Islamic profit rate swap simplified

Off balance sheet hedging of the on balance sheet benchmark rate risk Tariqullah Khan

Fixed rate murabahah

Rate is always fixed in

Murabahah as it is based on the price mechanism

Bank 1 finances 10 cars, for 5 years $9 price per car and $1 markup

rate per car total financing $100; to

be repaid in 5 equal annual installments

After signing the contract market rates may change

Value of $1 over time vis-à-vis the market rates

LIBOR There is a Benchmark

rate risk

Alternatives available regarding benchmark rate

risk

Speculate and do nothing

Close the risk on

balance sheet

Speculate on balance sheet & hedge the

gap off balance sheet

1 2 3

Speculate & do nothing

Very risky & not allowed by regulatory authorities

Close the risk on balance sheet

Always, easier said than done

How to hedge against the benchmark rate risk?

Covert the fixed rate Murabahah (the $1) into a floating rate

QA

How to convert the fixed rate into a floating rate?Q

A Swap the fixed rate with a floating rate Murabahah

But as a price isn't , Murabahah has to be a fixed rate not floating rate?

Yes true, but make a series of separate Murabahah contracts for a series of different time periods

QA

And we will have

A fixed rate murabahah

A floating rate murabahah (numbers of contracts)

Now swap the fixed rate murabahah for the series of floating rate murabahahs

Profit rate swap

1. We need a profit rate swap master agreement between

Bank 1 & Bank 2

2. We need one fixed rate

murabahah contract for 5

years with equal annual repayments

3. We need 5 separate murabahah contracts

one each corresponding to the 5

installment repayments on the

fixed contract

The Profit rate swap Master Agreement

Islamic Bank 1 will sell 10 cars on installment to Islamic Bank 2 at the rate of 10$ per car to be repaid yearly in 5 equal installments. 1

Islamic Bank 2 at the time of each installment payment will instead sell 2 cars to Islamic Bank 1 at the rate of $9+LIBOR per car

Profit rate swap Master Agreement

2

At the time of settling installments nothing except the difference of LIBOR from $9 will be paid.

Profit rate swap Master Agreement

3

Mur

abah

ah 1

fo

r 2 c

ars

$9

each

+LI

BOR

Floating rate Murabahah

Fixed rate MurabahahFi

rst

inst

allm

ent $

20

due

Seco

nd

inst

allm

ent $

20

due

Third

in

stal

lmen

t $20

du

e

Four

th

inst

allm

ent $

20

due

Fift

h in

stal

lmen

t $2

0 du

e

Mur

abah

ah 2

fo

r 2 c

ars

$9

each

+LI

BOR

Mur

abah

ah 3

fo

r 2 c

ars

$9

each

+LI

BOR

Mur

abah

ah 4

fo

r 2 c

ars

$9

each

+LI

BOR

Mur

abah

ah 5

fo

r 2 c

ars

$9

each

+LI

BOR

BANK 1SELLER

OF CARS FIXED RATE

BANK2 SELLER OF

CARS FLOATING

RATE

BANK2 BUYER OF

CARS FIXED RATE

BANK 1BUYER OF

CARS FLOATING

RATE

Fixed and Floating rate swap

• Bank A sells 10 cars to Bank B for $ 90 +$10 and Bank B will make payments in 5 equal installments for $ 20 each.– January 30 ($18 +$2)– February 30 ($18 +$2)– March 30 ($18 +$2)– April 30 ($18+ $2)– May 30 ($18 +$2)

Bank B sells 10 cars to Bank A for$ 90 +LIBOR two cars each when the installment is due.

MPO1 January 30 ($18 +LIBOR)MPO2 February 30 ($18 +LIBOR)MPO3 March 30 ($18 +LIBOR)MPO4 April 30 ($18+ LIBOR)MPO5 May 30 ($18+LIBOR)

Bank A will receive fixed rate

Bank A will pay floating rate

Bank B will pay fixed rate Bank B will receive floating rate

Net positions

• Bank A as seller receives$2 + $2 +$2 +$2 +$2

• Bank A as buyer pays

LIBOR +LIBOR +LIBOR +LIBOR +LIBOR

Bank B as seller receives Bank B as buyer pays

$2 + $2 +$2 +$2 +$2LIBOR +LIBOR +LIBOR +LIBOR +LIBOR

Price of the cars same in each case

No party is interested in cars; both parties are

interested in cash flows corresponding to only the

$1 in each installments

IMPORTANT

So, for all practical purposes the profit rate swap is about

exchanging the difference of the $1 and the LIBOR per 1 car on the time when the payment of

installment is dueBank 1 receives $1 on the first Murabahah but pays LIBOR on the second Murabahah per car

Bank 2 receives LIBOR on the second Murabahah but pays $1 on the first Murabahah per car

Summary

Islamic Bank 1 has sold 10 cars to Islamic bank 2, $9 per car + $1 markup per car (total due debt $100) to be repaid in $20 annual installments

Islamic bank 1 has bought 10 cars from Islamic bank 2 in 5 different contracts for two cars each at the price of $9+LIBOR each car; a contract will correspond to a an installment repayment on the fixed contract

Example 1

End of year 1 of the fixed rate murabahah contract Islamic bank 2 has to pay $20 as first installment of the $100 total financing

Instead, now in the framework of the master profit rate swap agreement, Islamic bank 2 will sell 2 cars for $9+LIBOR each car

BUT

Example 2

Islamic bank 2 has to pay $20 as first installment to Islamic bank 1

Islamic bank 1 has to pay $ 9+LIBOR (one car) +

$9+LIBOR (another car) ie., $18+LIBOR to Islamic

bank 2

Suppose the effective LIBOR cost is $2.5 for this contract, Islamic bank 1 will have to pay $18+$2.5 = $20.5

$0.5 is the net settlement amount on the first installment

& the corresponding first Murabahah contract

Islamic bank 2 has to pay $20 as first installment on the contract

Islamic bank 1 has to pay $20.5 as cost of the contract

No other cash flow except the $0.5 will take place

Likewise the net settlement amount on the other installments and the

corresponding murababah contracts will depend on the effective LIBOR on the date

of settlement

The arrangement shows that Islamic bank 1 whose assets are tied up in fixed rate earnings prefers to create floating rate payments; Islamic bank 2 whose payment liabilities are tied up in fixed rate likes to create floating rate income

Why?

Because,they want to free themselves from the worries of interest (benchmark) rate risk

How important is interest rate (benchmark) rate risk?

Terribly indeed!

Jun-07 Jun-08 Jun-09 Jun-10

516,407

683,814

604,622 582,655

684 trilli

on US

dollars

BIS reported total OTC derivative contracts outstanding (billion US $)

Terribly important because, look at this % components of global derivatives

FX9%

interest rate derivatives72%

Equity1%

commodity0%

credit5%

others7%

June 2010 BIS data% composition of global derivative

markets

2010 BIS data:Interest rate derivatives 452 trillion US dollars

FRAs12%

Interest rate swaps78%

options11%

Jun-2010Interest rate swaps

348 trillion

US dollars

BIS reported data

Market Risk in Islamic Banks are perceived high too

2.5

2.6

2.7

2.8

2.9

3

3.1

credit risk market risk liquidity risk operational risk

Source: Results of Khan and Ahmed 2001 market perception study