Islamic profit rate swap - exchange of the mark-up of a long dated fixed rate Murabahah contract with the LIBOR rate underlying a series of smaller Murabahahs corresponding to the date of installment payments on the fixed rate long dated contract.

1. Islamic profit
rate swap
simplified
Off balance sheet hedging
of the on balance sheet
benchmark rate risk Tariqullah Khan

2. Rate is always Bank 1 finances 10
cars, for 5 years
fixed in $9 price per car
Murabahah and $1 markup
rate per car total
as it is based financing $100; to
on the price be repaid in 5
equal annual
mechanism installments
Fixed rate murabahah

3. LIBOR There is a
After signing
the contract Benchmark
market rates rate risk
may change
Value of $1 over time vis-
à-vis the market rates

4. Speculate Close the Speculate on
risk on balance sheet
and do & hedge the
balance
nothing sheet gap off balance
sheet
1 2 3
Alternatives available
regarding benchmark rate
risk

5. Very risky & not allowed by
regulatory authorities
Speculate & do
nothing

6. Always, easier said than done
Close the risk on
balance sheet

7. A Covert the fixed rate
Murabahah (the $1) into a
floating rate
How to hedge
Q against the
benchmark rate
risk?

8. A
Swap the fixed rate
with a floating rate
Murabahah
How to convert
Q the fixed rate into
a floating rate?

9. A
Yes true, but make a series
of separate Murabahah
contracts for a series of
different time periods
But as a price isn't ,
Q Murabahah has to be a
fixed rate not floating
rate?

10. A fixed rate A floating
murabahah rate
murabahah
(numbers of
contracts)
And we will have

11. Now swap the fixed rate
murabahah for the series of
floating rate murabahahs
Profit rate swap

12. 2. We need one 3. We need 5 separate
fixed rate murabahah contracts
murabahah one each
contract for 5 corresponding to the 5
years with installment
equal annual repayments on the
repayments fixed contract
1. We need a profit rate swap
master agreement between
Bank 1 & Bank 2

13. 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.
The Profit rate swap
Master Agreement

14. 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

15. At the time of settling
installments nothing
except the difference of
LIBOR from $9 will be
paid.
Profit rate swap
Master Agreement

16. RATE
RATE
CARS
BANK2
BANK 1
BUYER OF
FLOATING
BUYER OF
CARS FIXED
Murabahah 1 First
for 2 cars $9 installment $20
each +LIBOR due
Murabahah 2 Second
for 2 cars $9 installment $
each +LIBOR 20 due
Murabahah 3 Third
for 2 cars $9 installment $20
each +LIBOR due
Murabahah 4 Fourth
for 2 cars $9 installment $20
each +LIBOR due
Murabahah 5 Fifth
for 2 cars $9 installment
Fixed rate Murabahah
each +LIBOR $20 due
Floating rate Murabahah
RATE
FIXED
SELLER
RATE
CARS
BANK 1
OF CARS
BANK2
FLOATING
SELLER OF

17. Fixed and Floating rate swap
• Bank A sells 10 cars to Bank B for Bank B sells 10 cars to Bank A for
$ 90 +$10 and Bank B will make $ 90 +LIBOR
payments in 5 equal installments two cars each when the installment is
for $ 20 each. due.
– January 30 ($18 +$2)
– February 30 ($18 +$2) MPO1 January 30 ($18 +LIBOR)
MPO2 February 30 ($18 +LIBOR)
– March 30 ($18 +$2) MPO3 March 30 ($18 +LIBOR)
– April 30 ($18+ $2) MPO4 April 30 ($18+ LIBOR)
– May 30 ($18 +$2) MPO5 May 30 ($18+LIBOR)
Bank A will receive fixed Bank A will pay floating
rate rate
Bank B will pay fixed rate Bank B will receive floating
rate

18. Net positions
• Bank A as seller • Bank A as buyer pays
$2receives +$2 +$2
+ $2 +$2 LIBOR +LIBOR +LIBOR
+LIBOR +LIBOR
Bank B as seller receives Bank B as buyer pays
LIBOR +LIBOR +LIBOR +LIBOR $2 + $2 +$2 +$2 +$2
+LIBOR
Price of the cars same in each case

19. No party is interested in
cars; both parties are
interested in cash flows
corresponding to only the
$1 in each installments
IMPORTANT

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

21. 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
Summary

22. 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
B Instead, now in the framework of
the master profit rate swap
U agreement, Islamic bank 2 will sell
T 2 cars for $9+LIBOR each car
Example 1

23. Islamic bank 2 has Islamic bank 1 has to pay
to pay $20 as first $ 9+LIBOR (one car)
installment to +$9+LIBOR (another car)
Islamic bank 1 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
Example 2

24. Islamic bank 2 has Islamic bank 1 has
to pay $20 as first to pay $20.5 as
installment on the cost of the
contract contract
No other cash flow except the $0.5 will take
place
$0.5 is the net settlement
amount on the first installment
& the corresponding first
Murabahah contract

25. 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

26. 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?

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

28. Terribly indeed!
How important is interest
rate (benchmark) rate
risk?

29. BIS reported total OTC derivative
contracts outstanding (billion US $)
683,814
604,622 582,655
516,407
Jun-07 Jun-08 Jun-09 Jun-10

30. commodity credit
0% 5% others
7%
Equity FX
1%
9%
June 2010 BIS data
% composition of interest rate
global derivative derivatives
markets 72%
Terribly important
because, look at this %
components of global

31. BIS reported data
Jun-2010
options FRAs
11% 12%
Interest rate
swaps
78%

32. Market Risk in Islamic Banks
are perceived high too
3.1
3
2.9
2.8
2.7
2.6
2.5
credit risk market risk liquidity risk operational risk
Source: Results of Khan and Ahmed 2001 market perception study