Chapter 8 Derivatives in Islamic Finance

ISLAMIC INVESTMENT

Mahyuddin Khalidem

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Derivatives in Islamic Finance

Topic Outline

What is Derivatives

Rationale: Why do we need derivatives?

Shariah Compliant Derivative Instrument

Forward

Futures

Option

Swap

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What Is a Derivative?

Types

Options

FuturesSwaps

Financial instrument that derives its value from the value

of its underlying asset.

Definition

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What Is a Derivative?

A derivative can be define as a financial instrument whose value depends on (or derives from) the values of other, more

basic, underlying variables.

Very often the variables underlying derivatives

are the prices of traded assets.

However, derivatives can be dependent on almost any variable.

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Use of Derivative Instruments

Regulatory arbitrage

• Tax loopholes, etc.

Reduced transaction

costs

• Sometimes cheaper than manipulating cash portfolios

Speculation

• Essentially making bets on the price of something

Risk management

• Hedging (e.g. farmer with corn forward)

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The Main Players in Derivatives Market

Hedgers

•Hedgers use derivatives markets to manage or reduce risk

•They are typically business that use derivatives to offset exposure resulting from their activities

Arbitrageurs

•Arbitrage is a process of trying to take advantage of price differentials between markets.

•Arbitrageurs closely follow quoted price of the same asset/instruments in different market looking for price divergence.

•Should the price be divergent enough to make profit, they would buy on the market with lower price and sell on the market where the quoted price is higher.

•Most financial market integrated by computer networks, arbitrage opportunities can quickly disappear, hence quick action is needed.

Speculators

•Take position in assets or markets without taking offsetting position.

•E.g. If they expect a certain asset to fall in value, they would short the asset.Should their expectation come true they would make profit from having shorted in asset.

•Hope profit from taking risk.

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Types of Derivatives

Exchange-Traded (ETD)

• Contracts that are traded on derivatives exchanges.

• Contracts traded are standardized as defined by the exchange.

• Derivatives exchange acts as a counter-party to all contracts.

Over-the-Counter (OTC)

• Contracts that are privately negotiated and traded directly between two parties.

• OTC market is the largest market for derivatives.

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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Rationale: Why do we need derivatives?

As with any other financial product, derivatives were the result of financial innovation.

Innovation that responded to the existing need to help manage risk.

While forward contracts were originally innovated for risk-management of agro-based products, the later instruments were needed as risk environments changed.

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 movements (unlike lock-in) managing contingent claims/liabilities.

The objective of all these innovation is Risk Management.

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Derivatives and Risk Management

Risk, from a finance viewpoint, refers to the uncertainties

associated with returns from an investment.

These uncertainties would translate into volatility or fluctuation of

returns from an investment.

Measured by std. deviation.

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Derivatives and Risk Management

Off Balance Sheet

All risk management techniques involving derivatives are Off Balance Sheet.

The hedging mechanism/method is “detached” from the underlying transaction.

Advantage: No need to change the way one does business. No loss of competitiveness,

customer convenience etc.

Despite the popularity of derivatives based off Balance-Sheet techniques; Islamic Jurists have

generally not been in favor.

On Balance Sheet

On Balance Sheet technique is one where a transaction is structured in such a way as to

manage the inherent risk.

E.g.: 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)

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All Islamic financial instruments in general must meet a number

of criteria in order to be considered halal (permissible).

At a primary level all financial instruments and transactions must

be free of at least the following items:

Riba (usury)

Gharar (uncertainty)

Maysir (gambling)

Other undue practices.

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Riba

• Riba can be in different forms and is prohibited in all its forms

• E.g. Riba can also occur when one gets a positive return without taking any risk.

Gharar

• As for gharar, there appears to be no consensus on what gharar means.

• It has been taken to mean, unnecessary risk, deception or intentionally induced uncertainty.

• In the context of financial transactions, gharar could be thought of as looseness of the underlying contract such that one or both parties are uncertain about possible outcomes.

Maysir

• Maysir from a financial instrument viewpoint would be one where the outcome is purely dependent on chance alone – as in gambling.

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Islamic Financial Service Act 2013 define Islamic Derivatives as:

Any agreement, including an option, a swap, futures or forward contract,

Made in accordance with Shariah,

Whose market price, value, delivery or payment obligations

Is derived from, referenced to or based on, but not limited to, Islamic securities, commodities,

assets, rates (including profit rates or exchange rates) or indices

The type of Islamic Derivatives that

currently in use are:

Islamic FX forwards (IFF)

Islamic swaps (Islamic FX swaps, Islamic Cross Country swaps and Islamic Profit Rate swaps)

Islamic options

Futures contract


There are numbers of muamalah contract that have features

resembles derivatives and can be used for hedging such as

salam, istisna, urbun and Hamish jiddiyah.

The muamalah contract that are used to create products which

have features similar to forwards, futures, options and swaps

are commodity murabahah, musawamah, bay’ al-’inah, BBA,

tawarruq and wa’ad.

In addition to these requirements for financial instruments, the

shariah has some basic conditions with regards to the sale of an

asset (in this case a real asset as opposed to financial assets).

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According to the shariah for a sale to be valid,

the commodity or underlying asset must currently exist in its

physical sellable form

the seller should have legal ownership of the asset in its final form.

These conditions for the validity of a sale would obviously render

impossible the trading of derivatives.

However, the shariah provides exceptions to these general

principles to enable deferred sale where needed.

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Forward contracts

Forward Contracts

Definition: a contract between two parties for one party to buy

something from the other at a later date at a price agreed upon

today

It can be contrasted with a spot contract, which is an agreement

to buy or sell an asset today.

A forward contract is traded in the over-the-counter market—

usually between two financial institutions or between a financial

institution and one of its clients.

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Forward contracts

Function in financial operation: hedge risk; as a means of

speculation; or to allow a party to take advantage of quality of

the underlying instrument which is time sensitive.

In this contract, both parties (buyer and seller) eliminate the

price risk by “locking in” the price at which they would carry out

the transaction at the future date.

Example:

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Futures contracts

Futures Contract:

Definition: A futures contract is an agreement between two parties

to buy or sell an asset at a certain time in the future for a specified

price.

Unlike forward contracts, futures contracts are normally traded

on an exchange.

To make trading possible, the exchange specifies certain

standardized features of the contract.

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Forward and Futures in Islamic Finance

Main Issues of forward and futures is deferment in price and

asset to a future date.

A number of instruments/contracts exist in Islamic finance that

could be considered a basis for forward/futures contracts within

an Islamic framework. These are Salam Contract, Istisna Contract

and Jualah Contract.

Each of these contracts concern deferred transactions, and

would be applicable for different situations.

However to defer both price and asset to future date is

problematic due to issue of Gharar.

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Salam Contract and Future

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

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

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

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

Thus, Salam contract is subject to several conditions:

Full payment by buyer at the time of effecting sale.

The underlying asset must be standardizable, easily quantifiable and of determinate quality.

Cannot be based on an uniquely identified underlying.

Quantity, Quality, Maturity date and Place of delivery must be clearly enumerated.


OIC Fiqh Academy ruled that defer both the counter-values in the

trading of commodities (forward contract) is not permissible, but

recommended that such commodity trading follow Salam rules in

order to be permissible.

It follows that forwards and futures contract may use Salam contract

but this requires full payment of the asset price at the time of

contract.

Specification of the reference must be clearly made; quantity,

type & date delivery

The first and probably the most relevant of these to modern day

forward/futures contracts would be the Salam Contract. If Salam

rules followed, then should be approves by all scholar

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Closing Out & Margin Trading

In futures, buyer and seller are required to take or make physical or cash settlement delivery upon expiry of the time specified, unless they close their position

Close position: re-sell the futures before its expiry. This normally happen when the parties feel that the contract has risen or fallen in their favour.

E.g. Trader bought future contract, he will sell it to close out when the price is gone up. On the other hand, if a trader has sold a futures contract he will buy back to close out when the price goes down.

OIC Fiqh Academy: Practice of closing out is not permissible.

Traders of futures don’t need a lot of money to start because they are only obliged to pay a percentage of the contract value. If the price swings are in their favour, they stand to gain an amount of profit that is calculated based on the whole contract value. But if it unfavourable, they stand to lose huge amount base on contract value.

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Views on Permissiblity of Futures contract:

Imam Al-Haramaini Al-Jauwaini

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

Needs of the Ummah

Shariah Advisory Council (SAC) of Securities Commission

Futures trading of commodities is approved as long as underlying asset is

halal.

Crude Palm Oil Futures Contracts are approved for trading.

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Stock Index Futures (SIF) contract

SAC of SC

SIF is permissible. However since the current Bursa Malaysia based SIF has

non-shariah compliant stocks, it is not approved.

SAC decided that an index futures should free from element gambling,

jahalah and gharar, should be allowed especially when it is a maslahah of

people and economy.

Ahmad Allam of OIC Islamic Fiqh Academy (14/5/1992)

SIF trading is prohibited, since some of the underlying stocks are not halal.

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

shariah-compliant; SIF trading is not approved.

Mufti Taqi Usmani

Futures transactions not permissible, for 2 reasons;

According to shariah, sale or purchase cannot be affected for a future date.

In most futures transactions delivery or possession is not intended.

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Options

Option contract:

Definition: financial instruments that convey a right, but not an obligation, to engage in a future transaction on some underlying securities, or in futures contract.

Options are traded both on exchanges and in the over-the-counter market.

There are two types of option:

Call option gives the holder the right to buy the underlying asset by a certain date for a certain price.

Put option gives the holder the right to sell the underlying asset by a certain date for a certain price.

The price in the contract is known as the exercise price or strike price.

The date in the contract is known as the expiration date or maturity.

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Options in Islamic Finance

When viewed solely as a promise to buy or sell an asset at a

predetermined price within a stipulated period, shariah scholars

find nothing objectionable with options.

It is in the trading of these promises and the charging of

premiums that 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 faith deposit.

Ahmad Muhayyuddin Hassan (1986)

Option trading contract is prohibited, for 2 reasons

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

The buyer gets more benefits than the seller – injustice.

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Abu Sulayman of OIC Islamic Fiqh Academy

Acceptable when viewed in the light of bai-al-urbun

But considers options to have been detached and independent of the

underlying asset – therefore: unacceptable.

Mufti Taqi Usmani of OIC Islamic Fiqh Academy

Promises as part of a contract is acceptable in Shariah, however the

trading and charging of a premium for the promise is not acceptable.

Yet others have argued against options by invoking “maisir” or

unearned gains. That is, the profits from options may be unearned.

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Hashim Kamali (1998)

Options trading is acceptable

Invokes the Hanbali tradition

Cites Hadiths of Barira (RA) and Habban Ibn Munqidh (RA).

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

Also cites that contemporary scholars such as Yusuf al-Qaradawi and Mustafa al-Zarqa have authenticated al-urbun. (similar stand by Iranian scholars)

Shariah Advisory Council (SAC) of 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. E.g. Call Warrants are simply long dated Call Options. Have similar risk/payoff

profile.

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Swap:

A bilateral contract where the parties agree to exchange a series of cash flows at fixed periodic intervals based on the underlying asset.

Features of Swap:

Exclusively over-the-counter

Other types of derivatives include swaptions and hybrids.

Their creation is a process called financial engineering.

The Underlying Asset

Called the underlying

A derivative derives its value from the underlying.

Five generic types of Swaps:

Interest rates swaps

Currency swaps

Credit Swaps

Commodity Swaps

Equity Swaps

Swaps and Other Derivatives

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Issues and Challenges in Islamic Derivatives

Shariah IssuesProduct

structuringUse of the Product

Legal Issues Lack of

standardizationEnforceability

of Wa’ad

Regulatory Issues

Lack of regulatory framework

Ethical and Moral Issues

SpeculationMaysir, Qimarand Gharar

Conventional mindset of derivatives

user

Mindset of banker

Conclusion

The overall stance of Fuqaha, of conventional derivative

instruments appears to be one of apprehension even suspicion.

That these instruments could easily be used for speculation

appears to be the key reason for objection.

That derivatives form the basis of risk-management appears to

have been lost.

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Summary

In this chapter you have learned about:

What is Derivatives


Forward

Futures

Option

Swap

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Thank you34

Education

Chapter 8 Derivatives in Islamic Finance