Financial Engineering 269
Step 2: With the help of a fi nancial intermediary, both parties agree to
enter into a currency swap where (A) promises to take (B)’s liability in $, and
(B) promises to take (A)’s liability in ¥. At the time of settlement, both par-
ties exchange the proceeds from the sukuk each received from the market.
Party
(A)Party
(B)¥ Capital
Markets$ Capital
Markets¥ Sukuk¥ Proceeds$ Proceeds$ SukukAt each sukuk coupon payment:
Step 3: At each coupon period, (A) pays $ coupons on (B)’s sukuk and
receives ¥ cash fl ows from (B), which are used to pay to the sukuk investors.
Similarly, (B) pays ¥ to (A) in exchange for $ coupons which are passed on
to the sukuk investors.
Party
(A)Party
¥ Capital (B) $ Capital¥ Coupon$ Coupon¥ Coupon$ CouponAt maturity (T):
Step 4: The principal amounts of the sukuk in the respective currencies
are exchanged. Party (A) receives ¥ principal from (B), which is used to pay
off the ¥ sukuk issued by (B). Similarly, (B) receives $ principal from (A),
which it used to pay back the $ sukuk.
Party
(A)Party
(B)¥ Capital
Markets$ Capital
Markets¥ Principal $ Principal¥ Principal$ PrincipalRATE - OF - RETURN SWAP
The interest-rate swap market is the largest over - the - counter (OTC) deriva-
tive market, which indicates the importance and prevalence of this instru-
ment. The idea behind an interest rate swap is to exchange cash fl ows in the
same currency according to a predetermined schedule. The main purposes
of entering into such an agreement are to lower the cost of funding, to
enhance yield, or to manage the interest rate risk. The most common type
is a fi xed - to - fl oating rate swap, where one party agrees to swap fi xed-rate
coupon payments against receipt of fl oating - rate coupon payments for a
predetermined notional amount.
The concept described above to develop currency swaps using sukuk
can be applied to developing an Islamic instrument similar to the rate -
of - return swap, with the main difference being that parties will agree to