fixed costs in the form of liquid assets.

Credit risk

Credit risk is linked to both investment of liquid assets, the management of those assets and agreements with financial institutions related to financial operations, e.g. hedging. The risk involved is directly related to the fulfilment of outstanding obligations of the Group’s counterparties. The Group is aware of potential losses related to credit risk exposure and chooses its counterparties subject to business experience and satisfactory credit ratings. The Company is committed to only trade derivatives with trusted parties. The counterparty risk that arises from trading derivatives, used in risk management, is therefore minimised.

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