MANAGEMENT’S DISCUSSION AND ANALYSIS DERIVATIVE FINANCIAL INSTRUMENTS Capstone has exposure to market, credit and liquidity risks from its use of financial instruments as described in notes 9 (Financial Instruments) and  10 (Financial Risk Management) in the consolidated financial statements for the year ended December 31, 2013. These notes contain further details on the implicit risks and valuation methodology employed for Capstone’s financial instruments. To manage the risks inherent in the business, Capstone enters into derivative contracts to mitigate the economic impact of the fluctuations in interest rates and foreign exchange rates. The fair values of these contracts, as reported in Capstone’s consolidated statements of financial  position, were: The net derivative contract liabilities were $16,118 lower than at December 31, 2012, primarily due to a $12,815 change in the fair value of the underlying instruments, followed by the settlement of $2,407 for Erie Shores' interest rate swap, reducing a liability, and purchase of $896 for  foreign exchange contracts, increasing an asset. The changes in fair value of the underlying instruments are included as part of other gain and losses  of $11,833 in the statement of income, both realized and unrealized portions respectively and $982 in other comprehensive income. The unrealized gain (loss) on derivatives on the consolidated statements of income and comprehensive income comprised: Unrealized gains on derivatives for the year ended December 31, 2013 were primarily attributable to the change in value of the interest rate swap  contracts, followed by the embedded derivative at Cardinal, partially offset by losses on the foreign currency contracts. The gain on interest rate swap contracts was primarily due to a gain of $6,217 on the interest rate swap on the Amherstburg debt. The fair value  increased due to an increase in long-term interest rates. The embedded derivative gain was primarily due to a decrease in the forecasted Direct Customer Rate ("DCR") and the passage of time. The liability  portion of the embedded derivative is calculated by discounting Capstone's expected cash flows from Cardinal's fuel supply agreement. Cardinal may swap gas mitigation payments at DCR for a fixed rate, which means that declines in forecasted DCR reduce the fair value of the liability. Additionally,  as time passes, fewer net payments are included in the calculation and the liability declines. The loss on foreign currency contracts was due to the net depreciation of forward-looking rates for the Swedish krona and UK pound sterling  relative to the fixed Canadian dollar conversion rate. The foreign exchange gains were primarily due to translation of Capstone’s SEK-denominated shareholder loan receivable with Värmevärden.  Capstone recorded a $2,924 foreign exchange gain in 2013 compared with a $1,620 gain in 2012.In2013, the Swedish krona appreciated by a greater margin against the Canadian dollar thereby increasing the carrying value of the loans in Canadian dollars, compared with 2012. The 2013 gain was partially offset by the decline in the shareholder loan balance following repayment of more than half of the balance in early 2012, reducing the impact of Swedish krona appreciation. Capstone hedges the interest payments from Värmevärden, but not the outstanding loan receivable. FOREIGN EXCHANGE As at Dec 31, 2013 Dec 31, 2012 Derivative contract assets 1,328 2,021 Derivative contract liabilities (13,840) (30,651) Net derivative contract liabilities (12,512) (28,630) Year ended Dec 31, 2013 Dec 31, 2012 Interest rate swap contracts 6,764 (100) Foreign currency option contracts (1,295) (975) Embedded derivative 6,364 3,680 Gains on derivatives in net income 11,833 2,605 Interest rate swap contracts in OCI 982 (642) Gains on derivatives in comprehensive income 12,815 1,963 42 CAPSTONE INFRASTRUCTURE CORPORATION