continued... - Islamic Finance News

Islamic Finance news Guide 2008
Page 44
Profi t Rate Swap — Breaking New Frontiers (continued...)
Once the swap is engaged and market conditions change,
the market value becomes positive for one party and
negative for the other. The party holding the positive value
thus assumes credit risk. The counterparty could declare
bankruptcy, leaving the party holding the positive value
swap with a claim that is subject to the legal process of
bankruptcy.
In most swap arrangements, netting is legally recognized, so
the claim has a value based on the net amount. This credit
mitigation feature is achieved by the new profi t rate swap
structure developed by The Islamic Bank of Asia, which is in
contrast to the higher credit risk inherent in the 2 parallel
Murabahah profi t rate swap structure. This is a signifi cant
milestone in the product development of Shariah compliant
profi t rate swap.
However, as we move into the life of the swap, the market
value to a given party can change from positive to negative
or vice-versa. Hence the party not facing the credit risk at a
given moment is not entirely free of risk because the swap
value could turn positive for it later.
Further, the credit risk in a swap varies during its life. A profi t
rate swap or an interest rate swap has no fi nal principal
payments. The credit risk is therefore greater in the middle
of the life of a swap. This occurs because near the end of
the life of the swap, not many payments remain, so there is
not much money at risk, and at the beginning of the life of
the swap, the credit risk is usually low because the parties
would probably not engage in the swap if a great deal of
credit risk were already present at the start.
Swap rate and credit quality — Incongruent
The parties that engage in swaps are generally of good credit
quality but the fear of default is still a signifi cant concern.
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Yet surprisingly, the rate that all parties pay on swaps is the
same, regardless of their credit quality. In a plain-vanilla
swap, the fi xed rate is determined by reference to the term
structure for the underlying rate. Therefore, if a party wanted
to engage in a swap to pay LIBOR and receive a fi xed rate, it
would get the fi xed rate based on the LIBOR term structure,
regardless of its credit quality or that of the counterparty.
Implicit in the fi xed rate is the spread between LIBOR and
the default free rate. Swap rates are quoted in the market
with respect to a spread over the equivalent default free
rate. This differential is called the ‘swap spread’. That the
swap spread is not a measure of credit risk on a given swap
but rather a refl ection of the general level of credit risk in the
global economy. Whenever a recession approaches or credit
concerns arise, this spread widens. This can be seen in the
screen shot below obtained from Bloomberg service. With
the sub-prime crises affecting globally, the swap spread
spiked during the month of July 2007.
Conclusion — Value Proposition
The premise and promise of a profi t rate swap is to be the
Shariah compliant sibling of the interest rate swap. It is then
a derivative instrument and its value can be ascertained by
using the same math and statistical models that are used
to value an interest rate swap. Certain structural issues still
remain and continue to test the minds of product developers.
Islamic fi nance has broken, and will continue to break, new
frontiers.
Kareem Hussaini
is vice-president at
The Islamic Bank
of Asia Limited. He
can be contacted via email at kareem@islamicbankasia.com
5 year semi annual US$ swap spread Source: Bloomberg