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Shariah Compliant Principal Protected Notes

Shariah Compliant Principal Protected Notes

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Published by profinvest786

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Categories:Business/Law, Finance
Published by: profinvest786 on Jul 30, 2010
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10/25/2012

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The Structure
At the risk of being mundane, but for completeness, we thought we shoulddescribe principal protected structured product in more detail. You ask, how?How can we have benefits with no downside risk in Islamic Finance? Well, theanswer is really quite trivial.For one thing, we have talked aboutShariah-Compliant Call Options (Calloptions thru set-off). This is just one of many possible mechanisms for a ShariahCompliant call option. Methods for generating calls include (some as yet to bediscussed in this blog):
Set-off 
(as discussed, combining Salam and Murabaha withsame counterparty together with contractual set-off)
Bay' al Arbun
(downpayment with revocation sale, as allowedby Hanbalis, now with much wider acceptance)
Wa'd
(unilateral promise, promissory note, estoppel)
And there are probably less natural ways of synthesizing calls through
rollingmurabahas
and
"Islamic Swaps"
(both used more for hightly structuredproduct).A conventional principal protected note is merely the combination of a zero-coupon bond and some call options, with maturity and exercise set to beidentical. So if we invest $100 and the zero rate for 5Y is X%, the price of thezero is 100/(1+X%)**5 and the remainder is invested into calls, typically struck atspot. Depending on the prevailing rates and underlying volatility, it may bepossible 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 hada 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 thirdcounterparty)
An Islamic principal protected note is the combination of a Murabaha and Islamiccall 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'vehad a risk-free rate/money-market/zero-coupon bond for some time, combiningthe two was inevitable.The payout will be the original principal + M * max(Price(T)-Strike,0), wherePrice(T) is the price of the equity/commodity at maturity of the note, Strike isusually set to Price(0), today's price, but can be set wherever we like (slightlyharder from a Shariah perspective but should be just fine), and M is themultiplier. 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 figurethat can be manipulated, so we must look to it and compare.While this may appear wonderful to some, we should comment that, unlike morevanilla products (e.g., straight call options, or the zero-coupon bonds), pricing isnot as easy to replicate and it is not absolutely trivial to know whether you aregetting ripped off or not.
Know what you can about pricing.
Try to price the call (with correctstrike) and zero independently.
If the underlying is liquid and calls are traded on it (e.g., calls on oil, calls ongold, 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 lessliquid, 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 fortheir inability to hedge.
 
Make sure you know whether dividends are paid to you or are not? Does theindex 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 upsideshould be larger).

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