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26.5.09

Shariah Compliant Principal Protected Notes

The Structure
At the risk of being mundane, but for completeness, we thought we should describe principal protected structured product in more detail. You ask, how? How can we have benefits with no downside risk in Islamic Finance? Well, the answer is really quite trivial.

For one thing, we have talked about Shariah-Compliant Call Options (Call options thru set-off). This is just one of many possible mechanisms for a Shariah Compliant call option. Methods for generating calls include (some as yet to be discussed in this blog):
  • Set-off (as discussed, combining Salam and Murabaha with same counterparty together with contractual set-off)
  • Bay' al Arbun (downpayment with revocation sale, as allowed by Hanbalis, now with much wider acceptance)
  • Wa'd (unilateral promise, promissory note, estoppel)
And there are probably less natural ways of synthesizing calls through rolling murabahas and "Islamic Swaps" (both used more for hightly structured product).

A conventional principal protected note is merely the combination of a zero-coupon bond and some call options, with maturity and exercise set to be identical. So if we invest $100 and the zero rate for 5Y is X%, the price of the zero is 100/(1+X%)**5 and the remainder is invested into calls, typically struck at spot. Depending on the prevailing rates and underlying volatility, it may be possible to give more or less than 100% of the upside of the underlying (equities, commodities, etc).

So the last thing we need is a zero-coupon bond/money market. This can be had a number of ways including:
  • Commodity Murabaha
  • Bay al Inah (sale at spot, resale with deferment and increase)
  • Tawarruq' (basically the same as 'Inah, with a third counterparty)
An Islamic principal protected note is the combination of a Murabaha and Islamic call options, with maturity and exercise dates set to be identical.

Notes for Prospective Buyers
Once we let the cat out of the hat with a Shariah-compliant call option, and we've had a risk-free rate/money-market/zero-coupon bond for some time, combining the two was inevitable.

The payout will be the original principal + M * max(Price(T)-Strike,0), where Price(T) is the price of the equity/commodity at maturity of the note, Strike is usually set to Price(0), today's price, but can be set wherever we like (slightly harder from a Shariah perspective but should be just fine), and M is the multiplier. We can get anywhere from say around 70% to 120% multipliers (70%-120% of the upside of FTSE 100, say). The multiplier is usually the only figure that can be manipulated, so we must look to it and compare.

While this may appear wonderful to some, we should comment that, unlike more vanilla products (e.g., straight call options, or the zero-coupon bonds), pricing is not as easy to replicate and it is not absolutely trivial to know whether you are getting ripped off or not.

  • Know what you can about pricing. Try to price the call (with correct strike) and zero independently.
  • If the underlying is liquid and calls are traded on it (e.g., calls on oil, calls on gold, etc), then it is likely that only at-the-money (ATM) options are active (i.e., ATM struck at the forward price). Spot-struck options are generally less liquid, involve pricing on a skew, which you as customer are not as aware of. Expect hidden fees.
  • If the underlying is liquid but calls are not actively traded (e.g., DJIM Index), the bank will use calls on whatever similar futures that they can get ahold of. The basis or the fact that these two indices do not mimic each other exactly--they will charge extra for that. So on top of the skew, you get charged for their inability to hedge.
  • Make sure you know whether dividends are paid to you or are not? Does the index accrue w/ no dividends? It makes it cheaper for them to pay it to you, and they should pay you that much more (i.e., the multiplier on the upside should be larger).
  • Shop around. Note that even though it seems like rocket science, it isn't. Every bank and their brother does this same deal. Smart users will ask for several quotes, even of Shariah-compliant products like this (vanilla shariah-compliant). Banks are used to giving quotes for reverse-engineered products (i.e., customer describes payout, bank finds price). Banks hide fees. Redistributers are usually upfront. By the time the end-user has it, 2 points to 10 points could have been taken from the mid-price (really!). That is, you paid 10% upfront for the privilege of running this simple strategy. Smart buyers will ask for quotes from 10 banks, pick the best price and expect to pay 1%-2%.
  • Know what will affect repricing (as opposed to the payoff--the pricing before maturity--something of importance for client reports, if it was bought on a margin which doesn't sound so shariah-compliant anyway, or if you might seek to unwind the product before final maturity). Lower prices do not necessarily imply the payoff is really impaired of course:
  • Credit Spreads. Whose Zero is it anyway? The commodity was bought and sold and now you have credit exposure to a large German or a large Swiss bank. If they get downgraded, you better believe the pricing of your product (prior to maturity) will look bad.
  • If volatility drops and suddenly the world looks less risky, your valuations may suffer. You are long an option and option prices drop when vol drops. Your pricing before maturity depends very much on vol and it dynamics and the whole skew shape (interaction between the underlying price levels, strikes and vol).
  • If prices rise of course, you are long a call and should expect your valuations to rise. This may be less than you think since the rise will be proportional to the call's Delta (calculated from Black-Scholes or some other fancy option valuation model). The more ITM (in the money) your option is, i.e., the more underlyings have risen in the past, the greater your price sensitivity. The more OTM (out of the money) your option is, i.e., the more you've lost, the lesser your price sensitivity. Higher vol will lessen sensitivities in general.
  • It pays to read up on option pricing, to get an intuition for this stuff.

Structured Product, whether we take the view that it is Islamically Acceptable or not, has both some pros and some very significant cons. But, more importantly, it is pushed by investment banks primarily because the fees are juicy, the pricing opaque and the customers are not always up to snuff. Make sure you are.





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