New Delhi: In a continuing sign that derivative losses at clients will continue to dog banks, Apollo Health Street Ltd, which processes health care bills and receipts, is set to lose money on derivatives that it claims were forced upon it by two banks in order to secure a loan.
The company, which is a unit of India’s largest health care chain, Apollo Hospitals Enterprise Ltd, has taken derivative products with an underlying value of $125 million (Rs500 crore) from the two banks that provided the loan—Barclays Bank Plc. and Bank of India—said an external spokesperson for Apollo Health, adding that the banks made the purchase of the derivatives pre-conditional to the loan approval last year.
He only spoke on the condition that neither he nor his public relations firm will be named. Both banks did not respond to emails seeking comment.
Forced to buy? (Graphic)
Apollo has incurred a loss of $1 million because of these derivative products in March 2008 alone, but the final figures have not been computed, said the spokesperson. The company didn’t elaborate on email saying it is not allowed to talk when a draft offer document is under consideration by Securities and Exchange Board of India (Sebi). Apollo had filed a draft public offer prospectus with the market regulator.
Derivatives are financial assets that are derived from other financial assets. Apollo bought the “exotic” derivative products, to protect itself from the foreign currency loan it took to fund the buyout of a US-based company, the external spokesperson said.
To hedge against future moves in interest rates, borrowers can opt for derivative instruments that are interest-rate swaps, where they can exchange a fixed-rate stream of payments for a floating-rate stream of payments, or vice versa. A borrower would look to swap floating-rate payments into fixed, as Apollo has done, if it anticipated a rise in interest rates.
In one case, Apollo took a derivatives product where it would get a fixed payment, equivalent to the London Interbank Offered Rates or Libor, on a contract valued at $80 million. For example, it agreed to pay and receive Libor pegged between 3.1% and 6.25%, so it doesn’t incur any losses or gains if the rates stayed in that range.
However, it agreed to pay a higher interest rate fixed at 5.1% if Libor fell below 3.1%. Libor is a rate set by a consortium of British banks and it fell below 3.1% starting 3 March 2008 for the one-month quote. Thus, Apollo would have received less than 3.1% on the derivative products, but would have paid 5.1% because they took a wrong call on where the rates were headed.
In the second derivatives contract worth $45 million, Apollo agreed to pay a fixed rate of 7.5% as an outgoing rate, with incoming rates pegged at Libor plus 275 basis point spreads. Thus, if Libor fell below 4.75%, then it would have to pay more than what it receives. Libor, for instance, fell below 4.75% at least twice last year and stayed below that level from 28 December 2007.
Companies need to accept responsibility for their financial investments, say experts.
Viren H. Mehta, director of Ernst and Young, says banks couldn’t have forced companies to subscribe to derivatives products, saying, “companies are not babies as they should have understanding and be cautious enough in subscribing to these products.”
Indian companies that have taken these complex derivative products either to protect their foreign currency borrowings or export earnings have started filing cases against banks claiming that the products were mis-sold and they were not made fully aware of the underlying risks. Raj Shree Sugars and Chemicals Ltd and Sundaram Brake Linings Ltd are some of the companies that have gone to court.
But, Apollo didn’t elaborate on what it plans to do with these products. The loss of around $1 million, or Rs4 crore, from derivative products, will hit the profit of the company if it decides to make mark-to-market provisions.
It also has two exit options from the current situation. One, it can ‘knock-out’ the product—which means pay the losses that had accrued until now. Alternatively, it can buy additional protection from banks. But, this option will be very expensive and banks would also be wary to offer a variant to the existing product.