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1 Derivatives in Islamic Finance An Overview Obiyathulla Ismath Bacha Management Centre, International Islamic University, Malaysia

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Derivatives in Islamic

Finance – An Overview

Obiyathulla Ismath Bacha

Management Centre,

International Islamic University, Malaysia

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What are derivatives?

A derivative security is a financial asset whose value isdependent on the value of an underlying asset. Theunderlying asset could be a basic financial asset likecommon stocks, bonds, currencies or commodities.

Since by this definition, a derivative is a "claim on aclaim" the value of the derivative will depend on thevalue of the asset (stocks, bonds, etc) on which it has aclaim.

Common forms : Forwards, Futures, Options, Swaps.Also, exotics like, Swaptions; LEAPs, CMOs etc.

At a basic level; derivatives enable the avoidance ofunnecessary risks.

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Evolution of Derivative Markets/Instruments

If one examines the evolution of derivative markets and

instruments the progression has been as follows:

Forward Contracts

Options

Futures Contracts

Synthetic Instruments

Exotic Options

Swaps etc.

Financial Engineering

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As with any other financial product, derivatives were the result of financialinnovation. Innovation that responded to the existing need to help managerisk in increasingly sophisticated business environments.

While forward contracts were originally innovated for risk-management ofagro-based products, the later instruments were needed as risk environmentschanged.

Each step down the evolutionary chain; added value.

Forward Futures; reduced

• Liquidity risk

• Counterparty risk

• Avoid price squeeze etc.

Futures Options

• Increased flexibility

• Ability to take advantage of favourable price movts (unlike lock-in)

*managing contingent claims/liabilities.

The objective of all these innovation is Risk Management.

Rationale: Why do we need derivatives?

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Risk, from a Finance viewpoint, refers to the uncertaintiesassociated with returns from an investment. These uncertaintieswould translate into volatility or fluctuation of returns from aninvestment. Measured by std. deviation.

An asset that does not come with “guaranteed” fixed returns hassome amount of uncertainty. Infact even a “guaranteed” instrumenthas risks if the issuer’s credibility is questionable.

Risk-Management; refers to the process/techniques of reducingthe risks faced in an investment.

It generally involves three broad steps;

Identifying the source and type of risk.

Measuring the extent of the risk.

Determining the appropriate response (either on Balance Sheet or OffBalance Sheet) methods.

What makes risk management challenging is the fact that risks andreturns are generally positively correlated. Thus, the risk-returntradeoff.

The challenge of risk-management is to protect the expectedreturns while simultaneously reducing or laying-off the risks.

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All risk management techniques involving derivatives are OffBalance Sheet. What this means is that, the hedgingmechanism/method is “detached” from the underlyingtransaction.

The advantage: No need to change the way one doesbusiness. No loss of competitiveness, customer convenienceetc.

An On Balance-Sheet technique is one where a transaction isstructured in such a way as to manage the inherent risk.

Example: Malaysian Exporter; Foreign Customer.

On Balance Sheet Technique

Quote only in Ringgit (HC)

Increase the FC price equivalent to cover risk (pricing strategy)

CRSA .(Currency Risk Sharing Agreement)

Off Balance Sheet vs On Balance Sheet techniques of risk

management.

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Forwards; Short FC forward contracts.

Futures; Short FC futures contracts.

Options; Long FC Put Options.

Swaps; FC payer, HC receiver

Off Balance Sheet techniques have become tremendously popular;

Cheap and flexible

No inconvenience to customer

Can enhance competitiveness

Despite the popularity of derivatives based offBalance-Sheet techniques; Islamic Jurists havegenerally not been in favor.

Off Balance Sheet

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All Islamic financial instruments in general must meet a number of critierain order to be considered halal (acceptable).

At a primary level all financial instruments and transactions must be free ofat least the following five items: (i) riba (usury), (ii) rishwah (corruption),(iii) maysir (gambling), (iv) gharar (unnecessary risk) and (v) jahl(ignorance).

Riba can be in different forms and is prohibited in all its forms. Forexample, Riba can also occur when one gets a positive return withouttaking any risk.

As for gharar, there appears to be no consensus on what gharar means. Ithas been taken to mean, unnecessary risk, deception or intentionallyinduced uncertainty.

In the context of financial transactions, gharar could be thought of aslooseness of the underlying contract such that one or both parties areuncertain about possible outcomes.

Masyir from a financial instrument viewpoint would be one where theoutcome is purely dependent on chance alone – as in gambling.

Finally, jahl refers to ignorance. From a financial transaction viewpoint, itwould be unacceptable if one party to the transaction gains because of theother party’s ignorance.

Requisites for a Shariah Compliant Derivative Instrument

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In addition to these requirements for financialinstruments, the shariah has some basic conditionswith regards to the sale of an asset (in this case a realasset as opposed to financial assets).

According to the shariah for a sale to be valid, (a) thecommodity or underlying asset must currently exist inits physical sellable form and (b) the seller should havelegal ownership of the asset in its final form.

These conditions for the validity of a sale wouldobviously render impossible the trading of derivatives.

However, the shariah provides exceptions to thesegeneral principles to enable deferred sale whereneeded.

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A number of instruments/contracts exist in Islamic financethat could be considered a basis for forward/futurescontracts within an Islamic framework.

We will examine three such contracts. These are (i) theSalam Contract, (ii) the Istisna Contract and (iii) Joa’laContract.

Each of these contracts concern deferred transactions,and would be applicable for different situations. The firstand probably the most relevant of these to modern dayforward/futures contracts would be the Salam Contract orBa’i Salam.

Futures Contracts and Islamic Finance

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Salam is essentially a transaction where two parties agree to carryout a sale/purchase of an underlying asset at a predeterminedfuture date but at a price determined and fully paid for today

This is similar to a conventional forward contract however, the bigdifference is that in a Salam sale, the buyer pays the entireamount in full at the time the contract is initiated. The contractalso stipulates that the payment must be in cash form.

The idea behind such a ‘prepayment’ requirement has to do withthe fact that the objective in a Ba’i Salam contract is to help needyfarmers and small businesses with working capital financing.

Since there is full prepayment, a Salam sale is clearly beneficial tothe seller. As such, the predetermined price is normally lowerthan the prevailing spot price.

This price behavior is certainly different from that of conventionalfutures contracts where the futures price is typically higher thanthe spot price by the amount of the carrying cost.

Ba’i Salam

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The lower Salam price compared to spot is the “compensation” bythe seller to the buyer for the privilege given him.

Despite allowing Salam sale, Salam is still an exception within theIslamic financial system which generally discourages forwardsales, particularly of foodstuff.

Thus, Ba’i Salam is subject to several conditions:

i) Full payment by buyer at the time of effecting sale.

ii) The underlying asset must be standardizable, easilyquantifiable and of determinate quality.

iii) Cannot be based on an uniquely identified underlying.

iv) Quantity, Quality, Maturity date and Place of delivery must beclearly enumerated.

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It should be clear that current exchange traded futureswould conform to these conditions with the exception of thefirst, which requires full advance payment by the buyer.

Given the customized nature of Ba’i Salam, it would moreclosely resemble forwards rather than futures. Thus, someof the problems of forwards; namely “double-coincidence”,negotiated price and counterparty risk can exist in theSalam sale.

Counterparty risk however would be one sided. Since thebuyer has paid in full, it is the buyer who faces the seller’sdefault risk and not both ways as in forwards/futures.

In order to overcome the potential for default on the part ofthe seller, the shariah allows for the buyer to requiresecurity which may be in the form of a guarantee ormortgage.

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The Salam Contract & Islamic Financial

Institutions

Since the Salam Contract involves transacting

in the underlying asset and financial institutions

may not want to be transacting in the

underlying asset, there are a number of

alternatives available. These are in the form of

parallel Salam Contracts.

(Jurists however are not all in agreement of the

permissibility).

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(I) Parallel with Seller

Here, after entering into the original Salam Contract, thebank can get into a parallel Salam sale to sell theunderlying commodity after a time lapse for the samematurity date.

The resale price would be higher and considered justifiablesince there has been a time lapse. The differencebetween the 2 prices would constitute the bank’s profit.The shorter the time left to maturity, the higher would bethe price.

Both transactions should be independent of each other.The original transaction should not have been priced withthe intention to do a subsequent parallel Salam

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(II) Offsetting Transaction with Third

Party

Here, the bank which had gone into an original Salam Contractenters into a contract promising to sell the commodity to a thirdparty on the delivery date.

Since this is not a Salam Contract the bank does not receiveadvance payment.

It would be a transaction carried out on maturity date based ona predetermined price.

Note : This is very much like modern day forward/futures. Thedifference here being that the Islamic bank is offsetting an obligation –not speculating.

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Istisna and Joala Contracts

In addition to Ba’i Salam , there are two other contracts where atransaction is made on a “yet to” exist underlying assets.

These are the Istisna and Joala contracts.

The Istisna Contract has as its underlying, a product to bemanufactured.

Essentially, in an Istisna, a buyer contracts with a manufacturerto manufacture a needed product to his specifications.

The price for the product is agreed upon and fixed. While theagreement may be cancelled by either party before productionbegins, it cannot be cancelled unilaterally once the manufacturerbegins production.

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Unlike the Salam Contract, the paymenthere is not made in advance. The time ofdelivery too is not fixed.

Like Ba’i Salam, a parallel contract is oftenallowed for in Istisna.

The Joala Contract is essentially a Istisnabut applicable for services as opposed to amanufactured product.

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The Bai’bil-wafa & Bai ‘bil Istighlal Contracts

The Bail bil-wafa is a composite of bai (sale) and rahnu (pledge).

Under this contract, one party sells an asset to a buyer who pledges to sellback the asset to the original owner at a predetermined future date.

The rahnu (pledge) being to sell back to the owner and not to a third party.

Looks like a REPO? Except that the resale price must be the same as theoriginal purchase price.

But like a REPO, the buyer has rights to benefits from ownership of theasset.

The Bai bil-Istighlal is really a combination of the Bai wafa and Ijarah.

Under this contract, the buyer not only promises to resell at apredetermined future price but to also lease the asset to the seller in theinterim period.

The Bai bil-Istighlal can therefore be a convenient means by which an IBcan provide short/medium term financing. The IB first purchases the asset,leases it the customer before finally reselling it to the customer.

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Options in Islamic Finance

Recall our earlier argument that to be acceptable aninstrument/investment must be free of gharar and nothave zero risk in order to provide some positive return.

The Istijrar Contract is a recently introduced Islamicfinancing instrument. The contract has embeddedoptions that could be triggered if an underlying asset’sprice exceeds certain bounds.

The contract is complex in that it constitutes acombination of options, average prices and Murabahaor cost plus financing

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The Istijrar involves two parties, a buyer which could be a companyseeking financing to purchase the underlying asset and a financialinstitution.

A typical Istijrar transaction could be as follows; a company seekingshort term working capital to finance the purchase of a commodity like aneeded raw material approaches a bank. The bank purchases thecommodity at the current price (Po ), and resells it to the company forpayment to be made at a mutually agreed upon date in the future – forexample in 3 months. The price at which settlement occurs on maturityis contingent on the underlying asset’s price movement from t0 to t90.Where t0 is the day the contract was initiated and t90 is the 90th daywhich would be the maturity day.

Unlike a Murabaha contract where the settlement price would simply bea predetermined price; P* where P* = Po (1+r), with ‘r’ being the bank’srequired return/earning, the price at which the Istijrar is settled onmaturity date could either be P* or an average price ( ) of thecommodity between the period t0 an t90.

Overview of Istijrar

P

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As to which of the two prices will be used for settlementwill depend on how prices have behaved and whichparty chooses to “fix” the settlement price. Theembedded option is the right to choose to fix the priceat which settlement will occur at anytime beforecontract maturity.

At the initiation of the contract; to, both parties agreeon the following two items (i) in the predeterminedMurabaha price; P* and (ii) an upper and lower boundaround the Po. (bank’s purchase price at to).

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where Po = The price that bank pays to purchaseunderlying commodity.

P* = Murabaha price; P* = Po (1+r).

PLB = The lower bound price

PUB = The Upper bound price

The settlement price (Ps) at t90 would be;

(i) Ps = ; if the underlying asset price remained within the bounds.

or (ii) Ps = P*; if the underlying asset exceeds the bounds and one of the parties chooses to exercise its option and use P* as the price at which to settle at maturity.

PLB P0 P* PUB

P

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The basic idea behind such a contract is to spread out thebenefits of favourable price movement to both parties. – i.e. Nota zero sum game.

Such a contract fulfills the need to avoid a fixed return on ariskless asset which would be considered “riba” and also avoidsgharar in that both parties know up front, P* and the range ofother possible prices. (by definition between the upper and lowerbounds).

The Istijrar from an Options Viewpoint

Given our description of the Istijrar Contract, the contract comesacross as something that is the result of modern day financialengineering.

Many of the products of financial engineering tend to have thecomplexities, bounds, trigger points etc. similar to that of theIstijrar.

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Payoff to Istijrar

where Ps = Settlement Price at Maturity

= Average price; Pto to Ptqo

Pt = Spot Price of underlying commodity on day t.

P* = The predetermined, cost-plus or Murabaha price.

P

(bank losses, buyer gains until exercise)

(buyer losses, bank gains until exercise)

if; lower bound Pt upper boundPs

Ps =

If Pt upper bound

P

If Pt < lower bound

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FUQAHA (JURISTS)

VIEWPOINTS ON

CONVENTIONAL DERIVATIVE

INSTRUMENTS

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Futures

1) Fatwa of Omam Al-Haramaini Al-Jauwaini

Futures Trading is Halal if the practice is based on Darurah and

the Needs or Hajaat of the Ummah

2) Syariah Advisory Council (SAC) of Securities

Commission

a) Futures trading of commodities is approved as long as underlying

asset is halal.

b) Crude Palm Oil Futures Contracts are approved for trading.

c) For Stock Index Futures contract, the concept is approved. However

since the current KLCI SE based SIF has non halal stocks, it is not

approved.

Thus is implies that a SIF contract contract of a halal index would be

acceptable.

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3) Ustaz Ahmad Allam; Islamic Fiqh Academy

(14/5/1992)

SIF trading is HARAM, since some of the underlying stocks are not

halal.

Until and unless the underlying asset or basket of securities in the SIF

is all Halal; SIF trading is not approved.

4) Mufti Taqi Usmani

Futures transactions not permissible.

For two reasons;

i. According to Syariah, sale or purchase cannot be affected for a

future date.

ii. In most futures transactions delivery or possession is not intended.

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Options

When viewed solely as a promise to buy or sell an asset at apredetermined price within a stipulated period, shariah scholars findnothing objectionable with options.

It is in the trading of these promises and the charging of premiumsthat objections are raised.

Options have generally been examined under the fiqh doctrine of al-khiyarat (contractual stipulations) or under the bai-al-urbun concept.Urbun being a transaction in which a buyer places an initial good faithdeposit.

1. Ahmad Muhayyuddin Hassan (1986)

Objects to option trading for 2 reasons

i. Maturity beyond three days as in al-khiyarat is not acceptable.

ii. The buyer gets more benefits than the seller – injustice.

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2) Abu Sulayman (1992) (Fiqh Academy – Jeddah)

Acceptable when viewed in the light of bai-al-urbunbut considers options to have been detached andindependent of the underlying asset – therefore:unacceptable.

3) Mufti Taqi Usmani (Fiqh Academy – Jeddah)

Promises as part of a contract is acceptable inShariah, however the trading and charging of apremium for the promise is not acceptable.

Yet others have argued against options by invoking“maisir” or unearned gains. That is, the profits fromoptions may be unearned.

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4) Hashim Kamali (1998)

Finds options acceptable

Invokes the Hanbali tradition

Cites Hadiths of Barira (RA) and Habban IbnMunqidh (RA).

Also draws parallels with the al-urbun in arguing thatpremiums are acceptable.

Also cites that contemporary scholars such as Yusufal-Qaradawi and Mustafa al-Zarqa haveauthenticated al-urbun. (similar stand by Iranianscholars)

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5) Shariah Advisory Council; Securities Commission

Though no formal opinion on stock or Index Options,the SAC has allowed other option-like instruments.

Warrants

TSRs

Call Warrants

Each of these are really option like instruments. CallWarrants for example, are simply long dated CallOptions. Have similar risk/payoff profile.

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Conclusion

The overall stance of Fuqaha, of conventional derivativeinstruments appears to be one of apprehension even suspicion.

That these instruments could easily be used for speculationappears to be the key reason for objection.

That derivatives form the basis of risk-management appears tohave been lost.

Key Problem: Evaluation has always been from a purely juridicalviewpoint. And like most juristic evaluation, have relied onprecedence? But there isn’t a precedence nor equivalence forthe kind of risk-management problems faced today.

When extrapolating/inferring : template may be wrong.

The object of juridical analysis appears to be a microexamination of each and every feature of a derivative instrumentto see if it passes, a often subjective religious filter.

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The overall intended use of the instrument nor thesocietal benefits that could accrue do not seem to havebeen given due consideration.

Aside from individual interpretation, the differingopinions among mazhabs/imams complicates thesituation further. Thus, an options contract may befound objectionable for exactly opposite reasons.

While some mazhabs like the Hanbalis have beenbroader in their acceptance, the Shafi’ and Hanafishave been less so. The Hanbalis for example aresomewhat liberal when it comes to Option of stipulation(Khiyar-al-Shart).

The Hanbalis hold that stipulations that remove ahardship, fulfills a legitimate need, provide a benefit orconvenience, or facilitate the smooth flow ofcommercial transactions are generally valid as a matterof principle.

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Obvious need for a more coordinatedevaluation; need based rather than purelyjuristic/precedent driven.

Muslim businesses operate in the sameenvironment and so face the same risks. Yet, inthe current state of affairs, shariah compliancecan impede risk management needs.

Unless there is a convergence between shariahcompliance and risk management needs,Muslim business can be seriously handicapped.