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Derivatives in Islamic Finance

Derivatives in Islamic Finance

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Published by Vampire
By ANDREAS A. JOBST.

Paper presented at the International Conference on Islamic Capital Markets held in
Jakarta, Indonesia
By ANDREAS A. JOBST.

Paper presented at the International Conference on Islamic Capital Markets held in
Jakarta, Indonesia

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Categories:Types, School Work
Published by: Vampire on Jun 28, 2008
Copyright:Attribution Non-commercial

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10/13/2012

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DERIVATIVES IN ISLAMIC FINANCE
ANDREAS A. JOBST
(forthcoming in
 Islamic Economic Studies
, Vol. 15, No. 1)
Paper presented at the International Conference on Islamic Capital Markets held inJakarta, Indonesia during August 27-29, 2007 jointly organized by IslamicResearch and Training Institute (IRTI) of the Islamic Development Bank (IDB),Jeddah, Saudi Arabia, and Muamalat Institute, Jakarta, Indonesia.
 
 
 
DERIVATIVES IN ISLAMIC FINANCE
ANDREAS A. JOBST
#
 
ABSTRACT
 Despite their importance for financial sector development, derivatives are few and  far between in countries where the compatibility of capital market transactionswith Islamic law requires the development of Shar 
i[ 
ah-compliant structures. Islamic finance is governed by the Shar 
i[ 
ah, which bans speculation, but stipulates that income must be derived as profits from shared business risk rather than interest or  guaranteed return. This paper explains the fundamental legal principles of Islamic finance, which includes the presentation of a valuation model that helps illustratethe Shar 
i[ 
ah-compliant synthetication of conventional finance through an implicit derivative arrangement. Based on the current use of accepted risk transfer mechanisms in Islamic structured finance, the paper explore the validity of derivatives from an Islamic legal point of view and summarizes the key objectionsof Shar 
i[ 
ah scholars that challenge the permissibility of derivatives under Islamiclaw. In conclusion, the paper delivers suggestions for Shar 
i[ 
ah compliance of derivatives.
Keywords:
derivatives, securitization, structured finance, Islamic banking, Islamicfinance, sovereign securitization, Shar 
i[
ah compliance,
uk 
,
mu
da 
rabah
,
ij
rah
,
mur 
ba
ah
,
rib
,
isti
n
a[ 
,
 gharar 
,
maisir 
,
ma
la
ah
.
 JEL Classification
: D81, G15, M20.
#
International Monetary Fund (IMF), Monetary and Capital Markets Department (MCM),700 19
th
Street, NW, Washington, D.C. 20431, USA; e-mail: ajobst@imf.org. The viewsexpressed in this paper are those of the author and should not be attributed to theInternational Monetary Fund, its Executive Board, or its management. Any errors andomissions are the sole responsibility of the author.
 
 International Conference on Islamic Capital Markets
2
1. INTRODUCTION
Financial globalization facilitates greater diversification of investment andenables risk to be transferred across national financial systems through derivatives.The resulting improvement in allocation of risks has made overall capital marketsmore efficient, while the availability of derivatives has increased liquidity in theunderlying cash markets. Amid a compressed spread environment, lower risk  premia have also encouraged investors to seek higher yields from emerging marketassets as alternative investment. With increasingly market-determined emergingmarket interest rates and currencies, extension of emerging market yield curves,rapidly growing volume of international trade and capital flows, and increasingstock market activity, the local and foreign interest in emerging derivative marketsis growing rapidly.The development of derivative markets in emerging markets plays a special rolein this context as more institutional money is dedicated to emerging markets, whichrequires the availability of financial instruments to manage market, credit andinterest rate risks in largely underdeveloped local capital markets. Derivatives ingeneral are financial contracts whose inherent value derives from, and exists byreference to, a pre-determined payoff structure of securities, interest rates,commodities, credit risk, foreign exchange or any other tradable assets, indicesthereof and/or baskets of any combination of the above with varied maturities.Derivatives assume economic gains from both risk shifting and efficient pricediscovery by providing hedging and low-cost arbitrage opportunities.While documentation standards and market practices that govern conventionalderivative transactions in mature markets have reached a point of uniformapplication, derivative markets are still poorly developed in many emerging marketcountries due to the absence of enabling legal provisions and accounting standardsspecific to the trading and enforcement of derivative claims have inhibited amaturing of derivative markets.Despite their importance for financial sector development, derivatives are fewand far between in countries where the compatibility of capital market transactionswith Islamic law requires the development of Shar 
i[
ah-compliant structures. Islamicfinance is governed by the Shar 
i[
ah, which bans interest, short selling andspeculation, and stipulates that income must be derived as profits from shared business risk rather than guaranteed return. Notwithstanding these religiousconstraints and legal uncertainty surrounding the enforceability of investor interestunder Islamic jurisprudence, Islamic finance can synthesize close equivalents toequity, mortgages, and derivatives known in conventional finance. To this end, itrelies on structural arrangements of asset transfer between borrowers and lenders toemulate traditional interest-bearing financial contracts.

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