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Opalesque Islamic Finance Intelligence

Featured Structure: Shariah Compliant Profit Rate Swap By Nikan Firoozye, PhD

Monday, May 31, 2010

Nikan has over 14 years experience in leading Wall Street and City firms on the buy and sell-side including Lehman Brothers, Goldman-Sachs, Deutsche Bank, Sanford Bernstein Alliance, Citadel and Nomura where he is currently Head of European Rates Strategy. He has worked in a variety of primarily technical or quantitative fixed income roles from Rates & Hybrids Structuring to Rates Strategy and Quantitative Modelling to Asset Allocation and Risk Management to Prepayment Analysis and Securitization and Capital Markets. Education: PhD Mathematics (Courant Institute, NYU), Asst Prof University of Illinois.

It had been obvious for some time that Murabaha represented a form of short-rate financing, an Islamic alternative to a LIBOR contract. Hence the ability to promise through the wa'd mechanism to enter into a forward Murabaha could easily lead to forward financing methods. However, the fact that a Murabaha, essentially a trade finance with a markup, could have this same markup linked to LIBOR did essentially open up some possibilities. In particular, why couldn't this same markup be linked to anything more exotic. For instance, it has been said that if a Muslim owned a beverage store and sold soft-drinks, his activities are permissible. If he also decided to 'keep up with the Joneses' and sell soft-drinks which had a price which ratched up whenever his next-door non-Muslim beer-selling neighbour ratched up his prices, this activity is similarly permissible or halal.

Just extending the logic further, it has been granted that it is permissible to link the markup in a Murabaha, trade financing vehicle, to just about any observable index, as long as this index had been set and could be verified before the Murabaha is actually entered into. This opens a world of possibilities. Thus we can link Murabaha markups to exotic instruments (e.g., to the number of days LIBOR was in a given range with the possibility of a knockout if it far exceeds the same range, or the slope of the yield curve, etc.) The key precondition being that this exotic payoff would have to be determined before the actual purchase of any underlying commodity, in other words one cannot agree to a markup sale if the markup price is not known at the time of the original sale.

Of course this leads one step further, in that one could have back-to-back Murabahas, where one counterparty sells another corn with a markup of LIBOR and this same counterparty sells the initial party platinum with markup linked to the slopes of the yield curve less a fixed spread. If we promise to enter into successive further Murabahas, we suddenly have a swap, known as a Profit Rate Swap (PRS), originated in Malaysia around the same time Deutschebank invented its now famous TRS (Total return Swap), specifically being a wa'd based total return swap (see Islamic-Finance Resources, " Shariah Compliant Swap: Shariah "conversion" or subversion?" for more details on the wa'd swap).

To reiterate, the essential ingredients are successive parallel Murabahas. Allen & Overy has a relevant discussion paper (see reference link on the structre which goes into some detail on the individual legs of the swap (the individual Murabahas/rolling murabahas). The idea is simple enough and is depicted in the adjoint graph:

Profit Rate Swap Structure

Source: Allen & Overy

For the floating leg, we are allowed Murabahas with markups linked to LIBOR. We can enter into consecutive Murabahas on a rolling basis, with Wa'd to enter into Murabaha at the market price + market determined LIBOR to make for rolling Murabahas.

For the exotic leg, some scholars would allow the linkage of the Profit Rate of the Murabaha to be almost anything so long as it is determined as of the time of entering into the Murabaha. So range accruals (i.e., the profit rate is LIBOR + X accruing times the number of days LIBOR is in between LowerBound and UpperBound) and almost any exotic payoff can be used as a markup so long as it is set at the time the Murabaha is entered into.

It may even be possible to do away with the underlying purchases altogether, especially if they are buys and sells of the same underlying commodity with the same two counterparties, under the rule of set-offs. If so, the swap is very much a regular swap except that all cashflows must be fixed before a given Murabaha sale takes place (i.e., no 'in-arrears' style payments).

Notes:

This not a typical exotic swap and in this case the exotic leg has a delayed payment. The typical structure for a range accrual is to pay periodically (say every 3M) LIBOR(t)+X% times the number of days LIBOR(t) is between LowerBound and UpperBound, for t between 0 and 3M, with payment made at t=3M. In the above PRS version, t=3M is the first date that the coupon (or profit markup) is known with complete certainty and is then the date at which the Murabaha is entered into with payment of this markup at t=6M. This delay is nonstandard in the exotic world but is really only a small matter for traders, structurers, and clients.

Sh Yusuf DeLorenzo's objections to DB's "Shariah Conversion Technology" (see reference link) applies equally well to this structure. Can we asset swap Pork Bellies for LIBOR using Murabahas and make it all seem Shariah Compliant?

Possibly countering Sh DeLorenzo's objections, it should be possible to use a PRS as long as hedging the underlying cashflows is entirely halal. So, one could do cross curency swaps easily, do fixed for floating, but applying the same principle to various more exotic structures become significantly more challenging. One could see the application of maslaha or public interest in the permissibility of fixed for floating or cross-currency swaps, but then again we could have those with knock-out double-touch Asian Himalaya payoffs (I just made up a term, but used quite a few in common exotics parlance). Do they really help the common good?

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