Lattice model (finance)

Binomial Lattice with CRR formulae

In finance, a lattice model[1] is a technique applied to the valuation of derivatives, where a discrete time model is required. For equity options, a typical example would be pricing an American option, where a decision as to option exercise is required at “all” times (any time) before and including maturity. A continuous model, on the other hand, such as Black–Scholes, would only allow for the valuation of European options, where exercise is on the option’s maturity date. For interest rate derivatives lattices are additionally useful in that they address many of the issues encountered with continuous models, such as pull to par.[2] The method is also used for valuing certain exotic options, where because of path dependence in the payoff, Monte Carlo methods for option pricing fail to account for optimal decisions to terminate the derivative by early exercise,[3] though methods now exist for solving this problem. Continue reading “Lattice model (finance)”

Asset pricing

Asset pricing models
Regime
Asset class
Equilibrium
pricing
Risk neutral
pricing
Equities(and foreign exchange and commodities; interest rates for risk neutral pricing)
  • Capital asset pricing model
  • Consumption-based CAPM
  • Intertemporal CAPM
  • Single-index model
  • Multiple factor models
    • Fama–French three-factor model
    • Carhart four-factor model
  • Arbitrage pricing theory
  • Black–Scholes
  • Black
  • Garman–Kohlhagen
  • Heston
  • CEV
  • SABR
Bonds, other interest rate instruments
  • Vasicek
  • Rendleman–Bartter
  • Cox–Ingersoll–Ross
  • Ho–Lee
  • Hull–White
  • Black–Derman–Toy
  • Black–Karasinski
  • Kalotay–Williams–Fabozzi
  • Longstaff–Schwartz
  • Chen
  • Rendleman–Bartter
  • Heath–Jarrow–Morton
    • Cheyette
  • Brace–Gatarek–Musiela
  • LIBOR market model
This article is theory focused: for the corporate finance usage see Valuation (finance); for the valuation of derivatives and interest rate / fixed income instruments see Mathematical finance.

In financial economics, asset pricing refers to a formal treatment and development of two main pricing principles,[1] outlined below, together with the resultant models. There have been many models developed for different situations, but correspondingly, these stem from general equilibrium asset pricing or rational asset pricing,[2] the latter corresponding to risk neutral pricing. Continue reading “Asset pricing”

Interest rate swap

In finance, an interest rate swap (IRS) is an interest rate derivative (IRD). It involves exchange of interest rates between two parties. In particular it is a “linear” IRD and one of the most liquid, benchmark products. It has associations with forward rate agreements (FRAs), and with zero coupon swaps (ZCSs).

In its December 2014 statistics release, the Bank for International Settlements reported that interest rate swaps were the largest component of the global OTC derivative market, representing 60%, with the notional amount outstanding in OTC interest rate swaps of $381 trillion, and the gross market value of $14 trillion.[1]

Interest rate swaps can be traded as an index through the FTSE MTIRS Index.

Interest rate swaps

General description

Graphical depiction of IRS cashflows between two counterparties based on a notional amount of EUR100mm for a single (i’th) period exchange, where the floating index {\displaystyle r_{i}} will typically be an -IBOR index.

An interest rate swap’s (IRS’s) effective description is a derivative contract, agreed between two counterparties, which specifies the nature of an exchange of payments benchmarked against an interest rate index. The most common IRS is a fixed for floating swap, whereby one party will make payments to the other based on an initially agreed fixed rate of interest, to receive back payments based on a floating interest rate index. Each of these series of payments is termed a “leg”, so a typical IRS has both a fixed and a floating leg. The floating index is commonly an interbank offered rate (IBOR) of specific tenor in the appropriate currency of the IRS, for example LIBOR in GBP, EURIBOR in EUR, or STIBOR in SEK.

To completely determine any IRS a number of parameters must be specified for each leg: [2]

  • the notional principal amount (or varying notional schedule);
  • the start and end dates, value-, trade- and settlement dates, and date scheduling (date rolling);
  • the fixed rate (i.e. “swap rate”, sometimes quoted as a “swap spread” over a benchmark);
  • the chosen floating interest rate index tenor;
  • the day count conventions for interest calculations.

Each currency has its own standard market conventions regarding the frequency of payments, the day count conventions and the end-of-month rule.[3]

Extended description

There are several types of IRS, typically:
  • “Vanilla” fixed for floating
  • Basis swap
  • Cross currency basis swaps
  • Amortising swap
  • Zero coupon swap
  • Constant maturity swap
  • Overnight indexed swap

As OTC instruments, interest rate swaps (IRSs) can be customised in a number of ways and can be structured to meet the specific needs of the counterparties. For example: payment dates could be irregular, the notional of the swap could be amortized over time, reset dates (or fixing dates) of the floating rate could be irregular, mandatory break clauses may be inserted into the contract, etc. A common form of customisation is often present in new issue swaps where the fixed leg cashflows are designed to replicate those cashflows received as the coupons on a purchased bond. The interbank market, however, only has a few standardised types.

There is no consensus on the scope of naming convention for different types of IRS. Even a wide description of IRS contracts only includes those whose legs are denominated in the same currency. It is generally accepted that swaps of similar nature whose legs are denominated in different currencies are called cross currency basis swaps. Swaps which are determined on a floating rate index in one currency but whose payments are denominated in another currency are called Quantos.

In traditional interest rate derivative terminology an IRS is a fixed leg versus floating leg derivative contract referencing an IBOR as the floating leg. If the floating leg is redefined to be an overnight index, such as EONIA, SONIA, FFOIS, etc. then this type of swap is generally referred to as an overnight indexed swap (OIS). Some financial literature may classify OISs as a subset of IRSs and other literature may recognise a distinct separation.

Fixed leg versus fixed leg swaps are rare, and generally constitute a form of specialised loan agreement.

Float leg versus float leg swaps are much more common. These are typically termed (single currency) basis swaps (SBSs). The legs on SBSs will necessarily be different interest indexes, such as 1M, LIBOR, 3M LIBOR, 6M LIBOR, SONIA, etc. The pricing of these swaps requires a spread often quoted in basis points to be added to one of the floating legs in order to satisfy value equivalence.

Uses

Interest rate swaps are used to hedge against or speculate on changes in interest rates.

Interest rate swaps are also used speculatively by hedge funds or other investors who expect a change in interest rates or the relationships between them. Traditionally, fixed income investors who expected rates to fall would purchase cash bonds, whose value increased as rates fell. Today, investors with a similar view could enter a floating-for-fixed interest rate swap; as rates fall, investors would pay a lower floating rate in exchange for the same fixed rate.

Interest rate swaps are also popular for the arbitrage opportunities they provide. Varying levels of creditworthiness means that there is often a positive quality spread differential that allows both parties to benefit from an interest rate swap.

The interest rate swap market in USD is closely linked to the Eurodollar futures market which trades among others at the Chicago Mercantile Exchange.

Valuation and pricing

IRSs are bespoke financial products whose customisation can include changes to payment dates, notional changes (such as those in amortised IRSs), accrual period adjustment and calculation convention changes (such as a day count convention of 30/360E to ACT/360 or ACT/365).

A vanilla IRS is the term used for standardised IRSs. Typically these will have none of the above customisations, and instead exhibit constant notional throughout, implied payment and accrual dates and benchmark calculation conventions by currency.[2] A vanilla IRS is also characterised by one leg being ‘fixed’ and the second leg ‘floating’ referencing an -IBOR index. The net present value (PV) of a vanilla IRS can be computed by determining the PV of each fixed leg and floating leg separately and summing. For pricing a mid-market IRS the underlying principle is that the two legs must have the same value initially; see further under Rational pricing.

Calculating the fixed leg requires discounting all of the known cashflows by an appropriate discount factor:

{\displaystyle P_{\text{fixed}}=NR\sum _{i=1}^{n_{1}}d_{i}v_{i}}

where {\displaystyle N} is the notional, {\displaystyle R} is the fixed rate, {\displaystyle n_{1}} is the number of payments, {\displaystyle d_{i}} is the decimalised day count fraction of the accrual in the i’th period, and {\displaystyle v_{i}} is the discount factor associated with the payment date of the i’th period.

Calculating the floating leg is a similar process replacing the fixed rate with forecast index rates:

{\displaystyle P_{\text{float}}=N\sum _{j=1}^{n_{2}}r_{j}d_{j}v_{j}}

where {\displaystyle n_{2}} is the number of payments of the floating leg and {\displaystyle r_{j}} are the forecast -IBOR index rates of the appropriate currency.

The PV of the IRS from the perspective of receiving the fixed leg is then:

{\displaystyle P_{\text{IRS}}=P_{\text{fixed}}-P_{\text{float}}}

Historically IRSs were valued using discount factors derived from the same curve used to forecast the -IBOR rates. This has been called ‘self-discounted’. Some early literature described some incoherence introduced by that approach and multiple banks were using different techniques to reduce them. It became more apparent with the 2007–2012 global financial crisis that the approach was not appropriate, and alignment towards discount factors associated with physical collateral of the IRSs was needed.

Post crisis, to accommodate credit risk, the now-standard pricing approach is the multi-curve framework where forecast -IBOR rates and discount factors exhibit disparity. Note that the economic pricing principle is unchanged: leg values are still identical at initiation. See Financial economics § Derivative pricing for further context. Here, Overnight Index Swap (OIS) rates are typically used to derive discount factors, since that index is the standard inclusion on Credit Support Annexes (CSAs) to determine the rate of interest payable on collateral for IRS contracts. As regards the rates forecast, since the basis spread between LIBOR rates of different maturities widened during the crisis, forecast curves are generally constructed for each LIBOR tenor used in floating rate derivative legs.[4]

Regarding the curve build, see: [5] [6] [2] Under the old framework a single self discounted curve was “bootstrapped”, i.e. solved such that it exactly returned the observed prices of selected instruments – IRSs, with FRAs in the short end – with the build proceeding sequentially, date-wise, through these instruments. Under the new framework, the various curves are best fitted to observed market prices — as a “curve set” — one curve for discounting, one for each IBOR-tenor “forecast curve”, and the build is then based on quotes for IRSs and OISs. Here, since the observed average overnight rate is swapped for the -IBOR rate over the same period (the most liquid tenor in that market), and the -IBOR IRSs are in turn discounted on the OIS curve, the problem entails a nonlinear system, where all curve points are solved at once, and specialized iterative methods are usually employed — very often a modification of Newton’s method. Other tenor’s curves can be solved in a “second stage”, bootstrap-style.

Under both frameworks, the following apply. (i) Maturities for which rates are solved directly are referred to as “pillar points”, these correspond to the input instrument maturities; other rates are interpolated, often using Hermitic splines. (ii) The objective function: prices must be “exactly” returned, as described. (iii) The penalty function will weigh: that forward rates are positive (to be arbitrage free) and curve “smoothness”; both, in turn, a function of the interpolation method. [7] [8] [9] (iv) The initial estimate: usually, the most recently solved curve set. ((v) All that need be stored are the solved spot rates for the pillars, and the interpolation rule.)

A CSA could allow for collateral, and hence interest payments on that collateral, in any currency.[10] To address this banks include in their curve-set, a USD discount-curve — sometimes called the “basis-curve” — to be used for discounting local-IBOR trades with USD collateral. This curve is built by solving for observed (mark-to-market) cross-currency swap rates, where the local -IBOR is swapped for USD LIBOR with USD collateral as underpin; a pre-solved (external) USD LIBOR curve is therefore an input into the curve build (the basis-curve may be solved in the “third stage”). Each currency’s curve-set will then include a local-currency discount-curve and its USD discounting basis-curve. As required, a third-currency discount curve — i.e. for local trades collateralized in a currency other than local or USD (or any other combination) — can then be constructed from the local-currency basis-curve and third-currency basis-curve, combined via an arbitrage relationship known as “FX Forward Invariance”.[11]

The complexities of modern curvesets mean that there may not be discount factors available for a specific -IBOR index curve. These curves are known as ‘forecast only’ curves and only contain the information of a forecast -IBOR index rate for any future date. Some designs constructed with a discount based methodology mean forecast -IBOR index rates are implied by the discount factors inherent to that curve:

{\displaystyle r_{j}={\frac {1}{d_{j}}}\left({\frac {x_{j-1}}{x_{j}}}-1\right)} where {\displaystyle x_{i-1}} and {\displaystyle x_{i}} are the start and end discount factors associated with the relevant forward curve of a particular -IBOR index in a given currency.

To price the mid-market or par rate, {\displaystyle S} of an IRS (defined by the value of fixed rate {\displaystyle R} that gives a net PV of zero), the above formula is re-arranged to:

{\displaystyle S={\frac {\sum _{j=1}^{n_{2}}r_{j}d_{j}v_{j}}{\sum _{i=1}^{n_{1}}d_{i}v_{i}}}}

In the event old methodologies are applied the discount factors {\displaystyle v_{k}} can be replaced with the self discounted values {\displaystyle x_{k}} and the above reduces to:

{\displaystyle S={\frac {x_{0}-x_{n_{2}}}{\sum _{i=1}^{n_{1}}d_{i}x_{i}}}}

In both cases, the PV of a general swap can be expressed exactly with the following intuitive formula:

{\displaystyle P_{\text{IRS}}=N(R-S)A}

where {\displaystyle A} is the so-called Annuity factor {\displaystyle A=\sum _{i=1}^{n_{1}}d_{i}v_{i}} (or {\displaystyle A=\sum _{i=1}^{n_{1}}d_{i}x_{i}} for self-discounting). This shows that the PV of an IRS is roughly linear in the swap par rate (though small non-linearities arise from the co-dependency of the swap rate with the discount factors in the Annuity sum).

During the life of the swap the same valuation technique is used, but since, over time, both the discounting factors and the forward rates change, the PV of the swap will deviate from its initial value. Therefore, the swap will be an asset to one party and a liability to the other. The way these changes in value are reported is the subject of IAS 39 for jurisdictions following IFRS, and FAS 133 for U.S. GAAP. Swaps are marked to market by debt security traders to visualize their inventory at a certain time. As regards P&L Attribution, and hedging, the new framework adds complexity in that the trader’s position is now potentially affected by numerous instruments not obviously related to the trade in question.

Risks

Interest rate swaps expose users to many different types of financial risk.[2] Predominantly they expose the user to market risks and specifically interest rate risk. The value of an interest rate swap will change as market interest rates rise and fall. In market terminology this is often referred to as delta risk. Interest rate swaps also exhibit gamma risk whereby their delta risk increases or decreases as market interest rates fluctuate. (See Greeks (finance), Value at risk #Computation methods, Value at risk #VaR risk management. )

Other specific types of market risk that interest rate swaps have exposure to are basis risks – where various IBOR tenor indexes can deviate from one another – and reset risks – where the publication of specific tenor IBOR indexes are subject to daily fluctuation.

Uncollateralised interest rate swaps – those executed bilaterally without a CSA in place – expose the trading counterparties to funding risks and credit risks. Funding risks because the value of the swap might deviate to become so negative that it is unaffordable and cannot be funded. Credit risks because the respective counterparty, for whom the value of the swap is positive, will be concerned about the opposing counterparty defaulting on its obligations. Collateralised interest rate swaps, on the other hand, expose the users to collateral risks: here, depending upon the terms of the CSA, the type of posted collateral that is permitted might become more or less expensive due to other extraneous market movements.

Credit and funding risks still exist for collateralised trades but to a much lesser extent. Regardless, due to regulations set out in the Basel III Regulatory Frameworks, trading interest rate derivatives commands a capital usage. The consequence of this is that, dependent upon their specific nature, interest rate swaps might command more capital usage, and this can deviate with market movements. Thus capital risks are another concern for users.

Given these concerns, banks will typically calculate a credit valuation adjustment, as well as other x-valuation adjustments, which then incorporate these risks into the instrument value.

Reputation risks also exist. The mis-selling of swaps, over-exposure of municipalities to derivative contracts, and IBOR manipulation are examples of high-profile cases where trading interest rate swaps has led to a loss of reputation and fines by regulators.

Hedging interest rate swaps can be complicated and relies on numerical processes of well designed risk models to suggest reliable benchmark trades that mitigate all market risks; although, see the discussion above re hedging in a multi-curve environment. The other, aforementioned risks must be hedged using other systematic processes.

Quotation and Market-Making

ICE Swap Rate

ICE Swap rate[12] replaced the rate formerly known as ISDAFIX in 2015. Swap Rate benchmark rates are calculated using eligible prices and volumes for specified interest rate derivative products. The prices are provided by trading venues in accordance with a “Waterfall” Methodology. The first level of the Waterfall (“Level 1”) uses eligible, executable prices and volumes provided by regulated, electronic, trading venues. Multiple, randomised snapshots of market data are taken during a short window before calculation. This enhances the benchmark’s robustness and reliability by protecting against attempted manipulation and temporary aberrations in the underlying market.

Market-Making

The market-making of IRSs is an involved process involving multiple tasks; curve construction with reference to interbank markets, individual derivative contract pricing, risk management of credit, cash and capital. The cross disciplines required include quantitative analysis and mathematical expertise, disciplined and organized approach towards profits and losses, and coherent psychological and subjective assessment of financial market information and price-taker analysis. The time sensitive nature of markets also creates a pressurized environment. Many tools and techniques have been designed to improve efficiency of market-making in a drive to efficiency and consistency.[2]

Controversy

In June 1988 the Audit Commission was tipped off by someone working on the swaps desk of Goldman Sachs that the London Borough of Hammersmith and Fulham had a massive exposure to interest rate swaps. When the commission contacted the council, the chief executive told them not to worry as “everybody knows that interest rates are going to fall”; the treasurer thought the interest rate swaps were a “nice little earner”. The Commission’s Controller, Howard Davies, realised that the council had put all of its positions on interest rates going down and ordered an investigation.

By January 1989 the Commission obtained legal opinions from two Queen’s Counsel. Although they did not agree, the commission preferred the opinion that it was ultra vires for councils to engage in interest rate swaps (ie. that they had no lawful power to do so). Moreover, interest rates had increased from 8% to 15%. The auditor and the commission then went to court and had the contracts declared void (appeals all the way up to the House of Lords failed in Hazell v Hammersmith and Fulham LBC); the five banks involved lost millions of pounds. Many other local authorities had been engaging in interest rate swaps in the 1980s.[13] This resulted in several cases in which the banks generally lost their claims for compound interest on debts to councils, finalised in Westdeutsche Landesbank Girozentrale v Islington London Borough Council.[14] Banks did, however, recover some funds where the derivatives were “in the money” for the Councils (ie, an asset showing a profit for the council, which it now had to return to the bank, not a debt)

The controversy surrounding interest rate swaps reached a peak in the UK during the financial crisis where banks sold unsuitable interest rate hedging products on a large scale to SMEs. The practice has been widely criticised[15] by the media and Parliament.

See also

  • Swap rate
  • Interest rate cap and floor
  • Equity swap
  • Total return swap
  • Inflation derivative
  • Eurodollar
  • Constant maturity swap
  • FTSE MTIRS Index

Further reading

General:

  • Leif B.G. Andersen, Vladimir V. Piterbarg (2010). Interest Rate Modeling in Three Volumes (1st ed. 2010 ed.). Atlantic Financial Press. ISBN 978-0-9844221-0-4. Archived from the original on 2011-02-08.
  • J H M Darbyshire (2017). Pricing and Trading Interest Rate Derivatives (2nd ed. 2017 ed.). Aitch and Dee Ltd. ISBN 978-0995455528.
  • Richard Flavell (2010). Swaps and other derivatives (2nd ed.) Wiley. ISBN 047072191X
  • Miron P. & Swannell P. (1991). Pricing and Hedging Swaps, Euromoney books

Early literature on the incoherence of the one curve pricing approach:

  • Boenkost W. and Schmidt W. (2004). Cross Currency Swap Valuation, Working Paper 2, HfB – Business School of Finance & Management SSRN preprint.
  • Henrard M. (2007). The Irony in the Derivatives Discounting, Wilmott Magazine, pp. 92–98, July 2007. SSRN preprint.
  • Tuckman B. and Porfirio P. (2003). Interest Rate Parity, Money Market Basis Swaps and Cross-Currency Basis Swaps, Fixed income liquid markets research, Lehman Brothers

Multi-curves framework:

  • Bianchetti M. (2010). Two Curves, One Price: Pricing & Hedging Interest Rate Derivatives Decoupling Forwarding and Discounting Yield Curves, Risk Magazine, August 2010. SSRN preprint.
  • Henrard M. (2010). The Irony in the Derivatives Discounting Part II: The Crisis, Wilmott Journal, Vol. 2, pp. 301–316, 2010. SSRN preprint.
  • Henrard M. (2014) Interest Rate Modelling in the Multi-curve Framework: Foundations, Evolution, and Implementation. Palgrave Macmillan. Applied Quantitative Finance series. June 2014. ISBN 978-1-137-37465-3.
  • Kijima M., Tanaka K., and Wong T. (2009). A Multi-Quality Model of Interest Rates, Quantitative Finance, pages 133-145, 2009.

References

  1. ^ “OTC derivatives statistics at end-December 2014” (PDF). Bank for International Settlements.
  2. Jump up to:a b c d e Pricing and Trading Interest Rate Derivatives: A Practical Guide to Swaps, J H M Darbyshire, 2017, ISBN 978-0995455528
  3. ^ “Interest Rate Instruments and Market Conventions Guide” Quantitative Research, OpenGamma, 2012.
  4. ^ Multi-Curve Valuation Approaches and their Application to Hedge Accounting according to IAS 39, Dr. Dirk Schubert, KPMG
  5. ^ M. Henrard (2014). Interest Rate Modelling in the Multi-Curve Framework: Foundations, Evolution and Implementation. Palgrave Macmillan ISBN 978-1137374653
  6. ^ See section 3 of Marco Bianchetti and Mattia Carlicchi (2012). Interest Rates after The Credit Crunch: Multiple-Curve Vanilla Derivatives and SABR
  7. ^ P. Hagan and G. West (2006). Interpolation methods for curve construction. Applied Mathematical Finance, 13 (2):89—129, 2006.
  8. ^ P. Hagan and G. West (2008). Methods for Constructing a Yield Curve. Wilmott Magazine, May, 70-81.
  9. ^ P du Preez and E Maré (2013). Interpolating Yield Curve Data in a Manner That Ensures Positive and Continuous Forward Curves.SAJEMS 16 (2013) No 4:395-406
  10. ^ Fujii, Masaaki Fujii; Yasufumi Shimada; Akihiko Takahashi (26 January 2010). “A Note on Construction of Multiple Swap Curves with and without Collateral”. CARF Working Paper Series No. CARF-F-154. SSRN 1440633.
  11. ^ Burgess, Nicholas (2017). FX Forward Invariance & Discounting with CSA Collateral
  12. ^ ICE Swap Rate. [1]
  13. ^ Duncan Campbell-Smith, “Follow the Money: The Audit Commission, Public Money, and the Management of Public Services 1983-2008”, Allen Lane, 2008, chapter 6 passim.
  14. ^ [1996] UKHL 12, [1996] AC 669
  15. ^ “HM Parliament Condemns RBS GRG’s Parasitic Treatment of SMEs Post date”.

Interest rate swap

In finance, an interest rate swap (IRS) is an interest rate derivative (IRD). It involves exchange of interest rates between two parties. In particular it is a “linear” IRD and one of the most liquid, benchmark products. It has associations with forward rate agreements (FRAs), and with zero coupon swaps (ZCSs).

In its December 2014 statistics release, the Bank for International Settlements reported that interest rate swaps were the largest component of the global OTC derivative market, representing 60%, with the notional amount outstanding in OTC interest rate swaps of $381 trillion, and the gross market value of $14 trillion.[1]

Interest rate swaps can be traded as an index through the FTSE MTIRS Index.

Interest rate swaps

General description

Graphical depiction of IRS cashflows between two counterparties based on a notional amount of EUR100mm for a single (i’th) period exchange, where the floating index {\displaystyle r_{i}} will typically be an -IBOR index.

An interest rate swap’s (IRS’s) effective description is a derivative contract, agreed between two counterparties, which specifies the nature of an exchange of payments benchmarked against an interest rate index. The most common IRS is a fixed for floating swap, whereby one party will make payments to the other based on an initially agreed fixed rate of interest, to receive back payments based on a floating interest rate index. Each of these series of payments is termed a “leg”, so a typical IRS has both a fixed and a floating leg. The floating index is commonly an interbank offered rate (IBOR) of specific tenor in the appropriate currency of the IRS, for example LIBOR in GBP, EURIBOR in EUR, or STIBOR in SEK.

To completely determine any IRS a number of parameters must be specified for each leg: [2]

  • the notional principal amount (or varying notional schedule);
  • the start and end dates, value-, trade- and settlement dates, and date scheduling (date rolling);
  • the fixed rate (i.e. “swap rate”, sometimes quoted as a “swap spread” over a benchmark);
  • the chosen floating interest rate index tenor;
  • the day count conventions for interest calculations.

Each currency has its own standard market conventions regarding the frequency of payments, the day count conventions and the end-of-month rule.[3]

Extended description

There are several types of IRS, typically:
  • “Vanilla” fixed for floating
  • Basis swap
  • Cross currency basis swaps
  • Amortising swap
  • Zero coupon swap
  • Constant maturity swap
  • Overnight indexed swap

As OTC instruments, interest rate swaps (IRSs) can be customised in a number of ways and can be structured to meet the specific needs of the counterparties. For example: payment dates could be irregular, the notional of the swap could be amortized over time, reset dates (or fixing dates) of the floating rate could be irregular, mandatory break clauses may be inserted into the contract, etc. A common form of customisation is often present in new issue swaps where the fixed leg cashflows are designed to replicate those cashflows received as the coupons on a purchased bond. The interbank market, however, only has a few standardised types.

There is no consensus on the scope of naming convention for different types of IRS. Even a wide description of IRS contracts only includes those whose legs are denominated in the same currency. It is generally accepted that swaps of similar nature whose legs are denominated in different currencies are called cross currency basis swaps. Swaps which are determined on a floating rate index in one currency but whose payments are denominated in another currency are called Quantos.

In traditional interest rate derivative terminology an IRS is a fixed leg versus floating leg derivative contract referencing an IBOR as the floating leg. If the floating leg is redefined to be an overnight index, such as EONIA, SONIA, FFOIS, etc. then this type of swap is generally referred to as an overnight indexed swap (OIS). Some financial literature may classify OISs as a subset of IRSs and other literature may recognise a distinct separation.

Fixed leg versus fixed leg swaps are rare, and generally constitute a form of specialised loan agreement.

Float leg versus float leg swaps are much more common. These are typically termed (single currency) basis swaps (SBSs). The legs on SBSs will necessarily be different interest indexes, such as 1M, LIBOR, 3M LIBOR, 6M LIBOR, SONIA, etc. The pricing of these swaps requires a spread often quoted in basis points to be added to one of the floating legs in order to satisfy value equivalence.

Uses

Interest rate swaps are used to hedge against or speculate on changes in interest rates.

Interest rate swaps are also used speculatively by hedge funds or other investors who expect a change in interest rates or the relationships between them. Traditionally, fixed income investors who expected rates to fall would purchase cash bonds, whose value increased as rates fell. Today, investors with a similar view could enter a floating-for-fixed interest rate swap; as rates fall, investors would pay a lower floating rate in exchange for the same fixed rate.

Interest rate swaps are also popular for the arbitrage opportunities they provide. Varying levels of creditworthiness means that there is often a positive quality spread differential that allows both parties to benefit from an interest rate swap.

The interest rate swap market in USD is closely linked to the Eurodollar futures market which trades among others at the Chicago Mercantile Exchange.

Valuation and pricing

IRSs are bespoke financial products whose customisation can include changes to payment dates, notional changes (such as those in amortised IRSs), accrual period adjustment and calculation convention changes (such as a day count convention of 30/360E to ACT/360 or ACT/365).

A vanilla IRS is the term used for standardised IRSs. Typically these will have none of the above customisations, and instead exhibit constant notional throughout, implied payment and accrual dates and benchmark calculation conventions by currency.[2] A vanilla IRS is also characterised by one leg being ‘fixed’ and the second leg ‘floating’ referencing an -IBOR index. The net present value (PV) of a vanilla IRS can be computed by determining the PV of each fixed leg and floating leg separately and summing. For pricing a mid-market IRS the underlying principle is that the two legs must have the same value initially; see further under Rational pricing.

Calculating the fixed leg requires discounting all of the known cashflows by an appropriate discount factor:

{\displaystyle P_{\text{fixed}}=NR\sum _{i=1}^{n_{1}}d_{i}v_{i}}

where {\displaystyle N} is the notional, {\displaystyle R} is the fixed rate, {\displaystyle n_{1}} is the number of payments, {\displaystyle d_{i}} is the decimalised day count fraction of the accrual in the i’th period, and {\displaystyle v_{i}} is the discount factor associated with the payment date of the i’th period.

Calculating the floating leg is a similar process replacing the fixed rate with forecast index rates:

{\displaystyle P_{\text{float}}=N\sum _{j=1}^{n_{2}}r_{j}d_{j}v_{j}}

where {\displaystyle n_{2}} is the number of payments of the floating leg and {\displaystyle r_{j}} are the forecast -IBOR index rates of the appropriate currency.

The PV of the IRS from the perspective of receiving the fixed leg is then:

{\displaystyle P_{\text{IRS}}=P_{\text{fixed}}-P_{\text{float}}}

Historically IRSs were valued using discount factors derived from the same curve used to forecast the -IBOR rates. This has been called ‘self-discounted’. Some early literature described some incoherence introduced by that approach and multiple banks were using different techniques to reduce them. It became more apparent with the 2007–2012 global financial crisis that the approach was not appropriate, and alignment towards discount factors associated with physical collateral of the IRSs was needed.

Post crisis, to accommodate credit risk, the now-standard pricing approach is the multi-curve framework where forecast -IBOR rates and discount factors exhibit disparity. Note that the economic pricing principle is unchanged: leg values are still identical at initiation. See Financial economics § Derivative pricing for further context. Here, Overnight Index Swap (OIS) rates are typically used to derive discount factors, since that index is the standard inclusion on Credit Support Annexes (CSAs) to determine the rate of interest payable on collateral for IRS contracts. As regards the rates forecast, since the basis spread between LIBOR rates of different maturities widened during the crisis, forecast curves are generally constructed for each LIBOR tenor used in floating rate derivative legs.[4]

Regarding the curve build, see: [5] [6] [2] Under the old framework a single self discounted curve was “bootstrapped”, i.e. solved such that it exactly returned the observed prices of selected instruments – IRSs, with FRAs in the short end – with the build proceeding sequentially, date-wise, through these instruments. Under the new framework, the various curves are best fitted to observed market prices — as a “curve set” — one curve for discounting, one for each IBOR-tenor “forecast curve”, and the build is then based on quotes for IRSs and OISs. Here, since the observed average overnight rate is swapped for the -IBOR rate over the same period (the most liquid tenor in that market), and the -IBOR IRSs are in turn discounted on the OIS curve, the problem entails a nonlinear system, where all curve points are solved at once, and specialized iterative methods are usually employed — very often a modification of Newton’s method. Other tenor’s curves can be solved in a “second stage”, bootstrap-style.

Under both frameworks, the following apply. (i) Maturities for which rates are solved directly are referred to as “pillar points”, these correspond to the input instrument maturities; other rates are interpolated, often using Hermitic splines. (ii) The objective function: prices must be “exactly” returned, as described. (iii) The penalty function will weigh: that forward rates are positive (to be arbitrage free) and curve “smoothness”; both, in turn, a function of the interpolation method. [7] [8] [9] (iv) The initial estimate: usually, the most recently solved curve set. ((v) All that need be stored are the solved spot rates for the pillars, and the interpolation rule.)

A CSA could allow for collateral, and hence interest payments on that collateral, in any currency.[10] To address this banks include in their curve-set, a USD discount-curve — sometimes called the “basis-curve” — to be used for discounting local-IBOR trades with USD collateral. This curve is built by solving for observed (mark-to-market) cross-currency swap rates, where the local -IBOR is swapped for USD LIBOR with USD collateral as underpin; a pre-solved (external) USD LIBOR curve is therefore an input into the curve build (the basis-curve may be solved in the “third stage”). Each currency’s curve-set will then include a local-currency discount-curve and its USD discounting basis-curve. As required, a third-currency discount curve — i.e. for local trades collateralized in a currency other than local or USD (or any other combination) — can then be constructed from the local-currency basis-curve and third-currency basis-curve, combined via an arbitrage relationship known as “FX Forward Invariance”.[11]

The complexities of modern curvesets mean that there may not be discount factors available for a specific -IBOR index curve. These curves are known as ‘forecast only’ curves and only contain the information of a forecast -IBOR index rate for any future date. Some designs constructed with a discount based methodology mean forecast -IBOR index rates are implied by the discount factors inherent to that curve:

{\displaystyle r_{j}={\frac {1}{d_{j}}}\left({\frac {x_{j-1}}{x_{j}}}-1\right)} where {\displaystyle x_{i-1}} and {\displaystyle x_{i}} are the start and end discount factors associated with the relevant forward curve of a particular -IBOR index in a given currency.

To price the mid-market or par rate, {\displaystyle S} of an IRS (defined by the value of fixed rate {\displaystyle R} that gives a net PV of zero), the above formula is re-arranged to:

{\displaystyle S={\frac {\sum _{j=1}^{n_{2}}r_{j}d_{j}v_{j}}{\sum _{i=1}^{n_{1}}d_{i}v_{i}}}}

In the event old methodologies are applied the discount factors {\displaystyle v_{k}} can be replaced with the self discounted values {\displaystyle x_{k}} and the above reduces to:

{\displaystyle S={\frac {x_{0}-x_{n_{2}}}{\sum _{i=1}^{n_{1}}d_{i}x_{i}}}}

In both cases, the PV of a general swap can be expressed exactly with the following intuitive formula:

{\displaystyle P_{\text{IRS}}=N(R-S)A}

where {\displaystyle A} is the so-called Annuity factor {\displaystyle A=\sum _{i=1}^{n_{1}}d_{i}v_{i}} (or {\displaystyle A=\sum _{i=1}^{n_{1}}d_{i}x_{i}} for self-discounting). This shows that the PV of an IRS is roughly linear in the swap par rate (though small non-linearities arise from the co-dependency of the swap rate with the discount factors in the Annuity sum).

During the life of the swap the same valuation technique is used, but since, over time, both the discounting factors and the forward rates change, the PV of the swap will deviate from its initial value. Therefore, the swap will be an asset to one party and a liability to the other. The way these changes in value are reported is the subject of IAS 39 for jurisdictions following IFRS, and FAS 133 for U.S. GAAP. Swaps are marked to market by debt security traders to visualize their inventory at a certain time. As regards P&L Attribution, and hedging, the new framework adds complexity in that the trader’s position is now potentially affected by numerous instruments not obviously related to the trade in question.

Risks

Interest rate swaps expose users to many different types of financial risk.[2] Predominantly they expose the user to market risks and specifically interest rate risk. The value of an interest rate swap will change as market interest rates rise and fall. In market terminology this is often referred to as delta risk. Interest rate swaps also exhibit gamma risk whereby their delta risk increases or decreases as market interest rates fluctuate. (See Greeks (finance), Value at risk #Computation methods, Value at risk #VaR risk management. )

Other specific types of market risk that interest rate swaps have exposure to are basis risks – where various IBOR tenor indexes can deviate from one another – and reset risks – where the publication of specific tenor IBOR indexes are subject to daily fluctuation.

Uncollateralised interest rate swaps – those executed bilaterally without a CSA in place – expose the trading counterparties to funding risks and credit risks. Funding risks because the value of the swap might deviate to become so negative that it is unaffordable and cannot be funded. Credit risks because the respective counterparty, for whom the value of the swap is positive, will be concerned about the opposing counterparty defaulting on its obligations. Collateralised interest rate swaps, on the other hand, expose the users to collateral risks: here, depending upon the terms of the CSA, the type of posted collateral that is permitted might become more or less expensive due to other extraneous market movements.

Credit and funding risks still exist for collateralised trades but to a much lesser extent. Regardless, due to regulations set out in the Basel III Regulatory Frameworks, trading interest rate derivatives commands a capital usage. The consequence of this is that, dependent upon their specific nature, interest rate swaps might command more capital usage, and this can deviate with market movements. Thus capital risks are another concern for users.

Given these concerns, banks will typically calculate a credit valuation adjustment, as well as other x-valuation adjustments, which then incorporate these risks into the instrument value.

Reputation risks also exist. The mis-selling of swaps, over-exposure of municipalities to derivative contracts, and IBOR manipulation are examples of high-profile cases where trading interest rate swaps has led to a loss of reputation and fines by regulators.

Hedging interest rate swaps can be complicated and relies on numerical processes of well designed risk models to suggest reliable benchmark trades that mitigate all market risks; although, see the discussion above re hedging in a multi-curve environment. The other, aforementioned risks must be hedged using other systematic processes.

Quotation and Market-Making

ICE Swap Rate

ICE Swap rate[12] replaced the rate formerly known as ISDAFIX in 2015. Swap Rate benchmark rates are calculated using eligible prices and volumes for specified interest rate derivative products. The prices are provided by trading venues in accordance with a “Waterfall” Methodology. The first level of the Waterfall (“Level 1”) uses eligible, executable prices and volumes provided by regulated, electronic, trading venues. Multiple, randomised snapshots of market data are taken during a short window before calculation. This enhances the benchmark’s robustness and reliability by protecting against attempted manipulation and temporary aberrations in the underlying market.

Market-Making

The market-making of IRSs is an involved process involving multiple tasks; curve construction with reference to interbank markets, individual derivative contract pricing, risk management of credit, cash and capital. The cross disciplines required include quantitative analysis and mathematical expertise, disciplined and organized approach towards profits and losses, and coherent psychological and subjective assessment of financial market information and price-taker analysis. The time sensitive nature of markets also creates a pressurized environment. Many tools and techniques have been designed to improve efficiency of market-making in a drive to efficiency and consistency.[2]

Controversy

In June 1988 the Audit Commission was tipped off by someone working on the swaps desk of Goldman Sachs that the London Borough of Hammersmith and Fulham had a massive exposure to interest rate swaps. When the commission contacted the council, the chief executive told them not to worry as “everybody knows that interest rates are going to fall”; the treasurer thought the interest rate swaps were a “nice little earner”. The Commission’s Controller, Howard Davies, realised that the council had put all of its positions on interest rates going down and ordered an investigation.

By January 1989 the Commission obtained legal opinions from two Queen’s Counsel. Although they did not agree, the commission preferred the opinion that it was ultra vires for councils to engage in interest rate swaps (ie. that they had no lawful power to do so). Moreover, interest rates had increased from 8% to 15%. The auditor and the commission then went to court and had the contracts declared void (appeals all the way up to the House of Lords failed in Hazell v Hammersmith and Fulham LBC); the five banks involved lost millions of pounds. Many other local authorities had been engaging in interest rate swaps in the 1980s.[13] This resulted in several cases in which the banks generally lost their claims for compound interest on debts to councils, finalised in Westdeutsche Landesbank Girozentrale v Islington London Borough Council.[14] Banks did, however, recover some funds where the derivatives were “in the money” for the Councils (ie, an asset showing a profit for the council, which it now had to return to the bank, not a debt)

The controversy surrounding interest rate swaps reached a peak in the UK during the financial crisis where banks sold unsuitable interest rate hedging products on a large scale to SMEs. The practice has been widely criticised[15] by the media and Parliament.

See also

  • Swap rate
  • Interest rate cap and floor
  • Equity swap
  • Total return swap
  • Inflation derivative
  • Eurodollar
  • Constant maturity swap
  • FTSE MTIRS Index

Further reading

General:

  • Leif B.G. Andersen, Vladimir V. Piterbarg (2010). Interest Rate Modeling in Three Volumes (1st ed. 2010 ed.). Atlantic Financial Press. ISBN 978-0-9844221-0-4. Archived from the original on 2011-02-08.
  • J H M Darbyshire (2017). Pricing and Trading Interest Rate Derivatives (2nd ed. 2017 ed.). Aitch and Dee Ltd. ISBN 978-0995455528.
  • Richard Flavell (2010). Swaps and other derivatives (2nd ed.) Wiley. ISBN 047072191X
  • Miron P. & Swannell P. (1991). Pricing and Hedging Swaps, Euromoney books

Early literature on the incoherence of the one curve pricing approach:

  • Boenkost W. and Schmidt W. (2004). Cross Currency Swap Valuation, Working Paper 2, HfB – Business School of Finance & Management SSRN preprint.
  • Henrard M. (2007). The Irony in the Derivatives Discounting, Wilmott Magazine, pp. 92–98, July 2007. SSRN preprint.
  • Tuckman B. and Porfirio P. (2003). Interest Rate Parity, Money Market Basis Swaps and Cross-Currency Basis Swaps, Fixed income liquid markets research, Lehman Brothers

Multi-curves framework:

  • Bianchetti M. (2010). Two Curves, One Price: Pricing & Hedging Interest Rate Derivatives Decoupling Forwarding and Discounting Yield Curves, Risk Magazine, August 2010. SSRN preprint.
  • Henrard M. (2010). The Irony in the Derivatives Discounting Part II: The Crisis, Wilmott Journal, Vol. 2, pp. 301–316, 2010. SSRN preprint.
  • Henrard M. (2014) Interest Rate Modelling in the Multi-curve Framework: Foundations, Evolution, and Implementation. Palgrave Macmillan. Applied Quantitative Finance series. June 2014. ISBN 978-1-137-37465-3.
  • Kijima M., Tanaka K., and Wong T. (2009). A Multi-Quality Model of Interest Rates, Quantitative Finance, pages 133-145, 2009.

References

  1. ^ “OTC derivatives statistics at end-December 2014” (PDF). Bank for International Settlements.
  2. Jump up to:a b c d e Pricing and Trading Interest Rate Derivatives: A Practical Guide to Swaps, J H M Darbyshire, 2017, ISBN 978-0995455528
  3. ^ “Interest Rate Instruments and Market Conventions Guide” Quantitative Research, OpenGamma, 2012.
  4. ^ Multi-Curve Valuation Approaches and their Application to Hedge Accounting according to IAS 39, Dr. Dirk Schubert, KPMG
  5. ^ M. Henrard (2014). Interest Rate Modelling in the Multi-Curve Framework: Foundations, Evolution and Implementation. Palgrave Macmillan ISBN 978-1137374653
  6. ^ See section 3 of Marco Bianchetti and Mattia Carlicchi (2012). Interest Rates after The Credit Crunch: Multiple-Curve Vanilla Derivatives and SABR
  7. ^ P. Hagan and G. West (2006). Interpolation methods for curve construction. Applied Mathematical Finance, 13 (2):89—129, 2006.
  8. ^ P. Hagan and G. West (2008). Methods for Constructing a Yield Curve. Wilmott Magazine, May, 70-81.
  9. ^ P du Preez and E Maré (2013). Interpolating Yield Curve Data in a Manner That Ensures Positive and Continuous Forward Curves.SAJEMS 16 (2013) No 4:395-406
  10. ^ Fujii, Masaaki Fujii; Yasufumi Shimada; Akihiko Takahashi (26 January 2010). “A Note on Construction of Multiple Swap Curves with and without Collateral”. CARF Working Paper Series No. CARF-F-154. SSRN 1440633.
  11. ^ Burgess, Nicholas (2017). FX Forward Invariance & Discounting with CSA Collateral
  12. ^ ICE Swap Rate. [1]
  13. ^ Duncan Campbell-Smith, “Follow the Money: The Audit Commission, Public Money, and the Management of Public Services 1983-2008”, Allen Lane, 2008, chapter 6 passim.
  14. ^ [1996] UKHL 12, [1996] AC 669
  15. ^ “HM Parliament Condemns RBS GRG’s Parasitic Treatment of SMEs Post date”.

Forward rate

The forward rate is the future yield on a bond. It is calculated using the yield curve. For example, the yield on a three-month Treasury bill six months from now is a forward rate.[1]

Forward rate calculation

To extract the forward rate, we need the zero-coupon yield curve.

We are trying to find the future interest rate {\displaystyle r_{1,2}} for time period {\displaystyle (t_{1},t_{2})}{\displaystyle t_{1}} and {\displaystyle t_{2}} expressed in years, given the rate {\displaystyle r_{1}} for time period {\displaystyle (0,t_{1})} and rate {\displaystyle r_{2}} for time period {\displaystyle (0,t_{2})}. To do this, we use the property that the proceeds from investing at rate {\displaystyle r_{1}} for time period {\displaystyle (0,t_{1})} and then reinvesting those proceeds at rate {\displaystyle r_{1,2}} for time period {\displaystyle (t_{1},t_{2})} is equal to the proceeds from investing at rate {\displaystyle r_{2}} for time period {\displaystyle (0,t_{2})}.

{\displaystyle r_{1,2}} depends on the rate calculation mode (simpleyearly compounded or continuously compounded), which yields three different results.

Mathematically it reads as follows:

Simple rate

{\displaystyle (1+r_{1}t_{1})(1+r_{1,2}(t_{2}-t_{1}))=1+r_{2}t_{2}}

Solving for {\displaystyle r_{1,2}} yields:

Thus {\displaystyle r_{1,2}={\frac {1}{t_{2}-t_{1}}}\left({\frac {1+r_{2}t_{2}}{1+r_{1}t_{1}}}-1\right)}

The discount factor formula for period (0, t) {\displaystyle \Delta _{t}} expressed in years, and rate {\displaystyle r_{t}} for this period being {\displaystyle DF(0,t)={\frac {1}{(1+r_{t}\,\Delta _{t})}}}, the forward rate can be expressed in terms of discount factors: {\displaystyle r_{1,2}={\frac {1}{t_{2}-t_{1}}}\left({\frac {DF(0,t_{1})}{DF(0,t_{2})}}-1\right)}

Yearly compounded rate

{\displaystyle (1+r_{1})^{t_{1}}(1+r_{1,2})^{t_{2}-t_{1}}=(1+r_{2})^{t_{2}}}

Solving for {\displaystyle r_{1,2}} yields :

{\displaystyle r_{1,2}=\left({\frac {(1+r_{2})^{t_{2}}}{(1+r_{1})^{t_{1}}}}\right)^{1/(t_{2}-t_{1})}-1}

The discount factor formula for period (0,t{\displaystyle \Delta _{t}} expressed in years, and rate {\displaystyle r_{t}} for this period being {\displaystyle DF(0,t)={\frac {1}{(1+r_{t})^{\Delta _{t}}}}}, the forward rate can be expressed in terms of discount factors:

{\displaystyle r_{1,2}=\left({\frac {DF(0,t_{1})}{DF(0,t_{2})}}\right)^{1/(t_{2}-t_{1})}-1}

Continuously compounded rate

EQUATION→ {\displaystyle e^{{(r}_{2}\ast t_{2})}=e^{{(r}_{1}\ast t_{1})}\ast \ e^{\left(r_{1,2}\ast \left(t_{2}-t_{1}\right)\right)}}

Solving for {\displaystyle r_{1,2}} yields:

STEP 1→ {\displaystyle e^{{(r}_{2}\ast t_{2})}=e^{{(r}_{1}\ast t_{1})+\left(r_{1,2}\ast \left(t_{2}-t_{1}\right)\right)}}
STEP 2→ {\displaystyle \ln {\left(e^{{(r}_{2}\ast t_{2})}\right)}=\ln {\left(e^{{(r}_{1}\ast t_{1})+\left(r_{1,2}\ast \left(t_{2}-t_{1}\right)\right)}\right)}}
STEP 3→ {\displaystyle {(r}_{2}\ast \ t_{2})={(r}_{1}\ast \ t_{1})+\left(r_{1,2}\ast \left(t_{2}-t_{1}\right)\right)}
STEP 4→ {\displaystyle r_{1,2}\ast \left(t_{2}-t_{1}\right)={(r}_{2}\ast \ t_{2})-{(r}_{1}\ast \ t_{1})}
STEP 5→ {\displaystyle r_{1,2}={\frac {{(r}_{2}\ast t_{2})-{(r}_{1}\ast t_{1})}{t_{2}-t_{1}}}}

The discount factor formula for period (0,t{\displaystyle \Delta _{t}} expressed in years, and rate {\displaystyle r_{t}} for this period being {\displaystyle DF(0,t)=e^{-r_{t}\,\Delta _{t}}}, the forward rate can be expressed in terms of discount factors:

{\displaystyle r_{1,2}={\frac {1}{t_{2}-t_{1}}}(\ln DF(0,t_{1})-\ln DF(0,t_{2}))}

{\displaystyle r_{1,2}} is the forward rate between time {\displaystyle t_{1}} and time {\displaystyle t_{2}},

{\displaystyle r_{k}} is the zero-coupon yield for the time period {\displaystyle (0,t_{k})}, (k = 1,2).

Related instruments

  • Forward rate agreement
  • Floating rate note

See also

  • Forward price
  • Spot rate

References

  1. ^ Fabozzi, Vamsi.K (2012), The Handbook of Fixed Income Securities (Seventh ed.), New York: kvrv, p. 148, ISBN 0-07-144099-2.

Covered interest arbitrage

Covered interest arbitrage is an arbitrage trading strategy whereby an investor capitalizes on the interest rate differential between two countries by using a forward contract to cover (eliminate exposure to) exchange rate risk.[1] Using forward contracts enables arbitrageurs such as individual investors or banks to make use of the forward premium (or discount) to earn a riskless profit from discrepancies between two countries’ interest rates.[2] The opportunity to earn riskless profits arises from the reality that the interest rate parity condition does not constantly hold. When spot and forward exchange rate markets are not in a state of equilibrium, investors will no longer be indifferent among the available interest rates in two countries and will invest in whichever currency offers a higher rate of return.[3] Economists have discovered various factors which affect the occurrence of deviations from covered interest rate parity and the fleeting nature of covered interest arbitrage opportunities, such as differing characteristics of assets, varying frequencies of time series data, and the transaction costs associated with arbitrage trading strategies.

Mechanics of covered interest arbitrage

A visual representation of a simplified covered interest arbitrage scenario, ignoring compounding interest. In this numerical example the arbitrageur is guaranteed to do better than would be achieved by investing domestically.

An arbitrageur executes a covered interest arbitrage strategy by exchanging domestic currency for foreign currency at the current spot exchange rate, then investing the foreign currency at the foreign interest rate. Simultaneously, the arbitrageur negotiates a forward contract to sell the amount of the future value of the foreign investment at a delivery date consistent with the foreign investment’s maturity date, to receive domestic currency in exchange for the foreign-currency funds.[4]

For example, as per the chart at right consider that an investor with $5,000,000 USD is considering whether to invest abroad using a covered interest arbitrage strategy or to invest domestically. The dollar deposit interest rate is 3.4% in the United States, while the euro deposit rate is 4.6% in the euro area. The current spot exchange rate is 1.2730 $/€ and the six-month forward exchange rate is 1.3000 $/€. For simplicity, the example ignores compounding interest. Investing $5,000,000 USD domestically at 3.4% for six months ignoring compounding, will result in a future value of $5,085,000 USD. However, exchanging $5,000,000 dollars for euros today, investing those euros at 4.6% for six months ignoring compounding, and exchanging the future value of euros for dollars at the forward exchange rate (on the delivery date negotiated in the forward contract), will result in $5,223,488 USD, implying that investing abroad using covered interest arbitrage is the superior alternative.

Effect of arbitrage

If there were no impediments, such as transaction costs, to covered interest arbitrage, then any opportunity, however minuscule, to profit from it would immediately be exploited by many financial market participants, and the resulting pressure on domestic and forward interest rates and the forward exchange rate premium would cause one or more of these to change virtually instantaneously to eliminate the opportunity. In fact, the anticipation of such arbitrage leading to such market changes would cause these three variables to align to prevent any arbitrage opportunities from even arising in the first place: incipient arbitrage can have the same effect, but sooner, as actual arbitrage. Thus any evidence of empirical deviations from covered interest parity would have to be explained on the grounds of some friction in the financial markets.

Evidence for covered interest arbitrage opportunities

Economists Robert M. Dunn, Jr. and John H. Mutti note that financial markets may generate data inconsistent with interest rate parity, and that cases in which significant covered interest arbitrage profits appeared feasible were often due to assets not sharing the same perceptions of risk, the potential for double taxation due to differing policies, and investors’ concerns over the imposition of foreign exchange controls cumbersome to the enforcement of forward contracts. Some covered interest arbitrage opportunities have appeared to exist when exchange rates and interest rates were collected for different periods; for example, the use of daily interest rates and daily closing exchange rates could render the illusion that arbitrage profits exist.[5] Economists have suggested an array of other factors to account for observed deviations from interest rate parity, such as differing tax treatment, differing risks, government foreign exchange controls, supply or demand inelasticity, transaction costs, and time differentials between observing and executing arbitrage opportunities. Economists Jacob Frenkel and Richard M. Levich investigated the performance of covered interest arbitrage strategies during the 1970s’ flexible exchange rate regime by examining transaction costs and differentials between observing and executing arbitrage opportunities. Using weekly data, they estimated transaction costs and evaluated their role in explaining deviations from interest rate parity and found that most deviations could be explained by transaction costs. However, accommodating transaction costs did not explain observed deviations from covered interest rate parity between treasury bills in the United States and United Kingdom. Frenkel and Levich found that executing such transactions resulted in only illusory opportunities for arbitrage profits, and that in each execution the mean percentage of profit decreased such that there was no statistically significant difference from zero profitability. Frenkel and Levich concluded that unexploited opportunities for profit do not exist in covered interest arbitrage.[6]

Using a time series dataset of daily spot and forward USD/JPY exchange rates and same-maturity short-term interest rates in both the United States and Japan, economists Johnathan A. Batten and Peter G. Szilagyi analyzed the sensitivity of forward market price differentials to short-term interest rate differentials. The researchers found evidence for substantial variation in covered interest rate parity deviations from equilibrium, attributed to transaction costs and market segmentation. They found that such deviations and arbitrage opportunities diminished significantly nearly to a point of elimination by the year 2000. Batten and Szilagyi point out that the modern reliance on electronic trading platforms and real-time equilibrium prices appear to account for the removal of the historical scale and scope of covered interest arbitrage opportunities. Further investigation of the deviations uncovered a long-term dependence, found to be consistent with other evidence of temporal long-term dependencies identified in asset returns from other financial markets including currencies, stocks, and commodities.[7]

Economists Wai-Ming Fong, Giorgio Valente, and Joseph K.W. Fung, examined the relationship of covered interest rate parity arbitrage opportunities with market liquidity and credit risk using a dataset of tick-by-tick spot and forward exchange rate quotes for the Hong Kong dollar in relation to the United States dollar. Their empirical analysis demonstrates that positive deviations from covered interest rate parity indeed compensate for liquidity and credit risk. After accounting for these risk premia, the researchers demonstrated that small residual arbitrage profits accrue only to those arbitrageurs capable of negotiating low transaction costs.[8]

See also

  • Uncovered interest arbitrage
  • Foreign exchange derivative

References

  1. ^ Madura, Jeff (2007). International Financial Management: Abridged 8th Edition. Mason, OH: Thomson South-Western. ISBN 978-0-324-36563-4.
  2. ^ Pilbeam, Keith (2006). International Finance, 3rd Edition. New York, NY: Palgrave Macmillan. ISBN 978-1-4039-4837-3.
  3. ^ Moffett, Michael H.; Stonehill, Arthur I.; Eiteman, David K. (2009). Fundamentals of Multinational Finance, 3rd Edition. Boston, MA: Addison-Wesley. ISBN 978-0-321-54164-2.
  4. ^ Carbaugh, Robert J. (2005). International Economics, 10th Edition. Mason, OH: Thomson South-Western. ISBN 978-0-324-52724-7.
  5. ^ Dunn, Robert M., Jr.; Mutti, John H. (2004). International Economics, 6th Edition. New York, NY: Routledge. ISBN 978-0-415-31154-0.
  6. ^ Frenkel, Jacob A.; Levich, Richard M. (1981). “Covered interest arbitrage in the 1970’s”. Economics Letters8 (3): 267–274. doi:10.1016/0165-1765(81)90077-X.
  7. ^ Batten, Jonathan A.; Szilagyi, Peter G. (2007). “Covered interest parity arbitrage and temporal long-term dependence between the US dollar and the Yen”. Physica A: Statistical Mechanics and Its Applications376 (1): 409–421. doi:10.1016/j.physa.2006.10.021.
  8. ^ Fong, Wai-Ming; Valente, Giorgio; Fung, Joseph K.W. (2010). “Covered interest arbitrage profits: The role of liquidity and credit risk”. Journal of Banking & Finance34 (5): 1098–1107. doi:10.1016/j.jbankfin.2009.11.008.

Margin (finance)

In finance, margin is the collateral that a holder of a financial instrument has to deposit with a counterparty (most often their broker or an exchange) to cover some or all of the credit risk the holder poses for the counterparty. This risk can arise if the holder has done any of the following:

  • Borrowed cash from the counterparty to buy financial instruments,
  • Borrowed financial instruments to sell them short,
  • Entered into a derivative contract.

The collateral for a margin account can be the cash deposited in the account or securities provided, and represents the funds available to the account holder for further share trading. On United States futures exchanges, margins were formerly called performance bonds. Most of the exchanges today use SPAN (“Standard Portfolio Analysis of Risk”) methodology, which was developed by the Chicago Mercantile Exchange in 1988, for calculating margins for options and futures.

Margin account

A margin account is a loan account with a broker which can be used for share trading. The funds available under the margin loan are determined by the broker based on the securities owned and provided by the trader, which act as collateral for the loan. The broker usually has the right to change the percentage of the value of each security it will allow towards further advances to the trader, and may consequently make a margin call if the balance available falls below the amount actually utilised. In any event, the broker will usually charge interest and other fees on the amount drawn on the margin account.

If the cash balance of a margin account is negative, the amount is owed to the broker, and usually attracts interest. If the cash balance is positive, the money is available to the account holder to reinvest, or may be withdrawn by the holder or left in the account and may earn interest. In terms of futures and cleared derivatives, the margin balance would refer to the total value of collateral pledged to the CCP (central counterparty clearing) and or futures commission merchants.

Margin buying

Examples
Jane buys a share in a company for $100 using $20 of her own money and $80 borrowed from her broker. The net value (the share price minus the amount borrowed) is $20. The broker has a minimum margin requirement of $10.

Suppose the share price drops to $85. The net value is now only $5 (the previous net value of $20 minus the share’s $15 drop in price), so, to maintain the broker’s minimum margin, Jane needs to increase this net value to $10 or more, either by selling the share or repaying part of the loan.

Margin buying refers to the buying of securities with cash borrowed from a broker, using the bought securities as collateral. This has the effect of magnifying any profit or loss made on the securities. The securities serve as collateral for the loan. The net value—the difference between the value of the securities and the loan—is initially equal to the amount of one’s own cash used. This difference has to stay above a minimum margin requirement, the purpose of which is to protect the broker against a fall in the value of the securities to the point that the investor can no longer cover the loan.

Margin lending became popular in the late 1800 as a means to finance railroads. In the 1920s, margin requirements were loose. In other words, brokers required investors to put in very little of their own money, whereas today, the Federal Reserve’s margin requirement (under Regulation T) limits debt to 50 percent. During the 1920s leverage rates of up to 90 percent debt were not uncommon.[1] When the stock market started to contract, many individuals received margin calls. They had to deliver more money to their brokers or their shares would be sold. Since many individuals did not have the equity to cover their margin positions, their shares were sold, causing further market declines and further margin calls. This was one of the major contributing factors which led to the Stock Market Crash of 1929, which in turn contributed to the Great Depression.[1] However, as reported in Peter Rappoport and Eugene N. White’s 1994 paper published in The American Economic Review, “Was the Crash of 1929 Expected”,[2] all sources indicate that beginning in either late 1928 or early 1929, “margin requirements began to rise to historic new levels. The typical peak rates on brokers’ loans were 40–50 percent. Brokerage houses followed suit and demanded higher margin from investors”.

Short selling

Examples
Jane sells a share of stock she does not own for $100 and puts $20 of her own money as collateral, resulting $120 cash in the account. The net value (the cash amount minus the share price) is $20. The broker has a minimum margin requirement of $10.

Suppose the share price rises to $115. The net value is now only $5 (the previous net value of $20 minus the share’s $15 rise in price), so, to maintain the broker’s minimum margin, Jane needs to increase this net value to $10 or more, either by buying the share back or depositing additional cash.

Short selling refers to the selling of securities that the trader does not own, borrowing them from a broker, and using the cash as collateral. This has the effect of reversing any profit or loss made on the securities. The initial cash deposited by the trader, together with the amount obtained from the sale, serve as collateral for the loan. The net value—the difference between the cash amount and the value of loan security—is initially equal to the amount of one’s own cash used. This difference has to stay above a minimum margin requirement, the purpose of which is to protect the broker against a rise in the value of the borrowed securities to the point that the investor can no longer cover the loan.

Types of margin requirements

  • The current liquidating margin is the value of a security’s position if the position were liquidated now. In other words, if the holder has a short position, this is the money needed to buy back; if they are long, it is the money they can raise by selling it.
  • The variation margin or mark to market is not collateral, but a daily payment of profits and losses. Futures are marked-to-market every day, so the current price is compared to the previous day’s price. The profit or loss on the day of a position is then paid to or debited from the holder by the futures exchange. This is possible, because the exchange is the central counterparty to all contracts, and the number of long contracts equals the number of short contracts. Certain other exchange traded derivatives, such as options on futures contracts, are marked-to-market in the same way.
  • The seller of an option has the obligation to deliver the underlying security associated with the option when it is exercised. To ensure they can fulfill this obligation, they have to deposit collateral. This premium margin is equal to the premium that they would need to pay to buy back the option and close out their position.
  • Additional margin is intended to cover a potential fall in the value of the position on the following trading day. This is calculated as the potential loss in a worst-case scenario.
  • SMA and portfolio margins offer alternative rules for U.S. and NYSE regulatory margin requirements.[clarification needed]

Margin strategies

Enhanced leverage is a strategy offered by some brokers that provides 4:1 or 6+:1 leverage. This requires maintaining two sets of accounts, long and short.

Example 1
An investor sells a put option, where the buyer has the right to require the seller to buy his 100 shares in Universal Widgets S.A. at 90¢. He receives an option premium of 14¢. The value of the option is 14¢, so this is the premium margin. The exchange has calculated, using historical prices, that the option value will not exceed 17¢ the next day, with 99% certainty. Therefore, the additional margin requirement is set at 3¢, and the investor has to post at least 14¢ (obtained from the sale) + 3¢ = 17¢ in his margin account as collateral.
Example 2
Futures contracts on sweet crude oil closed the day at $65. The exchange sets the additional margin requirement at $2, which the holder of a long position pays as collateral in his margin account. A day later, the futures close at $66. The exchange now pays the profit of $1 in the mark-to-market to the holder. The margin account still holds only the $2.
Example 3
An investor is long 50 shares in Universal Widgets Ltd, trading at 120 pence (£1.20) each. The broker sets an additional margin requirement of 20 pence per share, so £10 for the total position. The current liquidating margin is currently £60 “in favour of the investor”. The minimum margin requirement is now -£60 + £10 = -£50. In other words, the investor can run a deficit of £50 in his margin account and still fulfil his margin obligations. This is the same as saying he can borrow up to £50 from the broker.

Initial and maintenance margin requirements

The initial margin requirement is the amount of collateral required to open a position. Thereafter, the collateral required until the position is closed is the maintenance requirement. The maintenance requirement is the minimum amount of collateral required to keep the position open and is generally lower than the initial requirement. This allows the price to move against the margin without forcing a margin call immediately after the initial transaction. When the total value of the collateral dips below the maintenance margin requirement, the position holder must pledge additional collateral to bring their total balance back up to or above the initial margin requirement. On instruments determined to be especially risky, however, either regulators, the exchange, or the broker may set the maintenance requirement higher than normal or equal to the initial requirement to reduce their exposure to the risk accepted by the trader. For speculative futures and derivatives clearing accounts, futures commission merchants may charge a premium or margin multiplier to exchange requirements. This is typically an additional 10%–25%.

Margin call

The broker may at any time revise the value of the collateral securities (margin) after the estimation of the risk, based, for example, on market factors. If this results in the market value of the collateral securities for a margin account falling below the revised margin, the broker or exchange immediately issues a “margin call”, requiring the investor to bring the margin account back into line. To do so, the investor must either pay funds (the call) into the margin account, provide additional collateral, or dispose some of the securities. If the investor fails to bring the account back into line, the broker can sell the investor’s collateral securities to bring the account back into line.

If a margin call occurs unexpectedly, it can cause a domino effect of selling, which will lead to other margin calls and so forth, effectively crashing an asset class or group of asset classes. The “Bunker Hunt Day” crash of the silver market on Silver Thursday, March 27, 1980, is one such example. This situation most frequently happens as a result of an adverse change in the market value of the leveraged asset or contract. It could also happen when the margin requirement is raised, either due to increased volatility or due to legislation. In extreme cases, certain securities may cease to qualify for margin trading; in such a case, the brokerage will require the trader to either fully fund their position, or to liquidate it.

Price of stock for margin calls

The minimum margin requirement, sometimes called the maintenance margin requirement, is the ratio set for:

  • (Stock Equity − Leveraged Dollars) to Stock Equity
  • Stock Equity being the stock price multiplied by the number of shares bought, and leveraged dollars being the amount borrowed in the margin account.
  • E.g., An investor bought 1,000 shares of ABC company each priced at $50. If the initial margin requirement were 60%:
  • Stock Equity: $50 × 1,000 = $50,000
  • Leveraged Dollars or amount borrowed: ($50 × 1,000) × (100% − 60%) = $20,000

The maintenance margin requirement uses the variables above to form a ratio that investors have to abide by in order to keep the account active.

Assume the maintenance margin requirement is 25%. That means the customer has to maintain a net value equal to 25% of the total stock equity. That means they have to maintain net equity of $50,000 × 0.25 = $12,500. So at what price would the investor be getting a margin call? For stock price P the stock equity will be (in this example) 1,000P.

  • (Current Market Value − Amount Borrowed) / Current Market Value = 25%
  • (1,000P – 20,000) / 1000P = 0.25
  • (1,000P – 20,000) = 250P
  • 750P = $20,000
  • P = $20,000/750 = $26.66 / share

So if the stock price drops from $50 to $26.66, investors will be called to add additional funds to the account to make up for the loss in stock equity.

Alternatively, one can calculate P using {\displaystyle \textstyle P=P_{0}{\frac {(1-{\text{initial margin requirement}})}{(1-{\text{maintenance margin requirement}})}}} where P0 is the initial price of the stock. Using the same example to demonstrate this:

{\displaystyle P=\$50{\frac {(1-0.6)}{(1-0.25)}}=\$26.66.}

Reduced margins

Margin requirements are reduced for positions that offset each other. For instance spread traders who have offsetting futures contracts do not have to deposit collateral both for their short position and their long position. The exchange calculates the loss in a worst-case scenario of the total position. Similarly an investor who creates a collar has reduced risk since any loss on the call is offset by a gain in the stock, and a large loss in the stock is offset by a gain on the put; in general, covered calls have less strict requirements than naked call writing.

Margin-equity ratio

The margin-equity ratio is a term used by speculators, representing the amount of their trading capital that is being held as margin at any particular time. Traders would rarely (and unadvisedly) hold 100% of their capital as margin. The probability of losing their entire capital at some point would be high. By contrast, if the margin-equity ratio is so low as to make the trader’s capital equal to the value of the futures contract itself, then they would not profit from the inherent leverage implicit in futures trading. A conservative trader might hold a margin-equity ratio of 15%, while a more aggressive trader might hold 40%.

Return on margin

Return on margin (ROM) is often used to judge performance because it represents the net gain or net loss compared to the exchange’s perceived risk as reflected in required margin. ROM may be calculated (realized return) / (initial margin). The annualized ROM is equal to

(ROM + 1)(1/trade duration in years) – 1

For example, if a trader earns 10% on margin in two months, that would be about 77% annualized

Annualized ROM = (ROM +1)1/(2/12) – 1

that is, Annualized ROM = 1.16 – 1 = 77%

Sometimes, return on margin will also take into account peripheral charges such as brokerage fees and interest paid on the sum borrowed. The margin interest rate is usually based on the broker’s call.

See also

  • Collateral management
  • Credit default swap
  • Leverage (finance)
  • LIBOR
  • MVA, the x-Valuation Adjustment related to Margin
  • Portfolio margin
  • Repurchase agreement
  • Special memorandum account
  • Short selling
  • Badla system (Indian stock markets)

References

  1. Jump up to:a b Cundiff, Kirby R. (January 2007). “Monetary-Policy Disasters of the Twentieth Century”. The Freeman Online. Retrieved 10 February 2009.
  2. ^ Rappoport, Peter; White, Eugene N. (March 1994). “Was the Crash of 1929 Expected”. The American Economic Review. United States: American Economic Association. 84 (1): 271–281. JSTOR 2117982.

Yield spread

In finance, the yield spread or credit spread is the difference between the quoted rates of return on two different investments, usually of different credit qualities but similar maturities. It is often an indication of the risk premium for one investment product over another. The phrase is a compound of yield and spread.

The “yield spread of X over Y” is generally the annualized percentage yield to maturity (YTM) of financial instrument X minus the YTM of financial instrument Y.

There are several measures of yield spread relative to a benchmark yield curve, including interpolated spread (I-spread), zero-volatility spread (Z-spread), and option-adjusted spread (OAS).

It is also possible to define a yield spread between two different maturities of otherwise comparable bonds. For example, if a certain bond with a 10-year maturity yields 8% and a comparable bond from the same issuer with a 5-year maturity yields 5%, then the term premium between them may be quoted as 8% – 5% = 3%.

Yield spread analysis

Yield spread analysis involves comparing the yield, maturity, liquidity and creditworthiness of two instruments, or of one security relative to a benchmark, and tracking how particular patterns vary over time.

When yield spreads widen between bond categories with different credit ratings, all else equal, it implies that the market is factoring more risk of default on the lower-grade bonds. For example, if a risk-free 10-year Treasury note is currently yielding 5% while junk bonds with the same duration are averaging 7%, then the spread between Treasuries and junk bonds is 2%. If that spread widens to 4% (increasing the junk bond yield to 9%), then the market is forecasting a greater risk of default, probably because of weaker economic prospects for the borrowers. A narrowing of yield spreads (between bonds of different risk ratings) implies that the market is factoring in less risk, probably due to an improving economic outlook.

The TED spread is one commonly-quoted credit spread. The difference between Baa-rated ten-year corporate bonds and ten-year Treasuries is another commonly-quoted credit spread.[1]

Consumer loans

Yield spread can also be an indicator of profitability for a lender providing a loan to an individual borrower. For consumer loans, particularly home mortgages, an important yield spread is the difference between the interest rate actually paid by the borrower on a particular loan and the (lower) interest rate that the borrower’s credit would allow that borrower to pay. For example, if a borrower’s credit is good enough to qualify for a loan at 5% interest rate but accepts a loan at 6%, then the extra 1% yield spread (with the same credit risk) translates into additional profit for the lender. As a business strategy, lenders typically offer yield spread premiums to brokers who identify borrowers willing to pay higher yield spreads.

See also

  • I-spread
  • Option-adjusted spread
  • Yield curve
  • Yield spread premium
  • Z-spread

Exposure at default

Exposure at default or (EAD) is a parameter used in the calculation of economic capital or regulatory capital under Basel II for a banking institution. It can be defined as the gross exposure under a facility upon default of an obligor.[1]

Outside of Basel II, the concept is sometimes known as Credit Exposure (CE). It represents the immediate loss that the lender would suffer if the borrower (counterparty) fully defaults on its debt.

The EAD is closely linked to the expected loss, which is defined as the product of the EAD, the probability of default (PD) and the loss given default (LGD).

Definition

In general, EAD is seen as an estimation of the extent to which a bank may be exposed to a counterparty in the event of, and at the time of, that counterparty’s default. EAD is equal to the current amount outstanding in case of fixed exposures such as term loans. For revolving exposures like lines of credit, EAD can be divided into drawn and undrawn commitments; typically the drawn commitment is known whereas the undrawn commitment needs to be estimated to arrive at a value of EAD. Based on Basel Guidelines, EAD for commitments measures the amount of the facility that is likely to be drawn further if a default occurs.[2] Two popular terms used to express the percentage of the undrawn commitment that will be drawn and outstanding at default (in case of a default) are Conversion Factor (CF)[3] and Loan Equivalent (LEQ).[4]

Calculation

Calculation of EAD is different under foundation and advanced approach. While under foundation approach (F-IRB) calculation of EAD is guided by the regulators, under the advanced approach (A-IRB) banks enjoy greater flexibility on how they calculate EAD.

Foundation approach

Under F-IRB, EAD is calculated taking account of the underlying asset, forward valuation, facility type and commitment details. This value does not take account of guarantees, collateral or security (i.e. ignores Credit Risk Mitigation Techniques with the exception of on-balance sheet netting where the effect of netting is included in Exposure At Default). For on-balance sheet transactions, EAD is identical to the nominal amount of exposure. On-balance sheet netting of loans and deposits of a bank to a corporate counterparty is permitted to reduce the estimate of EAD under certain conditions. For off-balance sheet items, there are two broad types which the IRB approach needs to address: transactions with uncertain future drawdown, such as commitments and revolving credits, and OTC foreign exchange, interest rate and equity derivative contracts.[5]

Advanced approach

Under A-IRB, the bank itself determines how the appropriate EAD is to be applied to each exposure. A bank using internal EAD estimates for capital purposes might be able to differentiate EAD values on the basis of a wider set of transaction characteristics (e.g. product type) as well as borrower characteristics. These values would be expected to represent a conservative view of long-run averages, although banks would be free to use more conservative estimates. A bank wishing to use its own estimates of EAD will need to demonstrate to its supervisor that it can meet additional minimum requirements pertinent to the integrity and reliability of these estimates. All estimates of EAD should be calculated net of any specific provisions a bank may have raised against an exposure.[5]

Importance

For a risk weight derived from the IRB framework to be transformed into a risk weighted asset, it needs to be attached to an exposure amount. Any error in EAD calculation will directly affect the risk weighted asset and thereby affect the capital requirement.

References

  1. ^ Pg 46:Draft Supervisory Guidance on Internal Ratings-Based Systems for Corporate Credit
  2. ^ Overview of the New Basel Capital Accord BIS Consultative Document, April 2003
  3. ^ FSA:Expert Group Paper on Exposure at Default
  4. ^ OCC:Exposure at Default of Unsecured Credit Cards
  5. Jump up to:a b Financial Risk Management Regulation Information Archived 2012-07-05 at the Wayback Machine

Profit and loss sharing

Profit and Loss Sharing (also called PLS or “participatory” banking[citation needed] is a method of finance used by Islamic financial or Shariah-compliant institutions to comply with the religious prohibition on interest on loans that most Muslims subscribe to. Many sources state there are two varieties of profit and loss sharing used by Islamic banks – Mudarabah (مضاربة) (“trustee finance” or passive partnership contract)[1] and Musharakah (مشاركة or مشركة)[2] (equity participation contract).[1] Other sources include sukuk (also called “Islamic bonds”)[1] and direct equity investment (such as purchase of common shares of stock) as types of PLS.[1]

The profits and losses shared in PLS are those of a business enterprise or person which/who has obtained capital from the Islamic bank/financial institution (the terms “debt”, “borrow”, “loan” and “lender” are not used). As financing is repaid, the provider of capital collects some agreed upon percentage of the profits (or deducts if there are losses) along with the principal of the financing.[Note 1] Unlike a conventional bank, there is no fixed rate of interest collected along with the principal of the loan.[3] Also unlike conventional banking, the PLS bank acts as a capital partner (in the mudarabah form of PLS) serving as an intermediary between the depositor on one side and the entrepreneur/borrower on the other.[4] The intention is to promote “the concept of participation in a transaction backed by real assets, utilizing the funds at risk on a profit-and-loss-sharing basis”.[2]

Profit-and-loss-sharing is one of “two basic categories” of Islamic financing,[2] the other being “debt-based contracts” (or “debt-like instruments”)[5] such as murabaha, istisna’a, salam and leasing, which involve the “purchase and hire of goods or assets and services on a fixed-return basis”.[2] While early promoters of Islamic banking (such as Mohammad Najatuallah Siddiqui) hoped PLS would be the primary mode of Islamic finance, use of fixed return financing now far exceeds that of PLS in the Islamic financing industry.[6][7]

Background

One of the pioneers of Islamic banking, Mohammad Najatuallah Siddiqui, suggested a two-tier model as the basis of a riba-free banking, with mudarabah being the primary mode,[4] supplemented by a number of fixed-return models – mark-up (murabaha), leasing (ijara), cash advances for the purchase of agricultural produce (salam) and cash advances for the manufacture of assets (istisna’), etc. In practice, the fixed-return models – in particular murabaha model – have become the bank’s favourites,[7] as long-term financing with profit-and-loss-sharing mechanisms has turned out to be more risky and costly than the long term or medium-term lending of the conventional banks.[8]

Mudarabah

Structure of simple mudaraba contract[9]

Mudarabah or “Sharing the profit and loss with venture capital”,[10] is a partnership or trust financing contract (similar to western equivalent of General and Limited Partnership) where one partner (rabb-ul-mal or “silent partner”/financier),[11] gives money to another (mudarib or “working partner”) for investing in a commercial enterprise. The rabb-ul-mal party provides 100 percent of the capital and the mudarib party provides its specialized knowledge to invest the capital and manage the investment project. Profits generated are shared between the parties according to a pre-agreed ratio. If there is a loss, rabb-ul-mal will lose his capital, and the mudarib party will lose the time and effort invested in the project. The profit is usually shared 50%-50% or 60%-40% for rabb ul malmudarib.

Further, Mudaraba is venture capital funding of an entrepreneur who provides labor while financing is provided by the bank so that both profit and risk are shared. Such participatory arrangements between capital and labor reflect the Islamic view that the borrower must not bear all the risk/cost of a failure, resulting in a balanced distribution of income and not allowing the lender to monopolize the economy.

Muslims believe that the Islamic prophet Muhammad’s wife Khadija used a Mudaraba contract with Muhammad in Muhammad’s trading expeditions in northern Arabia – Khadija providing the capital and Muhammad providing the labour/entrepreneurship.[12]

Mudaraba contracts are used in inter-bank lending. The borrowing and lending banks negotiate the PLS ratio and contracts may be as short as overnight and as long as one year.[13]

Mudarabah contracts may be restricted or unrestricted.

  • In an al-mudarabah al-muqayyadah (restricted mudarabah), the rabb-ul-mal may specify a particular business for the mudarib, in which case he shall invest the money in that particular business only.[14] For the account holder, a restricted mudarabah may authorize the IIFS (institutions offering Islamic financial services) to invest their funds based on mudarabah or agency contracts with certain restrictions as to where, how, and for what purpose these are to be invested.[15] For the bank customer they would be held in “Investment Funds” rather than “Investment Accounts“.[16]
  • In a al-mudarabah al-mutlaqah (unrestricted mudarabah), the rabb-ul-mal allows the mudarib to undertake whatever business he wishes and so authorizes him to invest the money in any business he deems fit.[14] For the account holder funds are invested without any restrictions based on mudarabah or wakalah (agency) contracts, and the institution may commingle the investors funds with their own funds and invest them in a pooled portfolio,[15] going to “Investment Accounts” rather than “Investment Funds“.[16]

They may also be first tier ortwo tier.

  • Most mudarabah contracts are first tier or simple contracts where the depositor/customer deals with the bank and not with entrepreneur using the invested funds.
  • In two-tier mudarabah the bank serves as an intermediary between the depositor and the entrepreneur being provided financing. Two tier is used when the bank does not have the capacity to serve as the investor or expertise to serve as the fund manager.[17]

A variation of two-tier mudarabah that has caused some complaint is one that replaces profit and loss sharing between depositor and bank with profit sharing – the losses being all the problem of the depositors. Instead of both the bank and its depositors being the owners of the capital (rabb al-mal), and the entrepreneur the mudarib, the bank and the entrepreneur are now both mudarib, and if there are any losses after meeting the overhead and operational expenses, they are passed on to depositors. One critic (Ibrahim Warde) has dubbed this `Islamic moral hazard` in which the banks are able `to privatise the profits and socialize the losses`.[18][19]

Another critic (M.A. Khan), has questioned the mudarabah’s underlying rationale of fairness to the mudarib. Rather than fixed interest lending being unfair to the entrepreneur/borrower, Khan asks if it isn’t unfair to the rabb al-mal (provider of finance) to “get a return only if the results of investment are profitable”, since by providing funds they have done their part to make the investment possible, while the actions of entrepreneur/borrower – their inspiration, competence, diligence, probity, etc. – have much more power over whether and by how much the investment is profitable or a failure.[20]

Musharakah

Structure of simple musharaka contract[21]

Musharakah is a joint enterprise in which all the partners share the profit or loss of the joint venture.[22] The two (or more) parties that contribute capital to a business divide the net profit and loss on a pro rata basis. Some scholarly definitions of it include: “Agreement for association on the condition that the capital and its benefit be common between two or more persons”, (Mecelle)[23] “An agreement between two or more persons to carry out a particular business with the view of sharing profits by joint investment” (Ibn Arfa),[24] “A contract between two persons who launch a business of financial enterprise to make profit” (Muhammad Akram Khan).[25]

Musharakah is often used in investment projects, letters of credit, and the purchase or real estate or property. In the case of real estate or property, the bank assesses an imputed rent and will share it as agreed in advance.[26][27] All providers of capital are entitled to participate in management, but not necessarily required to do so. The profit is distributed among the partners in pre-agreed ratios, while the loss is borne by each partner strictly in proportion to respective capital contributions. This concept is distinct from fixed-income investing (i.e. issuance of loans).[28]

Musharaka is used in business transactions and often to finance a major purchase. Islamic banks lend their money to companies by issuing floating rate interest loans, where the floating rate is pegged to the company’s rate of return and serves as the bank’s profit on the loan. Once the principal amount of the loan is repaid, the contract is concluded[29]

  • Shirka al’Inan is a Musharaka partnership where the partners are only the agent but do not serve as guarantors of the other partner.[30]
    • Different shareholders have different rights and are entitled to different profit shares.
    • Al’Inan is limited a specific undertaking and is more common than Al Mufawada.
  • Mufawada is an “unlimited, unrestricted, and equal partnership”.[30]
    • All participants rank equally in every respect (initial contributions, privileges, and final profits)
    • Partners are both agents and guarantors of other partners.[30]

Other sources distinguish between Shirkat al Aqd (contractual partnership) and Shirkat al Milk (co-ownership), although they disagree over whether they are forms of “diminishing musharaka” or not.[31]

Permanent Musharaka

Investor/partners receive a share of profit on a pro-rata basis.

  • The period of contract is not specified and the partnership continues for as long as the parties concerned agree for it to continue.
  • A suitable structure for financing long term projects needing long term financing.[32]

Diminishing partnership

Musharaka can be either a “consecutive partnership” or “declining balance partnership” (otherwise known as a “diminishing partnership” or “diminishing musharaka”).

  • In a “consecutive partnership” the partners keep the same level of share in the partnership until the end of the joint venture, unless they withdraw or transfer their shares all together. It’s used when a bank invests in “a project, a joint venture, or business activity”,[33] but usually in home financing,[34] where the shares of the home are transferred to the customer buying the home.
  • In a “diminishing partnership” (Musharaka al-Mutanaqisa, also “Diminishing Musharaka”) one partner’s share diminishes as the other’s gradually acquires it until that partner owns the entire share. This mechanism is used to finance a bank customer’s purchase, usually (or often) of real estate where the share diminishing is that of the bank, and the partner acquiring 100% is the customer. The partnership starts with a purchase, the customer “starts renting or using the asset and shares profit with (or pays monthly rent to) its partner (the bank) according to an agreed ratio.”[35][36]

If default occurs, both the bank and the borrower receive a proportion of the proceeds from the sale of the property based on each party’s current equity. Banks using this partnership (as of 2012) including the American Finance House,[37][38] and Dubai Islamic Bank.[38]

Diminishing Partnership is particularly popular way of structuring an Islamic mortgage for financing homes/real estate and resembles a residential mortgage. The Islamic financier buys the house on behalf of the other “partner”, the ultimate buyer who then pays the financier monthly installments combining the amounts for

  1. rent (or lease payments) and
  2. buyout payment

until payment is complete.[39] Thus, a diminishing Musharaka partnership actually consists of a musharakah partnership contract and two other Islamic contracts – usually ijarah (leasing by the bank of its share of the asset to the customer) and bay’ (gradual sales of the bank’s share to the customer).[36]

In theory, a diminishing Musharaka for home purchase differs from a conventional mortgage in that it charges not interest on a loan, but `rent` (or lease payment) based on comparable homes in the area. But as one critic (M.A. El-Gamal) complained, some

“ostensibly Islamic Banks do not even make a pretense of attempting to disguise the role of market interest rates in a `diminishing musharaka`, and … the `rental` rate is directly derived from conventional interest rates and not from any imputed `fair market rent`”.

El-Gamal gives as an example the Islamic Bank of Britain’s explanation that its ‘rental rates’ are benchmarked to commercial interest rate “such as Libor (London Interbank Offered [interest] Rate) plus a further profit margin”, rather than being derived from the prevailing rental levels of equivalent units in the neighborhood.[40] The Meezan Bank of Pakistan is careful to use the term “profit rate” but it is based on KIBOR (Karachi Interbank Offered [interest] Rate).[41]

According to Takao Moriguchi, musharakah mutanaqisa is fairly common in Malaysia, but questions about its shariah compliance mean it is “not so prevailing in Gulf Cooperation Council (GCC) countries such as Saudi Arabia, Kuwait, the United Arab Emirates, Qatar, Bahrain, and Oman”.[36]

Differences

According to Mufti Taqi Usmani, a mudarabah arrangement differs from the musharakah in several ways:

  • In mudarabah:
    • investment is the sole responsibility of rabb-ul-maal, not all partners.[42]
    • the rabb-ul-maal has no right to participate in the management which is carried out by the mudarib only.[42]
    • the loss, if any, is suffered by the rabb-ul-mal only, because the mudarib does not invest anything. His loss is restricted to the fact that his labor has gone in vain and his work has not brought any fruit to him,[42] unless losses are due to the mudarib’s misconduct, negligence, or breach of the terms and conditions of the contract.[15]
    • all the goods purchased by the mudarib are solely owned by the rabb-ul-maal, and the mudarib can earn his share in the profit only in case he sells the goods profitably. Therefore, he is not entitled to claim his share in the assets themselves, even if their value has increased.[42]
  • In musharakah:
    • unlike mudarabah, investment comes from all the partners[42]
    • unlike mudarabah, all the partners can participate in the management of the business and can work for it.[42]
    • all the partners share the loss to the extent of the ratio of their investment[42]
    • as soon as the partners mix up their capital in a joint pool, all the assets of the musharakah become jointly owned by all of them according to the proportion of their respective investment. Therefore, each one of them can benefit from the appreciation in the value of the assets, even if profit has not accrued through sales.[42]
  • Liability
    • In musharakah all the partners share the financial loss to the extent of the ratio of their investment while in mudarabah the loss, if any, is suffered by the rabb-ul-mal only, because the mudarib does not invest any money. This is considered just because his/her/their time and effort has been in vain and yielded no profit. This principle is subject to a condition that the mudarib has worked with the due diligence required for whatever the business involved is. If there has been negligence or dishonesty, the mudarib is liable for whatever loss was caused by their negligence or misconduct.[43]
    • The liability of the partners in musharakah is normally unlimited, so that if the liabilities of the business exceed its assets and the business goes in liquidation, all the exceeding liabilities shall be borne pro rata by all the partners. However, if all the partners have agreed that no partner shall incur any debt during the course of business, then whichever partner has incurred a debt on the business in violation of the aforesaid condition shall be liable for that debt. In the case of mudarabah the liability of rabb-ul-maal is limited to his investment, unless he has permitted the mudarib to incur debts on his behalf.[22][42]
  • Appreciation of assets
    • In musharakah, as soon as the partners add their capital together in a joint pool, these assets become jointly owned by all of them according to the proportion of their respective investment. Therefore, each one of them can benefit from the appreciation in the value of the assets, even if profit has not accrued through sales.
    • The case of mudarabah is different. Here all the goods purchased by the mudarib are solely owned by the rabb-ul-maal, and the mudarib can earn his share in the profit only in case he sells the goods profitably. Therefore, he is not entitled to claim his share in the assets themselves, even if their value has increased.[14][22][42][44]

Promises and challenges

Profit and loss sharing has been called “the main justification” for,[5] or even “the very purpose” of the Islamic finance and banking movement”[45] and the “basic and foremost characteristic of Islamic financing”.[46]

One proponent, Taqi Usmani, envisioned it transforming economies by

  • rewarding “honest, honorable and forthright behaviour”;
  • protecting savers by eliminating the possibility of collapse for individual banks and for banking systems;
  • replacing the “stresses” of business and economic cycles with a “steady flow of money into investments”;
  • ensuring “stable money” which would encourage “people to take a longer view” in looking at return on investment;
  • enabling “nations and individuals” to “regain their dignity” as they become free of the “enslavement of debt”.[47]

Usmani notes that some non-Muslim economists[Note 2] have supported development of equity markets in “areas of finance currently served by debt”[49] (though they do not support banning interest on loans).

Lack of use

While it was originally envisioned (at least in mudarabah form), as “the basis of a riba-free banking”,[4] with fixed-return financial models only filling in as supplements, it is those fixed-return products whose assets-under-management now far exceed those in profit-loss-sharing modes.[7]

One study from 2000-2006 (by Khan M. Mansoor and M. Ishaq Bhatti) found PLS financing in the “leading Islamic banks” had declined to only 6.34% of total financing, down from 17.34% in 1994-6. “Debt-based contracts” or “debt-like instruments” (murabahaijarasalam and istisna) were far more popular in the sample.[6][5] Another source (Suliman Hamdan Albalawi, publishing in 2006) found that PLS techniques were no longer “a core principle of Islamic banking” in Saudi Arabia and Egypt.[50] In Malaysia, another study found the share of musharaka financing declined from 1.4% in 2000 to 0.2% in 2006.[51][52]

In his book, An Introduction to Islamic Finance, Usmani bemoans the fact that there are no “visible efforts” to reverse this direction of Islamic banking,

The fact, however, remains that the Islamic banks should have advanced towards musharakah in gradual phases …. Unfortunately, the Islamic banks have overlooked this basic requirement of Islamic banking and there are no visible efforts to progress towards this transaction even in a gradual manner, even on a selective basis.[53]

This “mass-scale adoption” of fixed-return modes of finance by Islamic financial institutions has been criticized by shariah scholars and pioneers of Islamic finance like Mohammad Najatuallah Siddiqui, Mohammad Umer Chapra, Muhammad Taqi Usmani and Khurshid Ahmad who have “argued vehemently that moving away from musharaka and mudaraba would simply defeat the very purpose of the Islamic finance movement”.[45]

(At least one scholar – M.S. Khattab – has questioned the basis in Islamic law for the two-tier mudarabah system, saying there are no instances where the mudharib passed funds onto another mudharib.[Note 3]

Explanations for lack

Critics have in turn criticized PLS advocates for remaining “oblivious to the fact” that the reason PLS has not been widely adopted “lies in its inefficiency” (Muhammad Akram Khan),[45] and their “consequence-insensitive” way of thinking, assuming that “ample supply” of PLS “instruments will create their own demand” (Nawab Haider Naqvi), consumer disinterest notwithstanding.[55] Faleel Jamaldeen describes the decline in the use of PLS as a natural growing process, where profit and loss sharing was replaced by other contracts because PLS modes “were no longer sufficient to meet industry demands for project financing, home financing, liquidity management and other products”.[56]

Moral Hazard

On the liability side, Feisal Khan argues there is a “long established consensus” that debt finance is superior to equity investment (PLS being equity investment) because of the “information asymmetry” between the financier/investor and borrower/entrepreneur – the financier/investor needing to accurately determine the credit-worthiness of the borrower/entrepreneur seeking credit/investment, (the borrower/entrepreneur having no such burden). Determining credit-worthiness is both time-consuming and expensive, and debt contracts with substantial collateral minimize its risk of not having information or enough of it.[57] In the words of Al-Azhar rector Muhammad Sayyid Tantawy, “Silent partnerships [mudarabah] follow the conditions stipulated by the partners. We now live in a time of great dishonesty, and if we do not specify a fixed profit for the investor, his partner will devour his wealth.”[58]

The bank’s client has a strong incentive to report less profit to the bank than it has actually earned, as it will lose a fraction of that to the bank. As the client knows more about its business, its accounting, its flow of income, etc., than the bank, the business has an informational advantage over the bank determining levels of profit.[5][59] (For example, one way a bank can under report its earnings is by depreciating assets at a higher level than actual wear and tear.)[60] Banks can attempt to compensate with monitoring, spot-checks, reviewing important decisions of the partner business, but this requires “additional staff and technical resources” that competing conventional banks are not burdened with.[7]

Higher levels of corruption and a larger unofficial/underground economy where revenues are not reported, indicate poorer and harder-to-find credit information for financiers/investors. There are several indicators this is a problem in Muslim majority countries (such as the presence of most Muslim-majority countries in the lower half of the Transparency International Corruption Perceptions Index and the “widespread tax evasion in both the formal and informal sectors” of Middle East and North Africa, according to A.R. Jalali-Naini.)[61][57] But even in the more developed United States, the market for venture capital (where the financier take a direct equity stake in ventures they are financing, like PLS) varies from around $30 billion (2011–12) to $60 billion (2004) compared to “several trillion dollar” market for corporate financing.[62]

Taqi Usmani states that the problems of PLS would be eliminating by banning interest and requiring all banks to be run on a “pure Islamic pattern with careful support from the Central Bank and government.”[63] The danger of dishonesty by borrowers/clients would be solved by

  1. requiring every company/corporation to use a credit rating;
  2. implementing a “well designed” system of auditing.[63]
Other explanations

Other explanations have been offered (and rebutted) as to why use of PLS instruments has declined to almost negligible proportions:

  • Most Islamic bankers started their careers at conventional banks so they suffer from a “hangover”, still thinking of banks “as liquidity/credit providers rather than investment vehicles”.[64][65]
    • But by 2017 Islamic banking had been in existence for over four decades and “many if not most” Islamic bankers had “served their entire careers” in Islamic financial institutions.[65]
  • In some countries, interest is accepted as a business expenditure and given tax exemption, but profit is taxed as income. The clients of the business who obtain funds on a PLS basis must bear a financial burden, in terms of higher taxes, that they would not if they obtained the funds on an interest or fixed debt contract basis;[5][59]
    • However as of 2015, this is no longer the case in “most jurisdictions”, according to Faisal Khan.[65] In the UK, for example, whose the government has hoped to make an IBF hub, “double taxation of Islamic mortgages for both individuals and corporations” has been removed, and there is “favorable tax treatment of Islamic debt issuance”.[66]
  • Islamic products have to be approved by banking regulators who deal with the conventional financial world and so must be identical in function to conventional financial products.[67]
    • But banks in countries whose governments favor Islamic banking over conventional – i.e. Malaysia, Pakistan, Sudan, Iran – show no more inclination towards Profit and Loss sharing than those in other countries.[62] Nor have regulations of financial institutions in these countries diverged in form from those of other “conventional” countries

When it comes to the manner in which Islamic securities are offered, the process and rules for such offerings, even in those jurisdictions with special licensing regimes, are, in effect, the same. (For example, the rules governing the listings of Islamic bonds issued by the Securities and Commodities Authority of the United Arab Emirates are almost identical to the rules governing the listing of conventional bonds save for the use of [sic] word ‘profit’ instead of ‘interest’.[68]

  • According to economist Tarik M. Yousef, long-term financing with profit-and-loss-sharing mechanisms is “far riskier and costlier” than the long term or medium-term lending of the conventional banks.[8]
  • Islamic financial institutions seek to avoid the “risk of exposure to indeterminate loss”.[5]
  • In conventional banking, the banks are able to put all their assets to use and optimize their earnings by borrowing and investing for any length of time including short periods such as a day or so. The rate of interest can be calculated for any period of time. However, the length of time it takes to determine a profit or loss may not be nearly as flexible, and banks may not be able to use PLS for short term investment.[69]
  • On the other side of the ledger, their customers/borrowers/clients do not like to give away any “sovereignty in decision making” by taking the bank as a partner[5] which generally means opening their books to the bank and the possibility of bank intervention in day-to-day business matters.[7]
  • Because customers/borrowers/clients can share losses with banks in a PLS financing, they (the clients) have less financial incentive to avoid losses of risky projects and inefficiency than they would with conventional or debt-based lending.[70]
  • Competing fixed-return models, in particular the murabaha model, provides “results most similar to the interest-based finance models” depositors and borrowers are familiar with.[7]
  • Regarding the rate of profit and loss sharing – i.e. the “agreed upon percentage of the profits (or deduction of losses)” the Islamic bank takes from the client – there is no market to set it or government regulation of it. This leaves open the possibility the bank could exploit the client with excessive rates.[71][72]
  • PLS is also not suitable or feasible for non-profit projects that need working capital, (in fields like education and health care), since they earn no profit to share.[5][59]
  • The property rights in most Muslim countries have not been properly defined. This makes the practice of profit-loss sharing difficult;[5][59][73][74]
  • Islamic banks must compete with conventional banks which are firmly established and have centuries of experience. Islamic banks that are still developing their policies and practices, and feel restrained in taking unforeseen risks;[5][59]
  • Secondary markets for Islamic financial products based on PLS are smaller;[5][59]
  • One of the forms of PLS, mudaraba, provides only limited control rights to shareholders of the bank, and thus denies shareholders a consistent and complementary control system.[5][59]
  • The difficulty in expanding a business financed through mudaraba because of limited opportunities to reinvest retained earnings and/or raise additional funds.[73]
  • The difficulty for the customer/borrower/client/entrepreneur to become the sole owner of a project financed through PLS, except through diminishing musharaka, which may take a long time.[73]
  • Also the structure of Islamic bank deposits is not sufficiently long-term, and so investors shy away from getting involved in long-term projects.[73]
  • The sharia calls for helping the poor and vulnerable groups such as orphans, widows, pensioners. Insofar as these groups have any capital, they will seek to preserve it and generate sources of steady, reliable income. While conventional interest-bearing savings accounts provide such conservative investments, PLS do not.[75]

Industry

Sudan

Between 1998 and 2002 musharkaka made up 29.8% of financing in Sudan and mudaraba 4.6%, thanks in at least part to pressure from the Islamic government. Critics complain that the banking industry in that country was not following the spirit of Islamic banking spirit as investment was directed in the banks’ “major shareholder and the members of the board(s) of directors”.[76][77]

Kuwait

In Kuwait the Kuwait Finance House is the second largest bank and was exempt from some banking regulations such that it could invest in property and rims outright and participate directly in musharaka financing of corporations and “generally act more like a holding company than a bank”. Nonetheless as of 2010 78.4% of its assets were in murabahahijara and other non-PLS sources.[78][77]

Pakistan

The Islamic Republic of Pakistan officially promotes Islamic banking – for example by (starting in 2002) prohibiting the startup of conventional non-Islamic banks. Among its Islamic banking programmes is establishing “musharaka pools” for Islamic banks using its export refinance scheme. Instead of lending money to banks at a rate of 6.5% for them to lend to exporting firms at 8% (as it does for conventional banks), it uses a musharaka pool where instead of being charged 8%, firms seeking export credit are “charged the financing banks average profit rate based on the rate earned on financing offered to ten `blue-chip` bank corporate clients”.[79] However, critic Feisal Khan complains, despite “rigamarole” of detailed instructions for setting up the pool and profit rate, in the end the rate is capped by the State Bank at “the rate declared by the State under its Export finance scheme”.[79]

Another use of musharaka in Pakistan is by one of the largest Islamic banks (Meezan Bank) which has attempted to remedy a major problem of Islamic banking – namely providing lines of credit for the working needs of client firms. This it does with a (putative) musharaka “Islamic running finance facility”. Since the workhorses of Islamic finance are product-based vehicles such as murabaha, which expire once the product has been financed, they do not provide steady funding – a line of credit – for firms to draw on. The Islamic running finance facility does. The bank contributes its investment to the firm as a partner by covering the “firms net (negative) position at the end of the day”. “Profit is accrued to the bank daily on its net contribution using the Karachi Interbank Offered Rate plus a bank-set margin as the pricing basis”.[80] However according to critic Feisal Khan, this is an Islamic partnership in name only and no different than a “conventional line of credit on a daily product basis”.[80]

Islamic Development Bank

Between 1976 and 2004 only about 9% of the financial transactions of the Islamic Development Bank (IDB) were in PLS,[81] increasing to 11.3% in 2006-7.[82] This is despite the fact that the IDB is a not a multilateral development agency, not a for-profit, commercial bank.[77] (While the surplus funds placed in other banks are supposed to be restricted to Shariah-compliant purposes, proof of this compliance was left to the affirmation of the borrowers of the funds and not to any auditing.)[83]

United States

In the United States the Islamic banking industry is a much smaller share of the banking industry than in Muslim majority countries, but is involved in `diminishing musharaka` to finance home purchases (along with Murabaha and Ijara). As in other countries the rent portion of the musharaka is based on the prevailing mortgage interest rate rather than the prevailing rental rate. One journalist (Patrick O. Healy 2005) found costs for this financing are “much higher” than conventional ones because of higher closing costs[84] Referring to the higher costs of Islamic finance, one banker (David Loundy) quotes an unnamed mortgage broker as stating, “The price for getting into heaven is about 50 basis points”.[85][86]

See also

  • Islamic banking and finance
  • Muamalat
  • Murabaha
  • Islamic finance products, services and contracts
  • Sharia and securities trading
  • Riba

References

Notes

  1. ^ The money originally invested or loaned, on which basis interest and returns are calculated. The term loan is not used in profit and loss sharing
  2. ^ James Robertson and John Tomlinson.[48] In his short book, Transforming Economic Life (Schumacher Briefings), James Robertson suggests several highly unorthodox ideas such as introducing multiple competing currencies (multinational, national, local, and community currencies) for consumers to use; banning banks from fractional-reserve banking and replacing the money credit “creates” with the issuing of “new money” “directly” by governments as a “component of Citizen’s income”; and “as a goal for the long term … limit[ing] the role of interest [in finance] more drastically … by converting debt to equity”
  3. ^ Khattab writes, “fuqaha are in agreement that a mudarib is not entitled to forward mudarabah money to a third party for business”.[54]

Citations

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