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THEEDGE MALAYSI A | JUNE 10, 2013 capital 48

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sukuk.The investor makes no initial pay-
ment.Cash ows are paid on a net basis.
At every period,the investors cash ows
will be netted o from the xed return and
he will receive a positive net payment (as
long as the Islamic Interbank Oer Rate
(IIBOR) stays relatively low).
The prot rate swaps may be struc-
tured 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 prot
rate swaps
All derivatives need to be recorded and
marked-to-market on a daily basis.Obtain-
ing the true value of the swap is not just
important from an accounting perspec-
tive 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
prot rate swap as the conventional in-
terest rate swap. In valuing the latter,
the future xed and oating cash ows
that are supposed to occur at each inter-
val are discounted to obtain the present
value of the swap.However,some practi-
cal problems will emerge when the con-
ventional method is being used to value
prot rate swaps.
i) Computing the future cash ows
The future xed rates are just extracted
from the contract and they often stay
the same throughout the swap period.
The problem lies with forecasting the
future oating rates,for example the
future IIBORs. In the conventional
world, the future oating 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 Jar-
row 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 agree-
ments and interest rate futures.
When the practitioner uses the above
conventional technique to extract
future IIBOR rates, problems occur
when there are insucient govern-
ment sukuks to enable bootstrapping.
In addition, as most sukuks are not
tradable,the price of the sukuks can-
not be ascertained in the secondary
market and hence the bootstrapping
technique fails.With the second way,
again,there needs to be a wide spec-
trum of Islamic forward rate agree-
ments to extract future rates.
ii) The discount rate
Following the conventional world that
uses the current oating rate as the
discount rate, practitioners use the
current IIBOR for the prot rate swap.
This does not pose much of an issue
unless the IIBORs are not entirely risk
free (namely, the banks carry credit
risk). The method of gathering and
computing the IIBOR,of course,needs
to be ethical and syariah 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 prot 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 collat-
eral? On the other hand,the market seems
content that parties face high commercial
risk with a default,so technically,a default
should be remote.
Conclusion
The prot rate swap is essentially sepa-
rate purchase and sale transactions.The
conventional interest rate swap is liter-
ally regular exchanges of interest rates
on a notional sum.The valuation issues
in prot rate swaps seem to appear as
they are priced like its conventional coun-
terpart, despite being very dissimilar in
structure.
This further justies the problems of
extracting future cash ows 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 prob-
lem is just a part of the bigger picture
where Islamic products are being rep-
licated from conventional instruments.
If the primary Islamic products were
not replicated from conventional prod-
ucts, but instead innovated within the
Islamic world,then the Islamic deriva-
tives structured based on the primary
products may not need to be called de-
rivatives at all!
Jasvin Josen is an ex-investment
banker from Europe, specialising
in valuation and risk in financial
derivatives. She is currently back
in Malaysia, providing consultancy
and training. Readers can follow her
at http://derivativetimes.blogspot.
com or send their comments to
Jasvin@souqmatters.com.
Islamic derivatives: Valuing prot rate swaps
zoxq
I
slamic derivatives have achieved
impressive growth over the years
worldwide and in Malaysia.The
Islamic profit rate swap, for ex-
ample, is commonly used for
risk management as well as for
investment. It is frequently associ-
ated with the conventional interest
rate swap.
Valuation of nancial products
is always challenging and Islamic
derivatives are no exception.In this
article I begin with how prot rate
swaps can be used for risk manage-
ment or investment and then discuss
some practical problems in valuing
the product.
e prot rate swap for risk
management: an example
When companies nance their trans-
actions by using syariah-compliant
contracts,they may be exposed to the
changing rental rates or prot rates
over the contract term.These compa-
nies may want to hedge the uncer-
tainty they face in these rates.
As for Islamic banks,it is a norm
to keep the xed and oating prot
rates in check,in their daily asset-li-
ability management.Prot rate swap
is a commonly used tool.
Very often the prot rate swap is
structured as a series of murabaha con-
tracts.Taking the case of the company
that faces uncertainty in the chang-
ing rental rates, a typical prot 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 xed rate;
The net result is the company be-
ing the net xed rate payer; and
The above transactions will be ar-
ranged 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
oating rate;
The net result is the company be-
ing the net oating rate receiver;
and
The above transac-
tions 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 xed rate and re-
ceive a oating rate.This oating rate
is passed on to its ijara counterpart as
the oating rental rate.(The oating
rate in the prot rate swap is usually
structured to closely match the oat-
ing rental rate on the companys ijara
contract.) The net eect of the swap
is that the company pays a xed rate
and thus is not exposed to oating
rental rates any more.
e prot rate swap for
investment: an example
Prot 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 prot rate swap with
his bank to get higher yields.
The prot rate swap here is linked
to an asset.In the chart,the asset is a
credit asset like an investment grade
BY
JASVI N JOSEN
e net cash ows from prot rate swaps
between the Islamic bank and the investor
E

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