270 AN INTRODUCTION TO ISLAMIC FINANCE
exchange the rate of return on one asset with another, rather than exchang-
ing interest rates. Rate - of - return swaps are different from currency swaps
in that there is no exchange of principal, since the cash fl ows belong to the
same currency. Note that ijarah - based sukuk are suitable for constructing a
rate - of - return swap because they are available in both fi xed - and fl oating -
return formats.
This rate - of - return swap can be constructed as follows:
Step 1: Party (A) has a comparative advantage in raising funds through
fi xed - rate sukuk, but would like to convert this liability into a fl oating-rate
liability to match its assets. Similarly, (B) has a comparative advantage in
raising funds through fl oating-rate sukuk, but would prefer to have a fi xed-
rate liability to match its assets.
Step 2: (A) decides to issue fi xed-rate sukuk and (B) issues fl oating-
rate sukuk. Both parties enter into an agreement to exchange cash fl ows on
the coupon dates. This could be an agreement to assume the other party’s
liability. Since both sukuk have the same amount of proceeds in the same
currency, there is no exchange of principal cash fl ows.
Step 3: On each coupon period, (A) pays fl oating-rate payments to (B)
against receipt of fi xed-rate coupons, which are ultimately passed on to pay
the sukuk holders. For (A), the net effect is a fl oating-rate liability. Similarly,
(B) pays fi xed coupons against receipt of fl oating coupons from (A), which
are passed on to the holders of the fl oating-rate sukuk.
Step 4: At maturity, no principal exchange takes place. Both parties
make payments to their respective sukuk holders.
The following example illustrates cost saving through an interest rate
swap.
Costs before Swap Party (A) Party (B)
Fixed-rate sukuk: 5% 5.5%
Floating-rate sukuk: [Islamic Index] +25 bps [Islamic Index] – 25 bps
Based on the comparative advantage, (A) decides to issue fi xed-rate
sukuk at 5 percent and (B) decides to issue fl oating-rate sukuk at [Islamic
Index] – 25 bps.
Costs After Swap Party (A) Party (B)
Receives from counterparty 5.0% [Islamic Index] – 25 bps
Pay to counterparty [Islamic Index] – 25 bps 5.0%
Pay to sukuk holders 5% [Islamic Index] – 25 bps
Net Funding Cost [Islamic Index] – 25 bps 5%
Net Savings (difference in
before and after cost)
50 basis points 50 basis points