continued... - Islamic Finance News

Islamic Finance news Guide 2008
Page 42
Profi t Rate Swap — Breaking New Frontiers (continued...)
assumptions in place, only one undertaking should be in the
money. In our example, the Murabahah to be executed under
Undertaking A will have a profi t rate of Libor – Fixed Rate: 5%–
6% = -1%. Undertaking A is “out of money”. Consequently, the
Murabahah to be executed under undertaking B will be “in
the money” having a profi t rate of 1% (6% – 5%).
Figure 3 below depicts the execution of the Murabahah trade
resulting from undertaking B being in the money on the
exercise date.
Figure 3.
Commodity Y
Commodity Y
Party X Party Y
“Principal + Profit”
Purchase
price
Table 1 below calculates the dollar netting and pay off received
by X and paid by Y.
Table 1: Position of the two counterparties on exercise
date
Party X Cash fl ow (US$ mil) Profi t = [Fixed
Buy commodity Y from
broker
Sell commodity Y to Y 50+0.50
SPOT COMMODITY MURABAHAH UNDER
UNILATERAL UNDERTAKING ‘B’
Infl ow Outfl ow
-50
Rate – Libor]
= 6%-5% =
1%
Net Position 50+0.50 -50 = 0.50
Party Y
Buy commodity Y from X -(50+0.50)
Sell commodity Y to
broker
50
Commodity Y
Broker A Broker B
Purchase
price
Net position 50 -(50+0.50) = -0.50
Therefore, in this structure, we achieve the desired result of
swapping one set of dollar amount with another set of dollar
amount with reference to some reference rate of return and
predetermined principal. Further, it has also achieved the
www.islamicfi nancenews.com
netting of payments. We will later see how this netting process
mitigates credit risk.
Critical analysis of the new structure
Both the interest rate swap and the Shariah compliant
profi t rate swap are representative of a plain vanilla swap.
Plain vanilla swap is probably the most common derivative
transaction in the global fi nancial system.
Table 2 gives a comparative of interest rate swap against other
derivative instruments on notional amounts outstanding, gross
market values. A plain vanilla swap is simply the swap in which
one party pays a fi xed rate and the other pays a fl oating rate,
with both payments in the same currency and both sets of
payments are on the same notional amount.
In the regular conventional interest rate swap, because we
are paying in the same currency, there is no need to exchange
notional principal at the beginning and end of an interest rate
swap. In addition, the interest payments can be — and nearly
always are — netted, which greatly reduces the credit risk.
The new profi t rate swap structure (developed by The Islamic
Bank of Asia) achieves just this. It is one of the strongest points
of this structure. The formulae are constructed in a manner
that ensures netting of amounts. Therefore, any amount owed
by one party to the other is only after the netting; this greatly
reduces the credit risk faced by the counterparties. This is
also a reason the structure is superior to the two-parallel
Murabahah profi t rate swap structure commonly used in
the market. In that structure, profi t payments under the two
opposite and parallel Murabahah trades has to be made,
thus exposing each party to the credit and settlement risk of
the other party.
Another advantage the new profi t rate swap structure has
over the two-parallel Murabahah profi t rate swap structure is
the ease in engaging in the swap, the effi cient monitoring and
management of the swap. Engaging in the swap requires only
the issuance of a unilateral undertaking by each counterparty
at the inception of the swap. Thereafter, only the reference
rate needs to be monitored.
Depending on a reference rate on an exercise date, only one
Murabahah contract needs to be executed on spot basis. This
cuts the monitoring and execution work by half, compared to
the two-parallel Murabahah profi t rate swap structure. The new
structure is also cost-effi cient because the brokerage cost is
incurred only on the execution of one Murabahah trade rather
than on two trades under the two-parallel Murabahah profi t
rate swap structure. Moreover, if the reference rate and the
continued...