One of the Islamic hedging tools used by Islamic Banks nowadays is the Islamic Profit Rate Swap (IPRS). There are many efforts by the industry to make available an Islamic hedging mechanism. The mechanism is generally still referenced to the conventional swap rate of KLIBOR. In Malaysia, where a lot of IPRS transactions have been generated, the Islamic Derivative Master Agreement (IDMA) is being used to facilitate the swap. However there have been concerted efforts by several international Islamic Money Market associations to standardise the documentation and mechanism required for the development of a viable hedging mechanism, including the IPRS.
IPRS is an agreement that allows two parties to exchange a series of profit payments in a single currency in exchange for another series of payments in the same currency. For example, it allows for the exchange of profit rate cash flows between a fixed rate party and a floating rate party or vice-versa. The exchanges are based on an agreed notional (the principal) amount for a pre-determined swap period.
The concept and structure of IPRS is based on Bai’ Inah as the main underlying concept. There are a total of three Shariah concepts applicable to IPRS:-
(i) Wa’ad: A unilateral promise by each party to (1) undertake a series of Bai’ Inah transactions on the effective date and each reset date for the life of the transaction; (2) enter into an asset sale and purchase transaction for the early termination amount in the event the transaction is terminated prior to maturity.
(ii) Bai’ Inah: Contract of sale and purchase of an asset whereby the seller sells to buyer in cash and subsequently buys back the asset at a marked up deferred price. (Note : Some Banks use Tawarruq / Commodity Murabahah as the alternative to Bai Inah. See below)
(iii) Muqassah: Netting off payment in the cash flow (1) notional amount and/or (2) party with higher price is expected to pay the difference to the other party.
Mudharabah Islamic Interbank (“MII”) is the main underlying asset to facilitate Bai’ Inah contracts under IPRS.
Another alternative contract for IPRS is Tawarruq Murabaha (buy and sell of commodities). The contract is similar to Bai Inah structure except for the underlying assets i.e. actual commodities will be used for the transaction instead of MII. In such structure, the Bai Inah portion is replace by a Murabaha, either as a Tawarruq structure (3 party transaction) or a Commodity Murabaha structure (Broker A + Broker B i.e. 4 party transaction). A Murabaha based structure will make the IPRS more acceptable to the middle-eastern counterparts, which rejects the contract of Bai Inah.
The IPRS transaction process will involve 2 stages:-
Stage 1: Sale and Purchase of MII to establish Fixed Profit rate (occurs once throughout the tenure of the IPRS i.e. on the effective date of the IPRS).
- Bank undertakes to sell the asset (MII) to its customer at RM100 million plus fixed profit rate payable every quarter (4.20% per annum).
- Customer undertakes to sell back the asset (MII) to Bank at RM100 million.
# Sale and purchase of the asset (MII) between Bank and customer will be made on effective date, and fixed profit rate will be payable on quarterly basis.
Stage 2: Sale and Purchase of MII to establish Floating Profit Rate (take effect on every periodic or Payment Date i.e. the first day of each profit period until maturity).
3. Bank undertakes to sell the asset (MII) to customer at RM100 million.
4. Customer undertakes to sell back the asset (MII) to customer at RM100 million plus 3-months KLIBOR.
# Sale and purchase of the asset (MII) between Bank and customer will be made on effective date and each profit payment date. The floating profit rate will be payable on quarterly basis.
At every reset date, Bai’ Inah transactions will take place and only net amounts will be settled. In this case, Bank will pay floating rate and receive fixed rate on each payment date until maturity. The fixed rate amount will be compared with the floating rate amount on each payment date:-
- If the floating amount is above the fixed rate amount, Bank will pay customer the differences; or
- If the floating rate amount is below fixed rate amount, customer will pay Bank the differences.