Monday, July 22, 2013

Islamic Derivatives: Practical problems in valuing profit rate swaps

By Jasvin Josen
This article appeared in The Edge, Malaysia on June 10, 2013
Islamic derivatives have achieved impressive growth over the years worldwide and in Malaysia. The Islamic profit rate swap, for example is commonly used for risk management as well as for investment. It is frequently associated with the conventional interest rate swap.

Valuation of financial products is always challenging and Islamic derivatives are no exception. In this article I begin with how profit rate swaps can be used for risk management or investment and then discuss some practical problems in valuing the product.

The profit rate swap for risk management: an example
When companies finance their transactions by using Shariah compliant contracts, they may be exposed to the changing rental rates or profit rates over the contract term. These companies may want to hedge the uncertainty they face in these rates.

As for Islamic Banks, it is a norm to keep the fixed and floating profit rates in check, in their daily asset-liability management. Profit rate swap is a commonly used tool.

Very often the profit rate swap is structured as a series of Murabaha contracts. Taking the case of the company that faces uncertainty in the changing rental rates, a typical profit rate swap structured with the Islamic Bank would involve the following:

·      The Islamic bank sells an asset to the company for a notional amount
·      The company re-sells the asset to the Islamic bank at notional plus a fixed rate
·      The net result is the company being the net fixed rate payer
·      The above transactions will be arranged to happen in a series, every quarter or half yearly.
Concurrently, on the reverse side,
·      The company sells an asset to the Islamic bank for a notional amount
·      The Islamic bank re-sells the asset to the company at notional plus a floating rate
·      The net result is the company being the net floating rate receiver
·      The above transactions will be arranged to happen in a series, every quarter or half yearly.
Brokers and agents are involved in the above transactions to ensure that they take place as separate and independent transactions.
At every quarter or half-yearly, the company will pay a fixed rate and receive a floating rate. This floating rate is passed on to its Ijara counterpart as the floating rental rate. (The floating rate in the profit rate swap is usually structured to closely match the floating rental rate on the company’s Ijara contract). The net effect of the swap is that the company pays a fixed rate and thus is not exposed to floating rental rates any more.

The profit rate swap for investment: an example
Profit rate swaps can also be used to enhance investment yields. Traditional investments like Islamic deposits have typically low yields. But the investor may enter into a profit rate swap with his bank to get higher yields.

The profit rate swap here is linked to an asset. In Chart 1, the asset is a credit asset like an investment grade sukuk. The investor makes no initial payment. Cash flows are paid on a net basis. At every period, the investor’s cash flows will be netted off from the fixed return and he would receive a positive net payment. (as long as Islamic Interbank Offer Rate (IIBOR) stays relatively low).
Chart 1: The net cash flows from profit rate swaps between the Islamic Bank and the Investor

The profit rate swaps may be structured as a series of Murabaha transactions where the investor and the Islamic bank sells and resells assets that is linked to the investment grade credit.

Practical problems in valuing profit rate swaps
All derivatives need to be recorded and marked-to-market on a daily basis. Obtaining the true value of the swap is not just important from an accounting perspective but also to allow for circumstances where one party terminates the swap. At this stage, the contract may stipulate a net payment of the swap value at the point of termination, by either party.

Practitioners around the world have taken a similar approach to valuing the profit rate swap as the conventional interest rate swap. In valuing the latter, the future fixed and floating cash flows that are supposed to occur at each interval are discounted to obtain the present value of the swap. However, some practical problems will emerge when the conventional method is being used to value profit rate swaps.

i) Computing the future cash flows
The future fixed rates are just extracted from the contract and they often stay the same through out the swap period. The problem lies with forecasting the future floating rates, for example the future IIBORs. In the conventional world, the future floating rates can be obtained using the term structure technique. (There are also other more complicated volatility models like the Black Derman Toy or the Heath Jarrow Morton.) Using this technique, the conventional future LIBOR rates are obtained by:
1.          Bootstrapping the rates from spot yields of zero-coupon government bond prices; or
2.          Inferred from forward rate agreements and interest rate futures
When the practitioner uses the above conventional technique to extract future IIBOR rates, problems occur when there are insufficient government sukuks to enable bootstrapping. In addition, as most sukuks are not tradable, the price of the sukuks cannot be ascertained in the secondary market and hence the bootstrapping technique fails. With the 2nd way, again, there needs to be a wide spectrum of Islamic forward rate agreements to extract future rates.

ii) The discount rate
Following the conventional world that uses the current floating rate as the discount rate, practitioners use the current IIBOR for the profit rate swap. This does not pose much of an issue unless the IIBORs are not entirely risk free (i.e. the banks carry credit risk). The method of gathering and computing the IIBOR, of course needs to be ethical and shariah compliant.

iii) Managing counterparty default risk
In the conventional world, the risk of the counterparty defaulting is not factored in the valuation of the swap. However either party (depending on their level of credit risk) pose collateral to mitigate this risk.
In the case of the profit rate swap, since the Murabaha contracts are structured as separate spot transactions based on a promise made at the start of the swap period, does it justify demanding collateral? On the other hand, the market seems content that parties face high commercial risk with a default, so technically, a default should be remote.

The profit rate swap is essentially separate purchase and sale transactions. The conventional interest rate swap is literally regular exchanges of interest rates on a notional sum. The valuation issues in profit rate swaps seem to appear as they are priced like its conventional counterpart, despite being very dissimilar in structure.

This further justifies the problems of extracting future cash flows from adjacent vehicles like the government sukuks and Islamic forward rate agreements that do not function like the conventional bonds, forward rate agreements or interest rate futures.

My view is that this valuation problem is just a part of the bigger picture where Islamic products are being replicated from conventional instruments. If the primary Islamic products were not replicated from conventional products, but instead innovated within the Islamic world, then the Islamic derivatives structured based on the primary products may not need to be called derivatives at all !


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