Hedging profit rate risk through swaps

Market risk is defined as the possibility of incurring loss due to movements in the exchange rate, commodity price, profit/interest rate, equity price and such. In this article, VENKATESH RAMAKRISHNA focuses on the profit rate risk for both asset and liability holders.

Let us take the example of an Islamic bank, Bank ABC, issuing a Sukuk facility for 10 years at a fixed coupon rate of say 6%. The bank will incur this cost at this rate for the next 10 years irrespective of changes in market rates. The bank will benefit if the rates rise further. However, if the rates decline, the bank will not be able to take advantage of this decline.

Additional risk comes in the form of the bank’s asset book, which will generally be priced be on a floating basis. If the market rates decline, bank continues to incur costs at a fixed rate, while its revenues continue to fall. This is called ‘profit rate risk’ in the bank’s books.

Corporates are also exposed to profit rate risk on account of market movements. For example, if a corporate has availed a financing facility linked to a floating rate, it runs the risk of the benchmark rate rising over the tenor of this facility.

How can the banks and corporates manage this risk? With limited opportunities available to undertake forward transactions due to Shariah-related restrictions, Islamic banks can hedge this risk through profit rate swaps (PRSs) and provide a hedging facility to their corporate clients.

How does a PRS work?

A PRS is a contract between two counterparties to exchange cash flows at regular intervals, say, every six months. The most popularly traded PRSs involve the exchange of fixed rate cash flows against floating rates such as the six-month LIBOR. Other variants include floating against floating where two different benchmarks are used such as the LIBOR against T-bills.

Although this holds good for conventional banks, Islamic banks are required to structure the transactions to comply with Shariah guidelines. The following are the popular PRS structures used in the Islamic finance industry:

Murabahah-based PRSs, and
• Waad-based PRSs.

Murabahah-based PRSs are explained briefly in the following paragraphs. To simplify the subject, only a fixed rate against a floating rate PRS is covered here.

Murabahah-based PRSs

This transaction involves two counterparties (two banks or one bank and one corporate), that agree to exchange cash flows at predetermined intervals on a notional principal amount. In the case of a fixed rate against a floating rate PRS, one party’s cash flows will be at a fixed rate, while those of the other counterparty will be linked to a benchmark.

In the aforementioned example of Islamic bank Bank ABC issuing Sukuk at a fixed coupon rate of 6% per annum, it can hedge the profit rate risk as follows:
• Bank ABC receives cash flows at a fixed rate of 3.25% per annum (ongoing 10-year swap rate) from the counterparty.
• Bank ABC pays cash flows linked to a benchmark (say six-month LIBOR) to the counterparty.

PRS methodology

Each set of PRS transactions involves two legs, namely spot leg and forward leg. In the instant case, forward leg is dated six months from the spot leg.

In the spot leg:
• Bank ABC buys Shariah compliant commodities worth US$500 million from the counterparty.
• Bank ABC sells Shariah compliant commodities worth US$500 million to the counterparty.

(Since the amount payable and amount receivable are equal, cash flows are generally netted off.)

In the forward leg:
• Bank ABC sells Shariah compliant commodities worth US$500 million at a mark-up of US$8,260,416.67 to the counterparty (the bank receives a fixed 3.25%)
(US$500 million X 183 X 3.25%)/360 = US$8,260,416.67
• Bank ABC buys Shariah compliant commodities worth US$500 million at a mark-up of US$6,608,333.33 (the bank pays six-month USD LIBOR 2.6%)
(US$500 million X 183 X 2.6%)/360 = US$6,608,333.33

(In practice, these payments are netted off and the bank receives a net amount of US$1,652,083.34 from the counterparty.)

For the next cycle of six months, the six-month LIBOR fixed by ICE at the end of six months is used for the calculation of the floating cash flow, while the methodology for the calculation of the fixed cash flow will remain the same. This process is repeated every six months for 19 times to cover a 10-year swap period.

Documentation

Needless to say, Islamic financial transactions cannot take place without proper agreements in place. PRSs involve the execution of the following documents between counterparties:
• Master swap agreement
• Asset purchase agreement-fixed
• Asset purchase agreement-floating
• Asset sale agreement-fixed, and
• Asset sale agreement-floating.

Conclusion

Market rates move not in a straight line, but with a lot of fluctuation. Hence, selecting a suitable time of execution of a PRS is a challenge for every market participant.

Issuers of fixed income securities like Sukuk and long-term borrowers generally enter into PRSs at the time of issuance/borrowing.

Venkatesh Ramakrishna is the head of Islamic treasury at the National Bank of Oman. He can be contacted at [email protected]