Hedge Fund Monthly

Derivatives in Islamic Finance
Andreas A Jobst, International Monetary Fund May 2008

Despite their importance in financial sector development, derivatives are few and far between in countries where the compatibility of capital market transactions with Islamic law requires the development of Shariah-compliant structures. Islamic finance is governed by the Shariah, which bans speculation, but stipulates that income must be derived as profits from shared business risk rather than interest or guaranteed return. Based on the current use of accepted risk transfer mechanisms in Islamic finance, this article explores the validity of derivatives in accordance with fundamental legal principles of the Shariah and summarises the key objections of Shariah scholars that challenge the permissibility of derivatives under Islamic law. In conclusion, the article delivers suggestions for Shariah compliance of derivatives. Types of Islamic Finance Since only interest-free forms of finance are considered permissible in Islamic finance, financial relationships between financiers and borrowers are not governed by capital-based investment gains but shared business risk (and returns) in lawful activities (halal). Any financial transaction under Islamic law implies direct participation in asset performance, which constitutes entrepreneurial investment that conveys clearly identifiable rights and obligations, for which investors are entitled to receive commensurate return in the form of state-contingent payments relative to asset performance. The Shariah does not object to payment for the use of an asset, as long as both lender and borrower share the investment risk together and profits are not guaranteed ex-ante but accrue only if the investment itself yields income. In light of moral impediments to passive investment and secured interest as form of compensation, Shariah-compliant lending requires the replication of interestbearing conventional finance via more complex structural arrangements of contingent claims, subject to the intent to create of an equitable system of distributive justice and promote permitted activities and public goods (maslahah). The permissibility of risky capital investment without explicit interest earning has spawned three basic forms of Islamic financing for both investment and trade: i. synthetic loans (debt-based) through a sale-repurchase agreement or back-to-back sale of borrower or third party-held assets lease contracts (asset-based) through a sale-leaseback agreement (operating lease) or the lease of third-party acquired assets with purchase obligation components (financing lease)


the put-call arrangement of asset-based Islamic lending implies a sequence of cash-neutral. or the acquisition of third-party assets by the lender on behalf of the borrower. The present value of the lender’s ex-ante position at maturity is . Since poor transparency of S in long-dated contracts could make the time value of +P(E) appear greater than its intrinsic value. through the attribution of economic benefits from the ownership of an existing or future (contractible) asset by means of an implicit derivatives arrangement. profit-sharing contracts (equity-based) of future assets. the combination of a put and call option on the same strike price represents a series of individual (and periodically extendible) forward contracts on asset value S over a sequence of rental payment dates t. Implicit Derivatives in Islamic Finance From an economic point of view. which have previously been acquired from either the borrower or a third party. so that Click on the image for an enlarged preview where and denote the risk-free interest rate analogue and the market price of risk implicit in the pre-specified repayment of the lending transaction. long-term Islamic lending with limited information disclosure would require a high repayment frequency to .and asset-based contracts are initiated by a temporary (permanent) transfer of existing (future) assets from the borrower to the lender. which equals the present value of the principal amount and interest of a conventional loan.iii. risk-free (forward) hedges of credit exposure. both debt. As opposed to equity-based contracts. the borrower leases from the lender one or more assets A valued at S. In asset-based Islamic finance. The lender entitles the borrower to (re)gain ownership of A at time T by writing a call option -C(E) with time-invariant strike price E subject to the promise of full repayment of E (via a put option +P(E)) plus an agreed premium in the form of rental payments over the investment period. The concept of put-call parity illustrates that the three main types of Islamic finance represent different ways to re-characterise conventional interest. This arrangement amounts a secured loan with fully collateralised principal (ie full recourse). In a more realistic depiction. Overall. creditor-in-possession-based lending arrangements of Islamic finance replicate interest income of conventional lending transactions in a religiously acceptable manner.

generic future contracts appear to contravene Shariah principles in the way they limit counterparty risk. maturity and quality. In Islamic profit-sharing (equity-based) agreements. Options remove the . Moreover. However. and thus are not deemed objectionable on religious grounds. rendering the contract out-of-the-money and making deliberate default more attractive. However. Since the absence of underlying asset transfer renders MTM pricing unacceptable under Islamic law. borrower indebtedness from a sale-repurchase agreement (cost-plus sale) of an asset with current value PV(E). While implicit derivatives in the form of forward contracts are essential to the put-call parity replication of interest through profit generation from temporary asset transfer or profit-sharing in Islamic finance. Although the non-defaulting party does have legal recourse. redress perceived market imperfections and financing constraints. a Shariahcompliant solution to this problem could be the marginal adjustment of periodic repayment amounts in response to any deviation of the underlying asset value from the pre-agreed strike price at different points in time until the maturity date. But conventional futures still imply contingency risk. this equity-based arrangement precludes any recourse in the amount +P(E) in the absence of enforceable collateral. Since the lender bears all losses. cumbersome and expensive. standardised forward contracts in terms of size. which are exchange-traded. ‘Explicit’ Derivatives Amid weak reliance on capital market financing in many Islamic countries. In debt-based Islamic finance. forward contracts elevate the risk of one counterparty defaulting when the spot price of the underlying asset falls below the forward price prior to maturity. especially in areas of conflicting legal governance as a matter of form (commercial law versus Islamic law). the process of seeking contractual enforcement can be lengthy. Parties to forward agreements need to have exactly opposite hedging interests. Futures are generally priced marked-to-market (MTM). the explicit use of derivatives remains highly controversial. which inter alia coincide in timing of protection sought against adverse price movements and the quantity of asset delivery. and thus do away with the constraint of double coincidence in forward contracts. These obvious shortcomings of forwards create the economic rationale for futures.ensure efficient investor recourse. the implicit forward element of Islamic lending contracts – like forwards in conventional finance – involves problems of double coincidence and counterparty risk due to privately negotiated customisation. implies a premium payment to the lender for the use of funds over the investment period T and the same investor pay-off L1 as asset-based Islamic finance. which requires margin calls from the party that is out-of-the-money. risk transfer mechanisms are subject to several critical legal hindrances that impact on the way derivatives. the lender receives a payout in accordance with a pre-agreed disbursement ratio only if the investment project generates enough profits to repay the initial investment amount and the premium payment at maturity T.

non-refundable premium. Unlike in conventional options. which transforms a derivative contract into a paper transaction without the element of a genuine sale. which could otherwise only be exercised by the purchase of the underlying asset at the prevailing spot price. there are no unilateral gains from favourable price movements (eg in-the-money appreciation of option premia) in the range between the current and the contractually agreed repayment amount. both creditor and debtor are obliged to honour the terms of the contract irrespective of changes in asset value. the bilateral nature and asset-backing ensure definite performance on the delivery of the underlying asset (unlike a conventional forward contract). in Islamic finance.. require creditors (or protection sellers) to actually own the reference asset at the inception of a transaction. the requirement of qabd (ie taking possession of the item prior to ii. the selection of reference assets that are nonexistent at the time of contract. which renders all commercial transactions Shariah compliant in the absence of a clear and specific prohibition. The sequence of periodic and maturitymatched put-call combinations (with a zero-cost structure) preserves equitable risk sharing consistent with the Shariah principles of entrepreneurial investment. Given the Islamic principle of permissibility (ibahah). as it supplants the concept of direct asset recourse and implies a zero-sum proposition. however. current objections to futures and options constitute the most discouraging form of religious censure (taqlid).exposure to discretionary non-performance in return for the payment of an upfront. the assurance of definite performance through either cash settlement (in futures) or mutual deferment (in options) like in conventional derivatives contracts is clearly not. Instead. While the premise of eliminating contingency risk is desirable per se under Islamic law. which negates the hadith (sell not what is not with you). Any deviation of the underlying asset value from the final repayment amount constitutes shared business risk (in an existing or future asset). . Shariah principles. in most futures transactions delivery of the commodities or their possession is not intended”. Options do not only serve to hedge adverse price movements so much as they cater for contingencies regarding the delivery or receipt of the asset and offer the opportunity to take advantage of favourable price movements. Futures and options also continue to be rejected by a majority of Islamic scholars on the grounds that “. Shariah scholars take issue with the fact that futures and options are valued mostly by reference to the sale of a non-existent asset or an asset not in the possession (qabd) of the seller. Besides the lack of asset ownership at the time of sale. parties reverse the transaction and cash settle the price difference only. Holders of a call option have the right (but not the obligation) to acquire the underlying asset.. other areas of concern shared by Islamic scholars about Shariah compliance of derivatives have centred on: i. Often. By virtue of holding equal and opposite option positions on the same strike price. Derivatives almost never involve delivery by both parties to the contract.

exercising it over a period of time or charging a fee for it. . Kamali (2001) finds that “there is nothing inherently objectionable in granting an option. Many policymakers. market participants and regulators are frequently unfamiliar with the intricate mechanics and the highly technical language of many derivative transactions. and eschew avertable uncertainty (gharar) as prohibited sinful activity (haram) in a bid to create an equitable system of distributive justice in consideration of public interest (maslahah). he also acknowledges the risk of exploitation and speculation. and as such. futures and options may be compatible with Islamic law if they: i.resale). Nonetheless. iii. improves stability at all levels of the financial system and enhances general welfare. ii. Although Khan (1995) concedes that “some of the underlying basic concepts as well as some of the conditions for (contemporary futures) trading are exactly the same as (the ones) laid down by the Prophet Mohammed (peace be upon him) for forward trading”. In principle. strong opposition to derivatives seems to be inherited from the pathology of religious interpretation that turns a blind eye to the fact that derivatives are a new phenomenon in an Islamic context. are employed to address genuine hedging demand on asset performance associated with direct ownership interest. mutual deferment of both sides of the bargain. For the same reasons. several scholars also consider options in violation of Islamic law. which reduces contingency risk but turns a derivative contract into a sale of one debt for another. resulting in zero-sum payoffs of both sides of the bargain. iii. Risk diversification through derivatives contributes to the continuous discovery of the fair market price of risk. and that options trading like other varieties of trade is permissible mubah. disavow mutual deferment without actual asset transfer. The governance of derivatives has no parallel in the conventional law of muamalat and should therefore be guided by a different set of rules. and excessive uncertainty or speculation that verges on gambling. which belie fundamental precepts of the Shariah. Establishing Islamic derivatives The heterogeneity of scholastic opinion about the Shariah compliance of derivatives is largely motivated by individual interpretations of the Shariah and different knowledge about the mechanics of derivative structures. iv. which hinder a more comprehensive understanding and objective appreciation of the role of derivatives in the financial system and their prevalence in a great variety of business and financial transactions. With that in mind. it is simply an extension of the basic liberty that the Quran has granted”.

such as an Islamic primary market project led by Bahrain-based International Islamic Financial Market (IIFM) in cooperation with the International Capital Markets Association (ICMA). By setting incentives for higher productivity. . Recent efforts of regulatory consolidation and standard setting have addressed economic constraints and the legal uncertainty imposed by both Islamic jurisprudence and poorly developed uniformity of market practices. market inefficiencies and concerns about contract enforceability caused by heterogeneous prudential norms and diverse interpretations of Shariah compliance are expected to dissipate in the near future. Also. Financial innovation will contribute to further development and refinement of Shariah-compliant derivative contracts. Kuwait and Malaysia have been gearing up for more Shariah-compliant financial instruments and structured finance – both on the asset and liability side. In November 2006. the issuance of stock options to employees would be an ideal candidate for a Shariah-compliant derivative. agreed to execute a derivative master agreement for the documentation of Islamic derivative transactions. As Islamic finance comes into its own and companies turn to means of hedging their exposures more efficiently. Private sector initiatives.Shariah-compliant derivatives would also maintain risk sharing that favours winwin situations from changes in asset value. Bank Islam and Bank Muamalat Malaysia. have resulted in the adoption of a memorandum of understanding on documentation standards and master agreement protocols for Islamic derivatives. For instance. Therefore. the de facto application of many derivative contracts is still objectionable due to the potential of speculation (or deficient hedging need) to violate the tenets of distributive justice and equal risk sharing. firm owners reap larger corporate profits that offset the marginal cost of greater employee participation in stock price performance. financial institutions in Bahrain. subject to religious restrictions lending and profit-taking without real economic activity and asset transfer. However. Malaysia’s only fully-fledged Islamic banks. national solutions are gaining traction.

3. to overcome this uncertainty. A speculator thrives on volatility. both on t+0 Deferred: commodity is delivered (t+0). In contrast. Lets look at an example of a farmer and a miller.the main scholars contend that excessive uncertainty (gharar) would invalidate the contract (for example. However. Despite these concepts being well established. There are two main reasons why an investor can use a derivative: speculation and hedging. but money is paid on a deferred basis (t+1) Salam: the opposite of a deferred contract. excessive forms of gambling or speculation (qimar) would also invalidate the contract. the subject matter needs to be specified: "I will sell you one of my cars..e. to be delivered to the miller in 6 months time. but the commodity is delivered in the future (t+1) Future: both money and commodity are deferred until the future (t+1) According to the vast majority of Sharia' scholars the first three types of transactions (spot." would be invalid as the car has not been defined). March 2009 1.what makes derivatives Islamic and are they part of the solution? Peter Lynch. Both of these parties face significant uncertainty about the future price of wheat. one of the leading investors in the conventional space.three sentences at most.Islamic Derivatives: Paradox or Panacea? Articles on Islamic banking.. With this in mind and given the recent problems caused by such instruments. the delivery is generally done by cash (i. the use of derivatives in Islamic banking is beginning to rise. 2. 4. deferred and Salam) are valid contracts. in futures contracts. This basic agreement is known as "hedging" . Therefore. As a result of this agreement (contract). the monetary difference is settled) rather than physical exchange of the commodity.home of complex financial instruments commentators believe that this will lead to a rise in Islamic alternatives for derivatives. we ask . in Salam money is paid immediately (t+0). With Islamic finance continuing to establish itself in the West . In addition to this.the contract . the miller agrees to buy a certain amount of wheat from the farmer at price X. the purpose of hedging is to protect an investor from a volatile market by taking an offsetting position to the investor's . What are derivatives? A derivative is a contract that derives its value from the underlying asset. this goes to the very heart of Islamic contract law. As a result some scholars contend that such contracts are primarily used for speculative purposes. If we take a look at Aqd' .with the use of a forward contract (forward derivative) What makes derivatives Islamic? There are four types of economic transactions: Spot: commodity and money exchanged simultaneously. once said before you buy or sell anything. In effect. you must be able to explain why you are buying or selling so that an 11 year old can understand . both parties are now certain about the future price . during the spring.the wheat farmer now knows how much money he can set aside for his family's education and the miller knows at what price he can sell the flour in 6 months time. aiming to profit from a rise or a fall in the price of a security.

current position. Sura 2. Some of the most popular products in the West. it is paramount that Islamic banking practitioners develop derivatives which are benchmarked against Sharia law and not only against conventional products. "In Islamic law. chief executive of INCEIF: "Islam encourages you to manage your risk. there is also recognition that businesses involve some level of risk. the complexity of derivatives can compound any problems. as shown by recent events. However. have been blamed for spreading risk.. recent events have strengthened the position of those scholars that dismiss derivatives as a form of gambling. but when does risk management end and gambling begin?" This is a question of interpretation: although there is agreement that excessive uncertainty (gharar) can invalidate a contract. there is a need for Sharia' compliant instruments for managing this volatility. such as credit default swaps. Indeed. some Sharia scholars agree that hedging is permissible with the aim of protecting the investor against a volatile market. there must be something tangible that you are selling. there is a problem with the above analysis for its simplicity. Mohammad Akram Laldin. Verse 275) as a sign that balance needs to achieved." according to leading Sharia scholar at HSBC Amanah. This has created uncertainty over the underlying asset and its value. Therefore. "You cannot be selling something in which you do not know the status of the subject matter. One key reason for the lack of confidence in western banks is their heavy use of derivatives. Secondly. With this in mind.. Having said this. . It is contended that derivatives have a destabilising impact on the market." Two things are for certain: in the current volatile economic environment. rather than containing it. one can point to the Qur'an's unequivocal approval of trade (Quran. as pointed out by Agil Natt.

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