1. INTRODUCTION

The conventional options, swaps and futures stem from debts and involve sale and

purchase of debts or liabilities. As a group, products such as interest-rate swaps, stock options

and futures, currency futures etc are called derivatives which are instruments derived from

the expected future performance of the respective underlying assets. These are very complex

and risky contracts having present market value of trillions of dollars over the world.

According to an article published in the Economist, some $ 128 trillion of over the counter

derivatives were outstanding in June 2002, a 28% increase over a year earlier1. It has been

observed, however, that global financial market is becoming increasingly fragile as more and

more derivatives and ‘hedging’ instruments emerge.

The development of derivative markets in emerging markets plays a special role in

this context as more institutional money is dedicated to emerging markets, which requires the

availability of financial instruments to manage market, credit and interest rate risks in largely

underdeveloped local capital markets. Derivatives in general are financial contracts whose

inherent values derive from, and exist by reference to, a pre-determined payoff structure of

securities, interest rates, commodities, credit risk, and foreign exchange or any other tradable

assets, indices thereof and/or baskets of any combination of the above with varied maturities.

Derivatives assume economic gains from both risk shifting and efficient price discovery by

providing hedging and low-cost arbitrage opportunities.

1.1 AN ASSESSMENT OF THE ARGUMENTS AGAINST DERIVATIVES

This final section is intended to evaluate some of the arguments and reservations put

forth by Islamic scholars, from a conventional finance viewpoint. The objective is to clarify

why the trading mechanism and other processes in derivative markets are the way they are.

Before proceeding, it must be kept in mind that contemporary derivative markets have in

place processes and trading systems that have been fine tuned over years of practice, There

have been many past failures and exchanges and markets have had painful lessons. They have

responded by tightening regulation, redesigning instruments and trading methods and added

new control features. It would be absurd to brush aside all of these experiential learning.

1.1.1 Trading Volume

The first issue that will be address here is the argument often put forth that the huge

trading volume of derivative markets is indicative of extensive speculation, that the market

attract and accentuates speculative behavior. While it cannot be denied that there is plenty of

speculative activity, there are logical reasons for why the total trading volume is often much

larger than underlying asset volume. Often 10 or 15 times higher, this huge divergence

between underlying assets and trading volume has to do with risk dissipation.

1.1.2 The Issue of Non Delivery

Issue that causes uneasiness among ulama’s is the fact that a large portion of those

trading in derivative markets have no intention of either making or taking delivery of the \

underlying asset. The implication is that since there is no intention of delivery, these people

must all be speculators. There are however many situations in which even genuine hedgers

world not want to take or make delivery.

1.1.3 Cash Settlement

The issue of cash settlement is yet another contentious point. Some have alleged that

cash settlement was designed in order 10 enhance speculative activity. Far from being

intended to help speculators, cash settlement is used for the many advantages it has. Cash

settlement is normally though not exclusively used with financial futures and options as for

example such as stock index futures and index options. Though a relatively new type of

settlement procedure, exchanges have a preference for cash settlement largely due to three

advantages.

The first advantage is convenience to both parties. Without cash settlement the

seller/short position would have to buy each of the underlying stocks in the correct proportion

in order to deliver. This would not only be tedious but cause complications of having to buy

in oddlot sizes. On delivery, the long position will have to get all these stocks registered or

sell them in the odd lot received, again a tedious and time consuming process. Cash

settlement overcomes this. If the long position wants to receive the stocks it would not be a

problem since underlying stocks are trading contemporaneously. The second advantage is

cost reduction. By avoiding the need for the short to buy the underlying stock and the long

position to sell the received stock, both parties save substantial transaction costs. A third

advantage of cash settlement is that a market cornering attempt will not work. It would be

impossible to corner a market when physical delivery is not needed. There is no reason why

cash settlement as opposed to physical delivery would induce any greater uncertainty or

gharar. A hedger who had taken a position will have locked in a price regardless of whether

the contract is cash or physically settled. Much of the argument that cash settlement increases

gharar ignores the convergence principle. By this principle, the futures price at maturity must

converge to the spot price, since on its maturity day a futures contract is essentially a spot

contract Aside from this reason, a disparity between futures and spot price at maturity will

mean easy riskless arbitrage. The existence of such arbitrage is yet another reason why there

cannot be any disparities to cause increased uncertainly or gharar.

FORWARD

A derivative instrument is simply a financial instrument or asset that derives its value

from the value of some other underlying asset. The first derivative instrument was probably

the forward contract. Not surprisingly, forwards was also the simplest type of derivatives. In

a forward contract two parties undertake to complete a transaction at a future date but at a

price determined today.

Forward in the terms of its benefits based on Fiqh Academy resolution are mainly

contracts that provide the opportunity for industrial and commercial institutions to finance

their projects through the issuance and sale of stocks and financial instruments. Besides that,

it also provides a permanent venue for traders in commercial instruments and commodities.

However, there are some objections to forward contract which are:

1) Its contracts are by and large paper transactions and not genuine purchases and

sales as they do not involve the delivery or taking of possession of their

underlying commodities.

2) Entail oppressive practices on the part of those who engage in them through a kind

of monopoly by making large sales and purchases of contracts in commodities to

force smaller traders to take a loss and suffer hardship as a result.

3) Bring price distortion. Price is not entirely the function of market forces of supply

and demand or genuine purchases and sales by parties who need to conclude a

certain transaction.

Although spot trading is basically a contract for the physical delivery, sometimes the

contract may involve some elements of forwarding.

SALAM AND THE FORWARD CONTRACT.

It is the closet among the contracts in Islamic law to the conventional forward

contracts. Some scholars have considered it as the Islamic alternative to the forward

contracts. Sudin Haron said:

Forward markets exist in Islamic financial system but only on a limited scale. In case

of forward markets for money there is a divergence of opinion pertaining to the legality of

such transaction from the point of view of shariah. Forward markets for commodities are

aloowed by shariah under the principle of bay’ al-salam (advance purchase) and istisna

(contract to manufacture).

Here, the outstanding issue is that in bay’ al-salam full payment at the time of

agreement is a requirement according to the majority of Muslim jurists which is not the case

in the forward contract. Other issue concern related to bay’ al-salam and the forward contract

is the claim made by many scholars that bay’ al-salam accepted in Islamic law but not in

accordance to the norms, rather its acceptance is considered to be an exception. It is not

possible to make an analogy between salam and any new contract. It is also need to be

addressed in connection with the legality of the forward contract. Zamir Iqbal had stated that

bay’ al-salam to be the closet substitute for the forward contract. He acknowledged that bay’

al-salam is not practiced in the financial market for two reasons that are first compared to the

western forward contract, bay’ al-salam requires full payment at the time of agreement.

Second, since interest is incorporated in the determination of the forward contract price it is

synonym with paying or receiving interest. He then concluded that a forward contract may

not incorporate the element of interest as it is prohibited.

It may submitted that the issues related to salam in connection to the forward contract

which need to be discussed are the issue if full payment at the time of agreement in salam and

other is possibility of drawing an analogy and not against it. Lastly, based on other argument

and the fact that salam is in line with qiyas and not against it, it can be understand that the

modern forward contract is a valid contract by way of analogy to salam.

ISTISNA AND THE FORWARD CONTRACT

It is a contract for selling a manufacturable thing with an undertaking by the seller to

present it manufactuered from the person own material with a specified descriptions and at a

determined price. Several conditions should be fulfilled that are:

a) The object of the contract must be precisely determined both in its essence and

quality.

b) The time of delivery must be specified (short and long) to avoid confusion of date of

delivery, which may otherwise lead to conflict between the parties.

c) The manufacturer should supply the material. If the material is supplied by the buyer,

the contract is ijara and not istisna.

d) The place of delivery should be specified if the commodity needs loading or

transportation expenses. In istisna, not a condition to advance the payment though it is

permissible to do so. Otherwise it could be deferred or made in instalments.

Moreover, it is not a condition that the seller be an expert in manufacturing.

However, istisna is more in line with the conventional forward contract where the

price is not paid in advance as well. Majority of Muslim jurists, istisna cannot be applied to

commodities that are normally available in the market. Thus, a seller agreeing to provide a

product in the future under istisna will have to be a producer or have to establish a parallel

contract with a producer. It is clear from the contractual specifications of istisna that is almost

the same as the modern forward contract. The deferment of price in istisna according to the

classical scholars is allowed on the basis of istihsan and need rather than norms. The

difference between istisna as a production contract and the modern forward contract as a

trading contract should not be used as an excuse to reject the forward contract.

Under bay’ al-istisna the two parties can agree on the sale of a nonexistent product as

it is elaborated. A certain percentage of the sale price as an advance is permissible. Istisna

achieved some of the benefits of the conventional forward contract. There is a need for the

adoption f the forward contract in Islamic finance.

IBTIDA’ AL-DAYN AND THE FORWARD CONTRACT

The sale of debt for debt called by the Malikis ibtida’ al-dayn bi al-dayn (deferment of

both countervalues) is at the core of forward trading. The different schools of law have

prohibited this form of sale of debt. Some of the sales involves riba’ while for others it is

gharar. The Malikis consider this as one of the lesser evils. Rafiq al-Masri argued that no

extra gharar is involved in deferring both countervalues compared to the deferment of one of

them only. In other words, if one of the countervalues has been delivered while the other is

deferred for a future date or both of them are deferred, the level of risk is the same and there

is no possibility of extra gharar. However the objective of the forward contract or uqud al-

tawrid is to satisfy the need of some public institutions, factories and construction companies

which are in need of certain materials on a specific date and may not be need of the money at

the time of contract.

BAY’ AL-SIFAH AND THE FORWARD CONTRACT’

Is the sale of something that is not present at the time of contract but will be delivered

in the future. The Hanafis validate the sale by description or bay’ al-sifah and the guarantee

the buyer the option of inspection whether the subject matter of the contract is presented

according to the agreed upon condition or not. The Malikis and Hanbalis guarantee the buyer

the right of the option of inspection only when the commodity is presented without fulfilling

the conditions required.

On the possibility of accommodating the conventional forward contract as a kind of

bay’ al-sifah, Abd al-Wahhab Abu Sulaiman maintained that first it is bay al-sifah and then

forward contract based on a detailed description of the subject matter, relying on previous

observation. Second, in both contracts the subject matter is absent and the parties have a real

intention to fulfil the contract and want it to be executed according to the time and place

specified. Lastly are both contracts countervalues are deferred although the price could be

paid by instalments as well.

The close similarities between the two contracts and the fact that the conventional

forward contract is immune from riba and gharar, which are the most commonly advanced

arguments to invalidate it, it could stated the forward contract is a valid contract in Islamic

law. Similarly there is no risk regarding the subject matter of the contract since it is well

defined.

SWAPS

It is an Islamic variant of the conventional transactions. The conventional swaps have

been generally observed to be unIslamic as they clearly involve interest payments. Islamic

swaps (al-murajaha al-Islamiyah) as highlighted in section 2 are in use by several Islamic

banks. A close look at the nature of contracting reveals that the same essentially involves an

exchange of two interest-free loans (qard) in different currencies which are repaid by both

parties at the end of a stipulated time period. It is easy to see that such swaps partially enable

the parties to hedge their currency risk. An Islamic swap between two banks may help both

banks to partially reduce their risk.

The major difference of this type of swap from its conventional counterpart is that in

case of the latter, the interest payments along with the principal are swapped. In case of

Islamic swap, only the principal is being swapped since the incomes to be generated on the

investments are not predetermined.

Islamic swaps may perform many other useful functions besides serving as a tool of

risk management, such as, reducing cost of raising resources, identifying appropriate

investment opportunities, better asset-liability management and the like. These are also the

benefits with conventional swaps. Islamic swaps are different in that they do not involve

interest-related cash flows. However, Islamic swaps are not free from controversies and there

is no consensus regarding their acceptability.

An Islamic profit rate swap is basically an agreement to exchange profit rates between

a fixed rate party and a floating rate party or vice versa implemented through the execution of

a series of underlying contracts to trade certain assets under the Shariah contracts. Each

party’s payment obligation is computed using a different pricing formula. In Islamic rate

profit rate swap, the notional principal is never exchanged as it netted off using the Islamic

principle of Muqasah.

An Islamic profit rate swap aims to match funding rates with return rates (from

investment), achieve lower cost of funding, restructure existing debt profile without raising

new finance or altering the balance sheet and manage exposure to interest rate movement. It

is also aimed to protect financial institutions from fluctuations in borrowing rates and to

provide a risk control mechanism.

Like other Islamic contracts, contracts in Islamic swaps must also be free from any

elements of riba (usury), maysir (gambling), Gharar (unnecessary risk) and jahl (ignorance).

In addition to these elements, Islamic swaps are different from conventional swaps in that

they are linked with asset-backed transactions such as Bai’, Bai’ Bithaman Ajil, Murabahah,

Ijarah and other.

Reference

http://www.kau.edu.sa/centers/spc/jkau/Doc/Isl/11/Financial%20Options%20in%20Islamic

%20Contracts.pdf

DERIVATIVES IN ISLAMIC FINANCE ANDREAS A. JOBST (forthcoming in Islamic

Economic Studies, Vol. 15, No. 1)

Smua jurnal yg ko bg kat aq cik ros....;p