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www.islamicfi nancenews.com<br />
<strong>Islamic</strong> <strong>Finance</strong> news Guide 2008<br />
Profi t Rate Swap — Breaking New Frontiers (<strong>continued</strong>...)<br />
Now, in a profi t rate swap, the same payoffs should be<br />
achieved as in the interest rate swap i.e. while constructing<br />
a profi t rate swap, the ultimate objective to be achieved is<br />
to enable swapping of one set of dollar amount with another<br />
set of dollar amount with reference to some reference rate of<br />
return and predetermined principal.<br />
The current popular Shariah compliant method commonly<br />
used to achieve this payoff is the execution of two opposite<br />
Murabahah contracts between X and Y. While one Murabahah<br />
transaction achieves the fi xed rate payment element, the other<br />
achieves the fl oating rate element. However, the structure that<br />
is currently employed by majority of the market makers in the<br />
<strong>Islamic</strong> fi nance world is quite cumbersome and burdensome.<br />
We will see why as we proceed.<br />
The <strong>Islamic</strong> Bank of Asia has developed a new and novel<br />
Shariah compliant structure to achieve a payoff similar to<br />
its conventional sibling, the interest rate swap but in a more<br />
effi cient manner.<br />
Figure 2.<br />
Time line [Exercise dates]<br />
Party X<br />
Fixed rate<br />
payer<br />
Unilateral undertaking to<br />
purchase @ profit of<br />
[Libor − Exercise rate]<br />
Party Y<br />
Party Y<br />
Fixed rate<br />
receiver<br />
Unilateral undertaking to<br />
purchase @ profit of<br />
[Exercise rate − Libor]<br />
Party X<br />
Party X Master Murabahah agreement<br />
Party Y<br />
• Shariah compliant structure<br />
In this Shariah compliant structure, X is the fi xed rate payer<br />
and consequently, Y is the fi xed rate receiver. Unilateral<br />
undertakings are issued by each counterparty to the other to<br />
effect swap positions.<br />
Unilateral Undertaking A: X issues a unilateral undertaking<br />
to Y to purchase commodity X (Shariah compliant) from Y on<br />
spot Murabahah basis on certain specifi ed dates (exercise<br />
dates) in the future. The profi t rate at which such Murabahah<br />
will be entered into will be defi ned in the unilateral undertaking<br />
by reference to a formula and reference rate: [Libor<br />
– Fixed Rate].<br />
Unilateral Undertaking B: Y also issues a unilateral undertaking<br />
to X to purchase commodity Y (again Shariah compliant)<br />
from X on spot Murabahah basis on certain specifi ed dates<br />
(exercise dates) in the future. As above, the profi t rate at<br />
which the Murabahah under this undertaking will be executed<br />
will also be defi ned in the unilateral undertaking by reference<br />
to a formula and reference rate: [Fixed Rate – Libor].<br />
Figure 2, depicts the engagement of the Shariah compliant<br />
profi t rate swap. The exercise dates are the agreed-upon<br />
dates between the two counterparties to exchange the dollar<br />
amounts. The two undertakings are independent of each<br />
other, implying that the functioning and execution of one is<br />
not dependent on the other.<br />
To align the two undertakings and to achieve the desired<br />
payoff the terms and conditions of each undertaking will be<br />
exact mirror image of the other with respect to all the terms<br />
and conditions. Therefore, the exercise dates and the principal<br />
for executing the Murabahah trade will be the same for both<br />
the above transactions. However, the following parameters<br />
will be different:<br />
• The commodities: each undertaking will be for a<br />
different commodity; and<br />
• The profi t margin formulae: these are different but<br />
opposite.<br />
The undertakings will be supported by a Master Murabahah<br />
Agreement which will defi ne the terms and conditions of<br />
the Murabahah transactions to be executed under the<br />
undertakings.<br />
• Execution<br />
Let’s fast forward to an exercise date. Once the swap is<br />
engaged and market conditions change, the market value<br />
becomes positive for one party and negative for the other.<br />
This is due to the way the formulae for the Murabahah<br />
profi t calculations are constructed under each undertaking.<br />
Because the formulae calculating the profi ts are structured<br />
in opposite directions, at any given point in time, only one of<br />
the undertakings will be ‘in the money’ while the other will<br />
be “out of money”. This is an important point to note. While<br />
the undertakings are independent and on any given exercise<br />
date, both undertakings can be exercised, it is the formulae<br />
that ensure that only one undertaking is worth exercising.<br />
Let us assume that the reference rate, i.e. ‘Libor’ on an exercise<br />
date is 5%. The fi xed rate remains the same at 6%. With these<br />
<strong>continued</strong>...<br />
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