ISLAMIC HEDGING (CONCEPT & INSTRUMENT)Bandar Seri Begawan, 30th Nov – 4th Dec 2015

2

Islamic Hedging (Concept & Instrument)

ISLAMIC HEDGINGISLAMIC HEDGING CONCEPT CONCEPT

Next 3 months

Y

Next 3 months

X

Hedging X/Y stable

Out

In

FOREIGN EXCHANGE

Bank A

Next 3 months

IDR 90 Million

Next 3 months

USD 10.000

Hedging X/Y stable in Rp 9.000/USD

Out

In

Bank A

FOREIGN EXCHANGE

Next 3 months

IDR 90 Million

Next 3 months

USD 10.000

Hedging In order to make X/Y stable in Rp 9000/USD

Out

In

In order to sale goods in the next 3 months, begin with purchasing goods worth IDR 90 Million, maturing: next 3 months

In order to earn USD 10.000 in the next 3 months, then sale the goods in USD worth USD 10.000. Maturing: next 3 months

Bank A

STRUCTURE OF CONTRACT

Next 3 months

Floating Rate

Next 3 months

Fixed Rate

Hedging In order to make the spread “relatively stable” If Floating > Fixed, Bank A net receiver If Floating < Fixed, Bank A net payer

Out

In

Bank A

PROFIT RATE SWAP

Next 3 months Floating Rate

Case 1 – Current 20% Case 2 – Current 12%

Next 3 months Fixed Rate

15%

Hedging Case 1 : Bank A net receiver 5%Case 2 : Bank A net payer 3%

Out

In

Bank A

PROFIT RATE SWAP

Hedging

Out

In

1 Month1 Month1 Month

12%20%15%

1 Month1 Month1 Month

12%20%15%

3 Months

15%

3 Months

15%

Bank A

STRUCTURE OF CONTRACT

SUKUK: HEDGING PRODUCT ACCORDING TO SUKUK: HEDGING PRODUCT ACCORDING TO IIFMIIFM

Sukuk: Hedging Products

• Profit Rate Swap:

– To give certainty of payments profit payments in respect of the sukuk certificates

– To hedge against the possible variance between profit rates due on income payable to Issuer and profit rate payments in respect of the sukuk certificates

IIFM Industry Seminar on Islamic Capital and Money Market

Tuesday, 6th May 2014, Bank Indonesia, Jakarta

Example: Profit Rate Swap for Sukuk

IIFM Industry Seminar on Islamic Capital and Money Market

Tuesday, 6th May 2014, Bank Indonesia, Jakarta

ISSUERHEDGING

BANK

SUKUK CERTIFICATE HOLDERS

Fixed Rate

Floating RateFloating Rate

Example: Profit Rate Swap for Sukuk

IIFM Industry Seminar on Islamic Capital and Money Market

Tuesday, 6th May 2014, Bank Indonesia, Jakarta

ISSUERHEDGING

BANK

SUKUK CERTIFICATE HOLDERS

Variable Rate

Floating RateFloating Rate

Income Stream Income Stream Income Stream

Sukuk: Hedging Products

• Cross Currency Swap:

– To hedge against currency fluctuations where sukuk certificates are issued in difference currency from income

– To hedge profit/cost of funding rates in difference currencies

IIFM Industry Seminar on Islamic Capital and Money Market

Tuesday, 6th May 2014, Bank Indonesia, Jakarta

Example: Cross Currency Swapfor Sukuk

IIFM Industry Seminar on Islamic Capital and Money Market

Tuesday, 6th May 2014, Bank Indonesia, Jakarta

ISSUERHEDGING

BANK

SUKUK CERTIFICATE HOLDERS

USD

EUREUR

IIFM Industry Seminar on Islamic Capital and Money Market

Tuesday, 6th May 2014, Bank Indonesia, Jakarta

Example: Cross Currency Swapfor Sukuk (Cont..)

ISSUERHEDGING

BANK

SUKUK CERTIFICATE HOLDERS

USD@ 3M USD LIBOR

EUR@ 3M EURIBOREUR@ 3M EURIBOR

INSTRUMENTS OF ISLAMIC HEDGINGINSTRUMENTS OF ISLAMIC HEDGING

Bank Negara Malaysia

Standard Chartered Bank

Al Inma - KSA

Merrill Lynch

Instrument IPRS IPRS IFRA ICCS

Jenis Profit Rate Profit Rate Profit Rate FoRex

Akad Murabahah Murabahah Murabahah Murabahah

General Structure

- A swap of fixed-for-floating profit rate- A master agreement for fixed rate profit- A floating or variable rate which is reset

periodically- A set off (muqasah) exercise at every reset time

to swap a fixed-for-floating profit rate- Floating rate is to based on a certain benchmark- The counterparty making fixed rate payments in a

swap is predominantly the less creditworthy participant

- Swap in in their format are structured as two commodity Murabaha deposits: One Murabaha with ML acting as depositor; one murabaha ML acting as receiving bank

- The two murabaha agreement are coupled through netting & collateral agreement for netting & set-off purposes

- Each Murabaha replicates the desired economics of the each swap leg. It can be highly structured (range accruals, knock-in, knock-out, lingkage to other underlying such as FX, equities, commodities, etc) or plain vanilla, through a market rate agreement

- Margining mechanism linked to the credit exposure to which ML & the Islamic Institution may be exposed, can be implemented using Murabhaha technology & be added to the structure

TABLE PRODUCT OF ISLAMIC HEDGING

Bank Negara Malaysia

Standard Chartered

Bank

Al Inma - KSA

Merrill Lynch

Example Stage I : Fixed Profit RateXYZ Bank (counter party) sells an asset to Murabaha basis at a selling price that comprises both principal and profit margin to be paid upon completion of subsequent transaction i.e. Step 2. An Asset Purchase Agreement is executed by the two parties.Illustration : Suppose the notional principal amount intended is BD 500.000 and the fixed mark-up is 5.75% for 2 years. The fixed mark-up profit rate amount is payable every 6 months for 2 years. (BD 500,000 x 5.75% x 5.75% x 180/365 = BD 14,178.08)

1. Bank X purchase commodities on 1st June 2014 with deferred payment to trader A, ex : worth IDR. 90 Million with maturity 31st July 2014

2. Bank X sale commodities to trader B on the same date as though the same deferred payment period for USD 10.000

3. On the maturity (31/07/2014) Bank X will pay to trader A for IDR. 90 Million to receive commodities and received payment from trader B for the commodities worth USD 10.000

TABLE PRODUCT OF ISLAMIC HEDGING

Bank Negara Malaysia

Standard Chartered

Bank

Al Inma - KSA

Merrill Lynch

Example Stage II : Floating Profit RateStep 1 : Just prior to 6 months, ABC Bank will sell an asset to XYZ Bank at selling price of BD 500,000 plus a mark-up based on CURRENT profit rate (agreed spread plus current benchmark). An asset Sale Agreement is execute by the two parties.Step 2 : Payment of selling price by both ABC & XYZ Bank is netted-offStep 3 : The net difference is profit, and is paid to the receiving party as the case may be spelt out in the settlement agreement

Stage IIIFloating Profit Rate (Stage II) is repeated every 6 months until maturity

4. In this way, Bank A able to fulfill the obligation in USD 10.000 at a price IDR. 90 Million, although the rate of USD rose higher than IDR. 9.000 per USD

TABLE PRODUCT OF ISLAMIC HEDGING

Islamic Profit Rate Swap intoduced to help manage profit rate risks to increase cash flows. IPRS is a structured mechanisme that allows the exchange of fund in billateral using 2 Murabaha contract parallel and back– to-back.

IPRS using a series of Murabaha sale and purchase contract that allows the parties to perform swap (barter) or profit rate exchange from fixed into floating rate or vice versa.

ISLAMIC PROFIT RATE SWAP (IPRS)

Islamic Profit Rate SwapCombination of buying and selling Commodity Murabaha

Stage I : Fixed Profit Rate

Islamic SwapCounterparty

Asset

Bank A

1 a

3 a

2 a

4 a

Islamic SwapCounterparty

Asset

Bank A

1 b

3 b

2 b

4 b

Stage II : Floating Profit Rate

SCHEME - ISLAMIC PROFIT RATE SWAP (1)

Step Ia : Bank “A” sells Asset to Islamic counterparty worth RM 500.000Step IIa : Islamic Swap counterparty sells asset to Bank A for RM 500.000 with

additional fixed profit rateStep IIIa : Principal amount of RM 500.000 set-off between Bank “A” and Islamic

Swap counterpartyStep IVa : Different price on step I and II paid by Bank A to Islamic Swap

counterparty, according to the agreed period of time , for example : 6 months later

Stage I : Fixed Profit Rate

Step Ib : Bank “A” sells Asset to Islamic counterparty worth RM 500.000 with additional floating profit rate

Step IIb : Islamic Swap counterparty sells asset to Bank A for RM 500.000Step IIIb : Principal amount of RM 500.000 set-off between Bank “A” and Islamic

Swap counterpartyStep IVb : Different price on step I and II paid by Islamic Swap counterparty to Bank

A, according to the agreed period of time, for example 6 months later

Tahap II : Fixed Profit Rate

SCHEME - ISLAMIC PROFIT RATE SWAP (2)

Bank : Keeping value of the exchange rate Adjusting Funding Rate to Return Rate Restructuring funding profile without changing the financing structure Managing the exposure of interest rate movement Obtained fee based income from transaction

Customer : Facilitate company’s asset liability management Keeping value of the exchange rate Adjusting Funding Rate to Return Rate Memperoleh biaya dana yang lebih murah Merestruktur profil pendanaan tanpa mengubah struktur pendanaan

PURPOSE OF ISLAMIC PROFIT RATE SWAP (3)

Islamic Profit Rate SwapCombination of buying and selling commodity Murabaha

Trader 2 Trader 1

Client

Bank as agent2

5

Commodity A

Commodity A

3Commodity

A

1Commodity

B

6Commodity

B

4

Commodity B

SCHEME – STANDARD CHARTERED ISLAMIC PROFIT RATE SWAP (1)

Islamic Profit Rate SwapCombination of buying and selling commodity Murabaha

Step I : Bank (as principal) buy Commodity A from trader 1Step II : Bank sells commodity A to customer at a price “P + SFR”Step III : Customer sells commodity A to trader 2 (through bank as agent)Step IV : Customer buy commodity B from trader 2 (through bank as

agent)Step V : Bank buy commodity B from customer at a price “P + LIBOR”Step VI : Bank sells commodity B to trader 2

STANDARD CHARTERED ISLAMIC PROFIT RATE SWAP (2)

ICCS uses a series of buying and selling Murabaha contract which allows the counterparties to establish swap or profit rate exchange from fixed rate to floating rate in order to cross-currency swap

The buying and selling Murabaha transaction involving one currency as a an exchange to another. The purpose of using one currency is to make the parties to exchange one income stream of currency with another.

ISLAMIC CROSS – CURRENY SWAP (ICCS)

General Structure

Merrill Lynch developed a technology that replicates FX and Interest Rate Swaps complies to sharia in order to replicates the terms of conventional FX and Interest Rate Swap, such as :- With exchange of notional (FX Swap) or without exchange of notional (IR

Swap)- Netting and Set off cash flows caused by each of two “legs”- Settlement on Mark-to Market value if early termination occurs

Merrill Lynch Islamic Swap program using Murabaha contract with market rate agreement. Merrill Lynch has a programm that can be used on pure treasury product also to develop more complex transaction.

Islamic Swap relatively new and expected to grow in the next few years.

MERRIL LYNCH ISLAMIC SWAPS (1)

General Structure

Swaps in this programm is prepared using two commodity Muranaha time deposit :- Merrill Lynch as Depositor on one commodity Murabaha- Merrill Lynch as receiving Bank on another commodity Murabaha

Both Murabaha agreement combined using Netting & Collateral Agreement in order to netting and set-off.

Each Murabaha replicates desired economics of each “swap leg”, can be highly structured (range accruals, knock-in, knock-outs, the relation with other underlying such as FX, equity, commodity, etc) or plain vanilla with market rate agreement.

The margin mechanisme assosiated to credit exposure by exposing Merril Lynch and Sharia institution, can be implemented by using Murabaha and can be added to the structure.

MERRIL LYNCH ISLAMIC SWAPS (2)

Commodity Supplier

Sharia Instirutions

CommoditySupplier

Netting & Collateral Agreement

MURABAHAH 1

MURABAHAH 2

1

2

5

3

4

6

SCHEME - MERRIL LYNCH ISLAMIC SWAPS (3)

Step I : Merrill Lynch (ML) buy commodity from supplierStep II : Sharia Institution buy commodity from ML in GBP using deferred

payment methodStep III : ML as an agent of Sharia Institution perform spot sale in GBP to

supplierStep IV : ML an agent of Sharia Institution buy commodity from supplierStep V : Sharia Institution sells commodity to ML using USD with deferred

payment method.Step VI : ML perform spot sales of commodity in USD to the supplier

MERRIL LYNCH ISLAMIC SWAPS (4)

Party A Merrill Lynch Internasional

Party B Sharia Institution

Commodity Supplier

Dawna Day

USD Notional USD 100 million

GBP Notional GBP 100 million

Trade Date Trade Date

Effective Date 2 working days since effective date

Termination Date 5 years since working date

Murabahah 1 Murabaha applied semi-annually, with party A and party B, where party B buy commodity from party A with deferred payment in GBP dan sells with spot basis to commodity supplier on a value according to GBP National, Profit amount will be assosiated to 6 months GBP LIBOR

Murabahah 2 Murabaha applied semi-annually, with party A and party B, where party A buy commodity from party B with deferred payment in GBP and sells in a spot basis to commodity supplier on a value according to USD National, Profit amount will become 5,30% (Avct/360) per annum

Working Days New York, London

Calculation Agent Merrill Lynch International

Documentation Master Perjanjian Murabahah dan Perjanjian Collateral dan Netting

Law English Law/English Court

MERRIL LYNCH ISLAMIC SWAPS (5)

Islamic Forward Rate Agreement is a hedging facility for bank and counterpart that allows for both party to exchange payment on floating rate based payment or otherwise using murabaha mechanism.

ISLAMIC FORWARD RATE AGREEMENT (IFRA)

Bank ACommodity Stock Exchange

Broker B

Broker A

3

2

10

6

8

1112

7

5

4

1

9

Proposed by KCI

SCHEME – CURRENCY FORWARD AGREEMENT (1)

Step I : Bank A asked Broker A to buy commodities worth IDR. 90.000.000 on matured deferred payment on August 31st, 2014Step II : Broker A buy commodities on deferred from commodity stock

exchange according to the request from Bank A Step III : Broker A gets the goods /documents from commodity stock exchangeStep IV : Bank A gets teh goods/documents from broker AStep V : Bank A asked broker B to sell the commodity mentioned in poin IV

worth USD 10.000 on matured deferred payment on August 31st, 2014Step VI : Broker B sells commodities on deferred to commodity stock exchangeStep VII: Bank A delivers goods/documents to broker BStep VIII : Broker B delivers goods/documents to commodity stock exchangeStep IX : (on maturity) Bank A pays to broker A worth IDR. 90.000.000Step X : Broker A pays to commodity stock exchange worth IDR. 90.000.000Step XI : Commodity stock exchange pays to broker B for USD 10.000Step XII : Broker B pays to Bank for USD 10.000

CURRENCY FORWARD AGREEMENT (2)