266 AN INTRODUCTION TO ISLAMIC FINANCE
CURRENCY SWAP
Currency swaps are one of the most popular applications of fi nancial
engineering and the market for them has grown exponentially since their
introduction in the early 1980s. The underlying concept is to exploit a
comparative advantage in a particular market to raise capital at favorable
rates and then agreeing with another party to exchange cash fl ows according
to a predetermined schedule for cash fl ows in another currency. As an off -
balance - sheet instrument, a currency swap is frequently used to hedge against
currency risks, to lower funding costs through arbitrage in different capital
markets, and to gain access to otherwise inaccessible emerging markets.
A currency swap can help an institution reduce its exposure to a par-
ticular currency by allowing it to swap existing assets or liabilities for
more desirable ones. For example, an Islamic fi nancial institution may
develop a comparative advantage in the market for assets or liabilities in
a particular currency and this advantage can lead to increased exposure in a
particular currency. Currency swaps enable fi nancial institutions to manage
currency exposure and also achieve better asset/liability management, which
can ultimately reduce the overall fi nancial risk.
Since a currency swap is an agreement to exchange cash fl ows in
accordance with a fi xed schedule, it can also be viewed as a series of cur-
rency forward contracts for each period of the schedule. Currency swaps
are currently not practiced in Islamic fi nancial markets, mainly because of
the prohibition on currency trading in the forward markets. However, there
are other ways of going about it. Currency swaps were a by - product of a
practice known as “parallel loans,” which was followed by several corpora-
tions to avoid regulatory constraints. With this practice, both a parent com-
pany and its foreign subsidiary borrow in their respective markets (foreign
and local currencies) and then swap the proceeds internally between them.
In this way, a currency swap can be viewed as an exchange of two bonds
(loans) in different currencies.
The following sections describe two different ways to construct a cur-
rency swap that may be acceptable in the Islamic fi nancial market. The fi rst
method involves a partnership with a fi nancial intermediary, and the second
is based on the exchange of sukuk proceeds.
Partnership - based Currency Swap
Suppose that an IFI has accumulated a portfolio of ijarah assets in a cur-
rency that is different from the currency of its liabilities (funding side). In
order to reduce its exposure to a single currency on its assets side, the IFI
wants to swap a portion of its portfolio into the currency of its liabilities
in order to improve its asset/liability management. For the sake of simplic-
ity, the example is reduced to a single ijarah asset, but the principle can be
extended to a pool of assets through securitization.