HedgingHedginginin

Islamic FinanceIslamic Finance

HedgingHedginginin

Islamic FinanceIslamic Finance

Sami Al-SuwailemSafar 1427 - March 2006

Sami Al-SuwailemSafar 1427 - March 2006

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ObjectivesObjectivesObjectivesObjectivesExplore dimensions of riskDevelop criteria for acceptable risksOutline strategy for product designDerive Islamic instruments for hedging

Explore dimensions of riskDevelop criteria for acceptable risksOutline strategy for product designDerive Islamic instruments for hedging

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State of RiskState of RiskState of RiskState of RiskMarkets are becoming more volatileEconomic instabilities are risingSolutions?

Markets are becoming more volatileEconomic instabilities are risingSolutions?

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Dow JonesDow JonesDow JonesDow Jones

0

50

100

150

200

250

300

02/ 01/ 1990 02/ 01/ 1993 02/ 01/ 1996 02/ 01/ 1999 02/ 01/ 2002 02/ 01/ 2005

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CommoditiesCommoditiesCommoditiesCommodities

0

20

40

60

80

100

120

140

160

December-91

J uly-93 J anuary-95

J uly-96 J anuary-98

J uly-99 J anuary-01

J uly-02 J anuary-04

J uly-05

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Currencies: USDCurrencies: USDCurrencies: USDCurrencies: USD

0

20

40

60

80

100

120

140

160

180

29/ 12/ 1989 29/ 12/ 1992 29/ 12/ 1995 29/ 12/ 1998 29/ 12/ 2001 29/ 12/ 2004

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Rising InstabilitiesRising InstabilitiesRising InstabilitiesRising Instabilities1990-1994 2000-2004

mean median mean median

DJ 38.6 27 159.4 199

S&P 500 52.1 36 156 176

FTSE 53.9 57 158.9 174

Commodities 57 52 123 124

USD 106.5 100.5 134.4 138

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Experts’ ViewsExperts’ ViewsExperts’ ViewsExperts’ Views

Bernstein (1996):• Volatilities seems to be proliferating rather than

diminishing.

Krugman (1999):• The world economy has turned out to be a much

dangerous place than we imagined.

Tumpel-Gugerell (2003):• Volatility of leading stock markets has doubled

since 1997. Financial volatility is transmuted into volatility of real output.

Bernstein (1996):• Volatilities seems to be proliferating rather than

diminishing.

Krugman (1999):• The world economy has turned out to be a much

dangerous place than we imagined.

Tumpel-Gugerell (2003):• Volatility of leading stock markets has doubled

since 1997. Financial volatility is transmuted into volatility of real output.

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DerivativesDerivativesDerivativesDerivativesExponential growthControversial impactQuestionable validity

Exponential growthControversial impactQuestionable validity

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0

50,000

100,000

150,000

200,000

250,000

300,000

350,000

Jun-98 Dec.1998

Jun-99 Dec.1999

Jun-00 Dec.2000

Jun-01 Dec.2001

Jun-02 Dec.2002

Jun-03 Dec.2003

Jun-04 Dec.2004

Jun-05

OTC OE

Size of DerivativesSize of DerivativesSize of DerivativesSize of Derivatives

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Structure of DerivativesStructure of DerivativesStructure of DerivativesStructure of DerivativesZero-sum gamesSeparate risk from ownershipAllow hedging only through speculationDominated by speculatorsThreaten system stability

Zero-sum gamesSeparate risk from ownershipAllow hedging only through speculationDominated by speculatorsThreaten system stability

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Market DistributionMarket DistributionMarket DistributionMarket Distribution

Hedging:2.70%

Speculation:97.30%

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Risk DilemmaRisk DilemmaRisk DilemmaRisk DilemmaEconomic activities always involve riskExcessive risk hurdles performancePure risk trading transforms into

wagering

Economic activities always involve riskExcessive risk hurdles performancePure risk trading transforms into

wagering

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Unresolved IssuesUnresolved IssuesUnresolved IssuesUnresolved Issues

Ken Arrow (2003):• Derivatives can be used to reduce risk but

people gamble on them.• Speculators are adding to the swings rather

than reducing them.

Ken Arrow (2003):• Derivatives can be used to reduce risk but

people gamble on them.• Speculators are adding to the swings rather

than reducing them.

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Unresolved Issues…Unresolved Issues…Unresolved Issues…Unresolved Issues…

Kreitner (2000):• No analytical formula could distinguish

gambling from risk allocation.• The question of gambling was eventually

swallowed and internalized, as if the problem were solved.

• The contract law stopped worrying and learned to love risk.

Kreitner (2000):• No analytical formula could distinguish

gambling from risk allocation.• The question of gambling was eventually

swallowed and internalized, as if the problem were solved.

• The contract law stopped worrying and learned to love risk.

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The ChallengeThe ChallengeThe ChallengeThe ChallengeHow to have hedging without

unproductive speculation?How to distinguish legitimate risk

taking from gambling?Where to draw the line?

How to have hedging without unproductive speculation?

How to distinguish legitimate risk taking from gambling?

Where to draw the line?

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Islamic FrameworkIslamic FrameworkIslamic FrameworkIslamic FrameworkAcceptable risk (ex ante):

• Minor, likelihood of success is high• Inevitable, inseparable from real activities

Payoff structure (ex post):• Non-zero-sum-game

Acceptable risk (ex ante):• Minor, likelihood of success is high• Inevitable, inseparable from real activities

Payoff structure (ex post):• Non-zero-sum-game

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Statistical MeasureStatistical MeasureStatistical MeasureStatistical MeasureExpected utility is a statistical meanAllows for gamblingStatistical median:

• Excludes low probability events• Immune to outliers• Consistent with Islamic concept of gharar

Expected utility is a statistical meanAllows for gamblingStatistical median:

• Excludes low probability events• Immune to outliers• Consistent with Islamic concept of gharar

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Payoff StructurePayoff StructurePayoff StructurePayoff StructureZero-sum games: conflict of interestPositive sum games: cooperativeNon-zero-sum games: mixedMixed games are acceptable if the

positive outcome is dominant

Zero-sum games: conflict of interestPositive sum games: cooperativeNon-zero-sum games: mixedMixed games are acceptable if the

positive outcome is dominant

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Zero-sum GamesZero-sum GamesZero-sum GamesZero-sum Games

(+ ، –)(– ، +)

(A, B)

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Positive GamesPositive GamesPositive GamesPositive Games

(+ , +)(– , –)

(A, B)

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Mixed GamesMixed GamesMixed GamesMixed Games

(+ ، +)(– ، +)

(A, B)

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Product DesignProduct DesignProduct DesignProduct DesignMixed games allow risk transfer with

win-win outcomeCombine best of both worlds

Mixed games allow risk transfer with win-win outcome

Combine best of both worlds

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Islamic Product DevelopmentIslamic Product DevelopmentIslamic Product DevelopmentIslamic Product DevelopmentStrategies for product developmentImitation dilutes valuesIslamic finance becomes a follower

Strategies for product developmentImitation dilutes valuesIslamic finance becomes a follower

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Hedging InstrumentsHedging InstrumentsHedging InstrumentsHedging Instruments

Instrument Risks HedgedAsset-Liability alignment General

Delta-hedging General

Mutual hedging General

Bilateral mutual adjustment Rate of return

Conditional mudharabah Capital, misreporting

Combining musharakah and deferred sale

Capital, rate of return

Third party hedging Capital, rate of return

Diversified deferred price Capital, rate of return, liquidity

Value-based hybrid salam Capital, rate of return, liquidity

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Natural HedgeNatural HedgeNatural HedgeNatural HedgeAlign costs and revenuesShift some operations to the same

regionBorrow in the same currency

Align costs and revenuesShift some operations to the same

regionBorrow in the same currency

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Cooperative HedgeCooperative HedgeCooperative HedgeCooperative HedgeNon-profit arrangementsNo legal guaranteeRisk is shared by membersSuite all kinds of risks

Non-profit arrangementsNo legal guaranteeRisk is shared by membersSuite all kinds of risks

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Bilateral AdjustmentBilateral AdjustmentBilateral AdjustmentBilateral AdjustmentMurabaha cannot have a changing rateAdjust installment but keep total debt

fixed• If market rate is up: increase installment,

reduce balance• If market rate is down: reduce installment,

increase balance• Done with mutual agreement

Murabaha cannot have a changing rateAdjust installment but keep total debt

fixed• If market rate is up: increase installment,

reduce balance• If market rate is down: reduce installment,

increase balance• Done with mutual agreement

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Diversified Deferred PriceDiversified Deferred PriceDiversified Deferred PriceDiversified Deferred PriceAlso for murabahaHave the price in two components:

• Principal: in money• Markup: in liquid assets

Allow return to adjust to marketIf markup is large, total price becomes

tradable

Also for murabahaHave the price in two components:

• Principal: in money• Markup: in liquid assets

Allow return to adjust to marketIf markup is large, total price becomes

tradable

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Parallel MurabahaParallel MurabahaParallel MurabahaParallel MurabahaReplaces currency forwardsIntegrates currency hedge with goods

tradedMurabaha can be for financing or for

hedgingIntegrates risk transfer with value-

creation

Replaces currency forwardsIntegrates currency hedge with goods

tradedMurabaha can be for financing or for

hedgingIntegrates risk transfer with value-

creation

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ConclusionConclusionConclusionConclusionStrategies for product developmentVision for the value of the industryCapitalize on Islamic principles

Strategies for product developmentVision for the value of the industryCapitalize on Islamic principles