Financial Engineering 267
A fi nancial intermediary can arrange such currency swaps through the
following steps:
Step 1: The fi nancial intermediary and the fi nancial institution (A) agree
to enter into a partnership where the fi nancial intermediary will buy that
portion of the portfolio which the fi nancial institution would like to swap:
in our case, the ijarah - based asset denominated in Japanese yen (¥).
Step 2: The fi nancial intermediary agrees to pay for the assets through
equity participation certifi cates issued by the fi nancial intermediary in a for-
eign currency; that is, US dollars ($).
Step 3: In order to be fully hedged, the intermediary enters into an iden-
tical agreement with another fi nancial institution (B), which is holding an
ijarah asset in the foreign currency ($) and desires to swap its assets to ¥. (A)
and (B) exchange the principal amounts in the respective currencies equal to
the respective asset values at the time of the settlement.
Step 4: All future cash fl ows of party (A) in ¥ will be passed on to the
fi nancial intermediary as part of the partnership agreement.
Step 5: All future cash fl ows of party (B) in $ will be passed on to the
fi nancial intermediary as part of the partnership agreement.
Step 6: At each future cash fl ow date, the fi nancial intermediary will
pass the ¥ cash fl ows which it received from party (A) to party (B), and all $
cash fl ows which it received from party (B) to party (A). This will effectively
convert each party’s assets from one currency to the other. At maturity, the
principal amounts equal to asset values will be exchanged back in the origi-
nal currencies. The intermediary earns fee income for arranging and servic-
ing this agreement.
Figure AC2 illustrates the fl ows and the role played by the fi nancial
intermediary.
The main difference between this and a conventional currency swap
is that the fi nancial intermediary becomes a partner in the assets of each
fi nancial institution and the cash fl ows are fully backed by the cash fl ows on
each underlying asset. Where in a conventional currency swap, the fi nancial
intermediary underwrites the credit risk only, in the Islamic version, the
fi nancial intermediary backs each agreement with a real asset in addition to
underwriting the credit risk.
This, of course, is a simplifi ed version for illustrative purposes and fi nd-
ing assets of the same maturity and equivalent value is not easy. One way to
reduce this problem would be to collect a pool of assets of similar maturity
and to securitize the assets through sukuk, which can be swapped as one
security. This idea is further refi ned in the second method.
Sukuk - based Currency Swap
As mentioned earlier, a currency swap can be viewed as two parallel streams
of cash fl ows from two bonds in two different currencies which the par-
ties agree to swap. Since Islamic bonds, sukuk, are similar to conventional