Hedging Mechanisms in Islamic Financial

Operations

A paper presented to the 7th conference of Sharah Boards of the

Islamic Financial Institutions- Auditing Unit for the Islamic Financial
Institutions

By

Dr. Muammad Al Elgar

King Abdul Aziz University - Jeddah

In the Name of Allah, the Beneficent, the Merciful

Praise is due to Allah alone. May peace and mercy be upon our Prophet Muammad
(SAW), on his household and companions.

1.

THE LITERAL MEANING OF TAAWWU (HEDGING)

The linguistic meaning of the word iyah includes precaution, protection, attention
and/or patronage. The Arabs say: Yataawwau akhhu atan asanah, which means:
He takes care of his brother and pays good attention to his affairs. awwaahu means: He
built a wall around it. The technical meaning of the word taawwu in the field of finance
is: the adoption of processes and arrangements and the selection of contractual formats
that guarantee the reduction of risks to a minimum while maintaining good possibilities
for return on investment.
Another technical definition is: a strategy with the goal of avoiding or eliminating risks
that fall outside the scope of the primary activity or outside the domain of the targeted
investment.

1.1 Hedging as Opposed to Hedge Funds

[Another financial term] is hedge funds; their purpose is not the meaning of taawwu
mentioned above, but, rather, the opposite. The purpose of hedge funds is to undertake
high risks in order to make high profits. Therefore, one should be careful to avoid mixing
up the two matters.

2.

IS THE EXISTENCE OF "RISK" NECESSARY FOR SHARAH

COMPLIANCE?

We often hear from specialists in Islamic banking and some members of Sharah boards
that the existence of risk is a basic requirement for making financial transactions

legitimate and that transactions which are risk-free are likely to be illegitimate and the
twin of rib (usury). [They also say] the existence of risk is a basic difference between an
interest-based loan and murabah1 and mushrakah;2 also, one of the reasons behind the
prohibition of the increment on a loan agreement is that it is profit without any attendant
risk. We are all familiar with these and similar statements.
This view means that the profit or the return from the investment must be a probable
matter, not something whose occurrence is certain. If not, the transaction, based on this
theory, would be illegitimate or give cause to suspect its legitimacy. Their basis for all
this is the principle of al-kharj bi al-amn ([The right to] profit is due to liability),
which was derived from a adth of the Prophet (peace be upon him).3 However, this is a
statement that must be examined and contemplated from many angles:

Editors note: Murabah is a silent-partnership contract in which one party supplies the capital and the
other party supplies his expertise and labor to manage a commercial venture. The profits are split between
them according to a percentage agreed upon by the two parties when the contract is first arranged. Any loss
would be borne by the supplier of capital.
2
Editors note: Mushrakah is a joint-partnership contract in which two or more parties invest capital in a
profit-seeking enterprise. The profits are split between them, usually in proportion to each partners share in
the capital investment, and the losses are borne in the same proportion.
3
Al-Shfi, Amad, the authors of the Sunan and al-kim reported from Urwah from ishah that a man
bought a slave during the time of the Messenger of Allah (peace be upon him). The slave remained with
him for a while before he decided to return him because of a defect that he had noticed. The Prophet (peace
be upon him) judged that he had the right to return him for that defect. The man who lost the case said, He
profited from him. The Prophet said, Al-kharj bi al-amn.
The jurists disagreed on the sanad (chain of transmission) of the adth and its interpretation. The adth
was authenticated by Ibn al-Qan, as fi Ibn ajar said in Talkh al-abr; he also reported a
judgment of its authenticity from al-Zarkash.
But Ibn azm said about this adth that it is not sound. Ibn al-Arab, in Tufat al-Awadh, said that the
statement Al-kharj bi al-amn, is not a adth reported [from the Prophet (peace be upon him)]; rather,
it is a report about an event that occurred; the remaining part [of the incident] is not known, and its sanad is
not authentic. He also said in al-Qabas al Muwaa' Ibn Anas that the statement Al-kharj bi al-amn.
is not an authentic adth.
However, the legal proof for the principle of al-kharj bi al-amn is not restricted to this adth only.
Those who support the principle also cited [a adth] transmitted by Ibn Mjah on the authority of Amr ibn
Shuayb, from his father, from his grandfather, that the Prophet (peace be upon him) said, It is unlawful to
sell what you do not possess and to profit from what is not guaranteed [by you]. [They also cite] what alBayhaq reported from A ibn afwn ibn Yal, from Umayyah, from his father, who narrated that the
Prophet (peace be upon him) appointed Attb ibn Asyad as governor of Makkah and said, I have placed
you in charge of the people of Allah [to rule] with God-consciousness; so none of you should consume any
profit from what he has not assumed liability for
There are some scholars, however, who restricted the meaning of the adth to grain. Imm Amad and
Isq ibn Rhawayh were asked about the profit made from that for which liability has not been assumed.
[Amad] said, That, according to my understanding, only applies to grain which has not been taken
possession of. Isq said about it what he said about all things sold by weight or volume.

First: There is no way to eliminate risk, so it is meaningless to say that an investment

devoid of risks is illegitimate because such an investment simply doesnt exist. Even a
loan secured by a pledge still has attendant risks because neither a guarantor nor a
mortgage can preclude the possibility that the debtor will die or that the mortgage will be
destroyed, or force majeureetc.
Second: The word amn (responsibility) mentioned in the adth has a different
meaning from risk as understood in financial terminology. Its meaning is restricted to
whatever may happen to the commodity that is the subject of the contract, like its
destruction, and it has nothing to do with the environment surrounding that commodity,
such as market fluctuation or a change in the value of the currency, etc; while these are
all considerable risks.
[Ibn Qudmah] said in al-Mughn, The expression al-kharj bi al-amn indicates
that whoever takes a profit must bear liability, for it makes liability the ratio legis (illah)
of his entitlement to it.1 Kharj is any gain derived from purchased property. Others
said Entitlement to kharj is due to liability; i.e., it is its cause.2 It is stated in al-Tj wa
al-Ikll: The meaning of al-kharj bi al-amn is that the buyer who would receive the
proceeds of [the commodity is the one who], if is ruined in his possession, it will be
regarded as his doing and the price which he paid would be lost; therefore, he has the
right to the profit by virtue of his liability for it.3
The references to al-kharj bi al-amn in the statements of the jurists is only in
connection with the growth associated with the sold item or what is derived from it, such
as benefits, etc. It is not related to risk in its monetary sense, i.e. the possibility of
incurring a loss.
The concept of al-kharj bi al-amn is only related to a specific type of risk, i.e., the
risks related to the physical integrity of the sold item, not the possibility of incurring a
loss in business. We have found indications in the statements of the jurists that the issues

Al-Mughn, vol. 8, p. 273.

Awn al-Mabd, vol. 8, p. 3.
3
Al-Tj wa al-Ikll, vol. 9, p. 187.
2

of risk in its financial connotation (i.e., the possibility of incurring a loss) are not
included, according to them, under the principle of al-kharj bi al-amn.
Third: The principle of (al-kharj bi al-amn) is not constant and unvarying.
a. The dominant opinion in Imam Amads madhhab is that if the fruits are
damaged before the buyer is able to pick them, then the seller is liable; although the
dominant opinion in his school of thought is also that the buyer is allowed freedom of
disposal of the fruits: to sell them, etc. Therefore, he has the right of disposal although
the liability is on the seller. This is profit without liability and is contrary to the
principle of al-kharj bi al-amn; however, its subject is not growth connected to the
purchased item; rather, it is risk according to its financial meaning and is, thus, not
prohibited.
b. Imam Mlik considers it permissible to sell a debt to other than the debtor, and the
same has been reported from Imam Amad, despite the fact that the [debts] owner is
not liable for its [repayment]. They allowed this despite it comprising profit without
liability; however, the risk therein is risk in its financial sense.
c. The Prophet (peace be upon him) allowed substitution in a debt that is the
counter-value of a sale for another [form of payment], despite the fact that the buyer is
liable for the price, as it has not been transferred to the liability of the seller. Likewise,
the subject of a salam sale, which is a debt, is lawful to sell despite the fact that it is the
liability of the seller and has not been transferred to the liability of the buyer.
d. Usufruct in a lease and the claiming of fruit before it has been harvested; all are
affirmed by authentic adths without any opposing evidence. [For instance,] the buyer
is released from liability for the price of fruit if it is affected by a cataclysm, although he
has the right to dispose of it. But if it is spoiled, he will be liable for the price that he
took for it, as it was guaranteed for him by the price he paid for it.
e. The scholars disagree on the issue of one who finds his property with a bankrupt
person. However, the most widely accepted view in the anbal school of thought, as
stated by the author of al-Mubdi, based on a report from Imm Amad, is that any
5

increase belongs to the seller, not the bankrupt person, despite the fact that the principle
of al-kharj bi al-amn requires that the increase should be the right of the bankrupt
buyer because the excess took place while the asset was in his possession.1

3.

HEDGING INSTRUMENTS IN CONVENTIONAL TRANSACTIONS

There are four contracts in conventional transactions that comprise what is known as
itim (seeking protection). They are options (financial options), forward sales, futures
sales and swaps.

3.1 Options

A financial option contract is a contract in which one party commits to the purchase (or
sale) of an asset at a specified price on a specific date (or during a specified period of
time) in consideration of a fee. The second party (the payer of the fee) has the option to
sell (or buy) or he may choose not to. Based on that, an option is a right that a person
buys to either make a purchase or a sale. He enjoys the prerogative in exchange for a
payment, and the second contracting party makes a commitment to honor the payers
preference.
Let us say we anticipate a rise in the value of the shares of a given company and would
like to benefit from this expectation by buying the shares today to sell them tomorrow
and profit from the price difference. On the other hand, we fear that these share prices
will not rise or that they may even drop. Is there any way to protect ourselves from the
risk of a price drop while benefiting from the opportunity presented by a price rise? That
is possible through the purchase of a contract called a call option, whereby the other
contracting party (in exchange for a fee) commits to sell us those shares at a pre-agreed
price (the current market price), despite the fact that we are not committed to the
purchase. But if our anticipations are realized, we would buy those shares at that price

Ibn Mufli, al-Mubdi, Shar al-Muqni, vol. 4, p. 318.

and then sell them at the new market price (which is high) and reap the benefit of the
difference, which represents profit for us. Likewise, it would be possible for usshould
we anticipate a drop in the price of the shares we possess and want to protect ourselves
from its consequences while still maintaining ownership of the shares (or assets)to
enter into an option contract in which the other contracting party (the seller of the option)
commits to buy from us those shares at a price we agree upon (the current market price)
without any commitment from us to sell. For that reason, it is possible for us during the
option period to feel at ease that we shall not be affected by a possible price drop while,
in case the price rises, we shall benefit from it by making a profit.

3.2 Forward Sale

This is an arrangement to conduct a sale in the future at a price fixed today; both parties
commit themselves to buy and sell at that fixed price. However, the contract is
incomplete because its effects, i.e. collection of the price and delivery of the sold item,
will not take place until the fixed date agreed upon. It is possible, by using this contract,
to gain protection from the effects of changing prices. If, for instance, we will need one
million Italian lira after six months, and we face the risk that the price of the lira will be
higher on that date than today, we could enter into a forward sale contract as mentioned.
When the time comes, we shall pay the price agreed upon in the contract (regardless of
the current market price) and collect the liras. Forward contracts are direct contracts that
take place through negotiation between the two parties. The subject of the forward
contract can be any asset or commodity or currency or precious metal.

3.3 Futures

Futures are similar to forward sales; however, they differ from them in the following
ways:

1. They are standardized contracts in which the type of commodity, its amount and
delivery date are specified; however, the price will be left undetermined; it will be
determined [later] by the forces of supply and demand.
2. They are conducted in organized markets specified for that purpose, the method
of sale being by auction.
3. The connection between its two contracting parties is not direct, as they are
always separated by the clearing house, which acts as a seller (to the buyer) and a buyer
(to the seller).
4. They are daily contracts; the clearance of all contracts takes place every day for
the purpose of price specification.
5. The buyer is not bound to pay the full price; rather, he is bound to pay daily the
difference between the price at which he purchased his commodity (the subject of the
contract) and the settlement price of the commodity that day. If the price drops, he has the
right to recoup from the clearing house part of what he previously paid. When the
contract due date arrives, the buyer has the right to collect the commodity he bought as
per the quantity and specifications [of the contract]. However, he can also forgo that and
suffice with collecting the difference between the purchase price and the sale price by
selling the commodity before the contract delivery date.
For that reason, only a small percent of these contracts end with collection [of the
commodity that is the subject of the contract]. However, the efficacy of futures contracts
in providing protection from the risk of fluctuating prices is clear. That is because a
wheat producer who expects to have 1000 bushels of wheat at harvest time will be able to
sell it now in the futures market, protecting himself thereby without having to pay
anything or commit himself to the sale of that grain.

3.4 Swaps

It is possible through swap contracts to protect against the risk of a change in foreign
currency prices or a change in interest rates without having to change an institutions
policy towards the sources of those risks. The swap agreement results in the exchange of
future income streams between two institutions. Let us say one bank makes a fixedinterest loan to a customer for five years. It could then enter into a swap contract by
which it would exchange its income stream of fixed-interest payments (not the principal
of the loan) with another bank for an income stream of variable-interest payments.
Therefore, it can protect itself from the risk of variable interest rates without having to
sell the loan in its entirety. Likewise, it is possible for an American company that has
sold articles for delayed payment over a period of five years to a Japanese customer to
exchange an income stream in yen with a Japanese company that has sold articles for
delayed payment to an American customer. The American company may take the
payments in dollars and relinquish the payments in yen. Thus, each of the two companies
can protect itself from the risk of fluctuating exchange rates without needing to restrict its
activities to its own country.

3.5 How the Use of Hedging Instruments Can Lead to the "Elimination" or
Reduction of Risks:

The oldest types of hedging are those used (and they are still in use) by the producers of
primary commodities for the purpose of averting the risks of price fluctuations. The
following example illustrates how: The activity of a sugar factory is based on the
purchase of raw sugar, refining it, and then selling it as a commodity suitable for
consumption.
But the profit realized by this factory is totally dependent on the difference in price
between a ton of raw sugar and a ton of refined sugar. It is well known that the sugar
market is an international market and that the two sugar prices mentioned above are

linked, which means that a drop in the price of raw sugar immediately affects the price of
refined sugar.
This means that the factory has to face great risks. Let us say the price of a ton of raw
sugar is US$100 at the start of the production cycle, while the price of a ton of refined
sugar is US$180. Therefore, if the cost of refining one ton is US$40, the factory knows it
can realize a net income of about US$40 per ton. But this is only valid if the price of
refined sugar remains at this level from the purchase date of the raw sugar till the date of
its sale in a refined state. If, after the purchase of the raw sugar for US$100, the price of
refined sugar drops from US$180 to US$120, there is nothing for the factory to do but
bear the loss of about US$20 per ton. It is a loss that may lead to the closure of the
factory, especially if the production volume is large and the factorys capacity high.
What will the factory do to avert this risk? At the very moment the factory undertakes the
purchase of a ton of crude sugar at a price of US$100, it immediately undertakes a short
sale (i.e. sale of commodity that it does not yet possess), i.e., the sale of a ton of refined
sugar for a price of US$160 (for instance). By this arrangement, the factory has
eliminated the risks of price fluctuation by the time the refining process is completed, for
the market price can only be US$160 or more or less.
If the price is more than US$160, it has lost the opportunity to get the US$180 price;
however, it has protected itself from a drop in price. If the price is less than US$160, then
the issue of protection will be clearer because it has insured the US$160 price, which
realizes a profit despite the fact that the market price is lower than that.
Of course, the reality is more complicated than this simple example because what really
happens is that it is possible to enter into other contracts by which it frees itself from the
previous contract before delivery. This makes it possible to benefit from rising prices
while maintaining protection against a drop in price.
(It is also possible for this factory to protect itself by entry into a financial options
contract, but this is another topic, outside the scope of our present discussion.) It is a
familiar procedure in many industries of Western countries.

10

4. HEDGING IS LAWFUL WHEN SHARAH-COMPLIANT

INSTRUMENTS ARE USED

If we say that the risk in an investment is the possibility of the occurrence of something
unpleasant, it is apparent to us that the reduction and prevention of risks by lawful
mechanisms is not only permissible but praiseworthy. That is because it serves to
preserve wealth, which is one of the objectives of the Sharah.1 The outcome of these
procedures is protection of ones wealth from loss and distancing it from exposure to
countless risks in the quest for increased profits when the probability of achieving them is
low. If a person adopts devices within the sphere of permissible contracts and procedures
for the purpose of reducing risks, his action is consistent with the objectives of the
Sharah.
Seeking protection from risks in investment and selection of the best procedures,
conditions and contracts has long been a part of human activity. It has been reported in
Sunan al-Bayhaq and in Majma al-Zawid that whenever Abbs bn Abd al- Muallib
contributed capital for a murabah venture, he would make a condition on his partner
that he would not take it on the sea nor camp with it in a valley2 nor buy a live animal
with it. If he did so, he would be liable [for any loss]. Abbs then presented his
stipulation to the Messenger of Allah (peace be upon him), who declared it lawful.3
Some jurists have talked about lawful mechanisms for protection from risks. An example
of that can be found in the Fatw of Ibn Taymiyyah. Ibn Taymiyyah (May Almighty
Allah have mercy on him) said: Musqt and muzraah4 depend on the
trustworthiness of the worker, which may frequently be hard to find. This may cause
1

The objective of protecting money is not limited to general procedures and rules like cutting the hand of a
thief, placing interdiction on the legally incompetent, and imposing liability on transgressors [against the
property of others]. In fact, the evidence is clear that it is obligatory to deal with wealth in ways that will
protect it from loss; for instance, the prohibition of spending money on unlawful things, the invitation to
increase wealth and invest, and the prohibition of hoarding and of withholding [wealth] from circulation.
Another aspect is the order to record loans and call witnesses and take collateral for them. The result of all
these [policies] is the preservation of wealth and its protection from the risk of destruction and loss.
2
Editors note: Flash floods in the desert can suddenly sweep away anyone who happens to be in a dry
riverbed at the time.
3
Al-Ksn, Badi al-ani, vol. 13, p. 150.
4
These are two forms of sharecropping.

11

people to resort to rental of agricultural land, which will guarantee their money as an
owed liability. This is the reason why many people at various places and times prefer
renting their land to engaging in sharecropping contracts.1 The issue is clear; both
musqt and muzraah are trust-based contracts, which expose the landowner to what is
known as moral risks, i.e., cheating by the worker. For that reason they turn to land rental
so that their money can be guaranteed without being affected by the results of the
agricultural process. Ibn Taymiyyah added: It is also a known fact that the obligations
the Sharah has prescribed are only obligatory when it is possible [to do them] and that
the conditions it has imposed in worship and contracts are according to human capacity.
That is, this type of act is not contrary to the rulings of Islamic Law, which takes into
consideration human ability and capacity.

4.1 A Third-Party Guarantee of Invested Capital or of Capital and Profit

If the investment activity is based on a credit arrangement, for instance, the sale of real
estate for a fixed payment period, then the price is a liability for which [the buyer] is
responsible. There is no harm in securing the debt with personal guarantees or a
mortgage, etc. However, the investment may, alternatively, be based upon a waklah
(agency) contract, whereby [the investor] would deliver his capital to a manager who
invests it in return for a [fixed] fee, or on the basis of murabah, whereby he would
manage it for compensation in the form of a portion of the profit. In those two situations,
he is considered a trustee in his possession of the capital.2 When that is the case, he is not
liable [for any financial loss].3 It is obvious that this entails additional risks. Is it then
allowed for a third party to volunteer to provide a guarantee so that the investors goal
can be realized?
Providing a guarantee is, in and of itself, a lawful matter; in fact, it is even an act for
which its performer will be rewarded, if the person does it seeking only a reward from
Allah, as it fulfills the need of the guaranteed party. As for a guarantee provided by a
1

Majm al-Fatw, vol. 30, p. 235.

Editors note: This legal status is known as yad amnah in Arabic.
3
Editors note: except in case of transgression or negligence.
2

12

third party for the capital of a murabah venture, there is a resolution from the
International Islamic Fiqh Academy in connection with the issue of murabah ukk:
There is nothing in the Sharah that would prohibit a statement in the
prospectus or the certificate of the murabah ukk that a third party,
separate in personality and financial responsibility from the two contracting
parties, has promised to voluntarily contribute, without compensation, an
amount specifically for the restitution of loss in a specific project, on the
condition that it must be a commitment independent of the murabah
contract. This means that execution of his commitment is not a condition for
the validity of the contract or its legal effects on the parties concerned.
Therefore, neither the ukk-holders nor the murib1 can repudiate the
murabah as invalid or refuse to fulfill their commitments resulting from it
due to the failure of the voluntary contributor to make good his promised
contribution, based on the argument that this commitment is integral to the
validity of the contract.
But is there a practical format for implementing this resolution? Whoever contemplates
the resolution will see that a number of conditions were stipulated for the validity of the
third-party guarantee:
a. The guarantor must be independent in personality and financial responsibility
from the two contracting parties. That independence is not limited to statutory
independence, where each of the parties will be an independent personality from a legal
point of view. It is also incumbent that the financial independence be real; so the
guarantor cannot be a wholly owned subsidiary of the guaranteed party (the murib)
because this will be, in effect, a guarantee of the murabah capital, which is prohibited.
But can one really imagine that a person or an organization fulfilling the abovementioned
independence would voluntarily offer a guarantee, considering the risks and expenses it
entails? If that happens, the guarantee would be provided for no other reason than
assistance of this investor. For the life of me, this is inconceivable.
b. Likewise, the verdict of the Academy made the condition that the guarantee
should be free. Is something like this imaginable in the world of economy and trade?

A murib is the party in a murabah contract that supplies the skilled labor.

13

Whoever would venture into this type of free guarantee would be supposed to expect
some benefit from it and, thus, would not be a real voluntary contributor.
c. The third condition is the independence of the guarantee from the contract that
regulates the investment activity, for instance, a murabah contract. The intention
behind the independence is that the contract of murabah should not be invalidated
should the guarantor fail to fulfill the commitments of the guarantee or withdraw from it.
The verdict emphasized that with the statement: Therefore...the ukk-holders [cannot]
repudiate the murabah as invalid...due to the failure of the voluntary contributor to
make good his promised contribution... In other words, it is the same for the investor
whether he has the guarantee or not. All of that is inconceivable.
d. It is obvious that these conditions will not be fulfilled in financial transactions
with an aim of profit. No wonder this resolution of the Academy has not been
implementedas far as we knowwith fulfillment of its strict conditions. It is also no
secret that this resolution was in the context of a preamble for the advancement of the
properties of endowments in Jordan, with the government offering the guarantee to the
investors in its role as an [interested] party.

4.1.1 A Voluntary Guarantee Separate from the Secured Activity

It has been made clear that a voluntary guarantee offer by an independent third party is
unimaginable on the practical level. Is it, then, permissible for a party with a connection
to the investment activity to offer a voluntary guarantee when the condition is fulfilled of
having the two contracts totally separate from each other; i.e., if the guarantee is offered
in a contract independent of the murabah or waklah contract?
This would happen when there is an investment transaction between two parties. The
capital provider wants the manager to invest his wealth along with a guarantee of the
capital or the profit. However, if the guarantee is made a condition in the waklah or
murabah contract itself, it will invalidate them because the wakl (authorized agent)
and the murib have the status of trustees. The transaction, by this guarantee, is

14

transformed into a loan, based on the principle, Consideration in contracts is given to

realities and meanings, not words and forms. The reality of the contract is that it is
wealth for which the agent is liable, so it resembles a loan; and any addition to it, which
is conceived as profit, is very similar to rib.
This is when the guarantee is made a condition in the contract, but what if the agent
volunteers to provide this guarantee after the contract? The jurists differ on this issue. It
was said in Shar Mayyrah Murabah is not permissible with a guarantee, i.e. by
stipulating liability on the worker; but if he volunteers it after the contract, there are two
juristic opinions on whether it is binding or not.1 In shiyat al-Dasq on al-Shar alKabr: But if the worker volunteers the guarantee, there is a difference of opinion
whether the murabah is valid or not2 And in shiyat al-w on al-Shar alaghr: But if the worker volunteers the guarantee, there is a difference of opinion
whether the murabah is valid or not.3
If we support the view of those who ruled in favor of the permissibility of the guarantee
after the contract, then it is necessary for the validity of this guarantee that the following
conditions be realized:
a. It must be truly voluntary, as it was said in Mawhib al-Jall f Shar Mukhtaar
Khall in the chapter on amn (Guarantee): A voluntary contribution (tabarru) is what
is given without being asked.4 But if there is collusion on it or it is a component
completing the investment process, then it is not a real voluntary contribution, even if it is
so named.
b. No claims can be made upon the voluntary donor because voluntary donation
(tabarru) is like a gift (hibah), which does not occur except when possession is taken of
it; likewise, a voluntary donation (tabarru) is not accomplished except by payment. For
that reason, if the guarantor rescinds the guarantee after the contracting of murabah or

Shar Mayyrah, vol. 3, p. 89.

shiyat al-Dasq al al-Shar al-Kabr, vol. 15, p. 232.
3
shiyat al-w al al-Shar al-aghr, vol. 8, p. 397.
4
Mawhib al-Jall f Shar Mukhtaar Khall, vol. 14, p. 315.
2

15

waklah, the investor has no right to oblige him, since he has no claim upon him if he is
truly a voluntary contributor.
Some Sharah boards have even adopted a standard for the independence and separation
of the two contracts that the cancelling of either contract will not result in the cancellation
of the other. It would be an effective standard, except that cancellation never takes place
except by intention; and when the intention of the two contracting parties is to maintain
the guarantee as long as the contract governing the guaranteed activity remains effective,
then that standard will be meaningless.

4.1.2 Programmed Daily Circulation with a Guarantee

Some banks have developed a computer program for use by the managers of the
investment funds for the purpose of protecting the capital invested in stock markets. The
program is based on complex and confidential mathematical equations to which its
developers have intellectual property rights. The participating manager is allowed to use
the program for a fee payable to the owner of the program; and the programs developer
offers, as part of the contract of usage, a guarantee of the capital, on the condition that the
manager adhere to the daily dictates of the program. The function of the program is based
on the division of the invested capital (lets say, 100 million) into two parts. The major
part of that should be for delayed-payment murbaah1 secured with mortgages and
guarantees and rated low risk. (For conventional banks, the manager would buy
government bonds with this part.) The second half would be invested in the stock market,
with the program identifying for the manager of the fund the specific stocks he must buy
for that day and those he must sell so as to reap a profit.
The program is based on the fact that losses (a drop in the traded price) which the shares
may be exposed to in one day are limited to a specified percentage by the management of
each exchange (10% in some markets; more or less in other markets), after which trading
will be stopped in the shares of the company dropping at that rate. For that reason, the
1

Murbaah is a mark-up sale. The seller informs the buyer of the items cost to the seller plus the amount
of mark-up, either as a flat amount or a percent of the original price. Payment can be either spot or deferred.

16

program starts by covering this percentage initially; then, whenever the profit of the
shares increases, this means it is possible to bear a greater percentage of risks, because
the capital invested has become secure. If the manager adheres to the dictates of the
program but still loses, then the presenter of the program will guarantee his capital
(without profit) for him. The reality is that the guarantee is based on the fact that
investments based on the instructions of the program cannot possibly be exposed to loss.
The only condition that could (possibly) lead to loss is when the prices of the shares are
dropping when there is no liquidity, i.e. when the manager cannot find anyone to buy the
shares from him and so continues to own them for another day, in which case the losses
would continue to increase. That is the reason why this situation has been stipulated as an
exception to the guarantee.

4.1.2.1 The Basis for the Legal Opinion that This Program is Permissible:

Some Sharah boards have ruled that it is permissible for fund managers to use this
program. The basis for the opinion of permissibility is the ruling of the anaf School
that allows this type of guarantee. It was said in al-Fatw al-Hindiyyah: Shaykh alIslm mentioned in Shar al-Jmi al-aghr, in the book of ul (Settlement of
Disputes) that if one man said to another person, Take this road; if your wealth is taken,
I will be liable, and the person takes that road and his wealth is taken, the guarantee is
valid and authentic.1
And in Radd al-Mutr ...If he said, Take this road, for it is safe; if your wealth is
taken, I will be liable, he is liable.2
Also, in Majma al-amnt: If he said to another person, Take this road; if your
wealth is taken, I will be liable, and his wealth is taken, the guarantee is valid.3

Al-Fatw al-Hindiyyah, vol. 23, p. 433.

Ibn bidn, Radd al-Mutr, vol. 20, p. 23.
3
Majma al-amnt, vol. 5, p. 164.
2

17

4.2 Bay al-Arbn1 for Investment Protection

A structure is known in conventional investment for the protection of capital money. It is

based on the division of the investment amount (100 for instance) into two parts. The first
part composes 93% (for example), which the investment manager may use to buy goldcoupon bonds. These are bonds sold by public auction at a discount that represents the
rate of interest. If the bill pays 100 after a year, it will be bought through auction for 93
(for example), with the 7 being the interest rate. This means that at the end of the year we
shall get the amount of 100. This part [of the conventional] structure is especially set up
to guarantee [investment] capital because it will be a debt for which the bond issuer is
liable. If they are governmental bonds, it means that the risks have become low, and the
capital becomes [virtually] guaranteed. As for the remaining amount, which is 7, the fund
manager will use it to buy an option (a contract by which the recipient of the payment is
committed to sell to the other party to the option, shares at a specific price on a particular
date, while the other party would have the option [to buy or not]). The manager would
select the shares that he expects will rise in price. If the expectation is realized, he would
buy those shares at the price agreed upon; then sell them in the market, and thereby make
a profit from the deal. By these means, the capital of the investors will be kept safe and
they will make a substantial profit. But if the prices of the intended shares have not risen
as anticipated by the manager, he will not exercise the option. His loss would be
whatever he paid as a price for the option, but he will have protected the capital of the
investors.
The fund managers of Islamic banks went about adopting a structure that would lead to
the same result, except that it relies on the formula of bay al-arbn. The way it works is
that the capital (100 for instance) is divided into two parts; the first would represent 93
[of the total], which the manager will use to enter into low-risk murbaah, having a
profit of 7, with a creditworthy party. The safety of the capital can, thus, be realized,
since he will achieve 100 at the end of the year. As for the remainder, which is 7, the
1

Arbn is a non-refundable deposit paid by the buyer to reserve the right to purchase a commodity. The
main difference between it and the reservation fee in an option contract is that it is usually treated as part of
the eventual purchase price.

18

manager may use it to enter into a contract with an investment bank for the sale of shares
on the basis of arbn. He would buy shares worth 700 but pay 7 as a deposit. If the price
of the shares rises, he would execute the contract, take possession of the shares and sell
them (for 800, for instance), then pay the price to the seller. The fund would make 100,
which would realize a great profit for the participants. But if the anticipated price rise
does not occur, all the manager has to do is forgo the execution of the contract, in which
case he could not retrieve the amount of 7 that he paid earlier as a deposit in the
previously mentioned purchase contract; however, the safety of the investors capital has
been achieved. With this, the same economic result will be achieved for the safety of the
capital, but in a Sharah-compliant way.
The formula of an arbn sale, as mentioned in the books of Islamic jurisprudence, is:
To buy or hire a commodity (giving a part) of the price (on the condition that if he) i.e.
the buyer (dislikes the sale, he would leave it)1 for the seller, but if he wants it, he would
count it [as part of the purchase] or relinquish it [altogether].2
The jurists have disagreed on arbn sales; the majority considered it a means of usurping
the property of others wrongfully, but the anbal School permits it. The author of Shar
al-Muntah said: An arbn sale is valid; so is an arbn lease.3 Also, the author of alMughn quoted al-Athram, who stated that he asked Amad, Do you accept it? He said,
What can I say when Umar [allowed it]?45 The International Islamic Fiqh Academy
also issued its Resolution 72 (8/3) permitting arbn sales: The arbn sale is
permissible if the waiting period is restricted to a specific time and the deposit is regarded
as a part of the price when the purchase is finalized but becomes the right of the seller if
the buyer decides not to buy.

Editors note: It refers here to the deposit.

shiyat al-w al al-Shar al-aghr, vol. 6, p. 347.
3
Al-Buht, Shar Muntah al-Irdt, vol. 4, p. 425.
4
Al-Mughn, vol. 8, p. 430.
5
Editors note: The Arabic form of Dr. Elgaris article has a typographical error. It should read
2

. :
The quote is so abbreviated as to be highly obscure. Imm Amad was referring to a narration in which
Nfi ibn Abd al-rith bought a building from afwn in Umayyah, on the condition that if Umar
rejected the sale afwn would still receive a certain amount of the price.

19

4.3 Various Mutual Promises Regarding the Proceeds

Among the arrangements adopted by some banks to protect their investing customers is a
method based on the issuance of a promise of purchase undertaking by the bank for the
benefit of the investors. The bank is bound by it to purchase the assets possessed by the
customer on a specified date at a specific price, but the purchase is conditional. It would
happen if the market price is less than a specific agreed-upon level (100 for instance). If
the period expires and the market price is still less than 100, the bank will make an offer
to purchase from the customer for 100. This achieves security for the investor. In return,
the customer would make a binding promise of sale to the bank, on the condition that
when the period expires, if the market price is more than 100, it is bound to sell those
assets to the bank for 100. When the period expires, if the market price is more than 100,
the customer will make an offer of sale to the bank, based on the binding promise.
The end result for the investment setup is that these assets will be sold by the customer to
the bank for 100 because the current market price when the period expires can only be
less or more than 100. (If it is 100, its sale to the bank or in the market is the same for the
investor. Likewise, its purchasefrom the investor or from the [market]1is the same
for the bank). If the investing customer wants to benefit from this arrangement, all he has
to do is authorize the bank to buy shares for him (for instance) on the first day; then the
promises will be issued from the two contracting parties, and when the time lapses [the
promise] will executed so that the customer will get his capital plus a profit specified in
advance. It is apparent that the customer has achieved complete protection from the
fluctuations in market prices, but at the same time he cannot realize a high profit when
the prices of shares in the market are rising. There are many issues to discuss in this type
of arrangement:
First: Are these promises independent from each other or are they mutual promises?

Editors note: The Arabic text has the word bank here, which would seem to be a typographical error.

20

As for mutual promises, the International Islamic Fiqh Academy issued Resolution nos.
40-41(5/2 and 5/3) in December 1988 CE, regarding the fulfillment of promises and
murbaah lil mir bil shir (a markup sale for a purchase orderer). It was stated:
A mutual promise issued by the two contracting parties is permissible in a
murbaah sale on the condition that both promisors, or one of them, have
the option [to rescind]. If there is no option, it is not permissible because a
binding mutual promise in a murbaah sale is similar to the sale itself, as it
is stipulated that the seller should be the owner of the item being sold.
But the marketers of this investment product say that what is issued by the bank and the
investor is not a bilateral promise because a bilateral promise applies to a single subject at
a single time; for instance, if the first promisor says, I promise you that I will buy from
you a particular item for 100 on a particular date; then the second promisor says, I
promise you that I will sell you that particular thing for that very price on that very date.
By that, each one of them will the promisor and the promisee. If it is implemented, the
promises will apply to the same subject.
However, in the suggested method, the first and second promises shall not apply to one
subject; the first promise is linked to the condition that the market price will be higher
than 100, while the condition of the second is that it should be less than 100. When the
period expires, one of the two promises is fulfilled. For this reason, the Sharah boards
that allow this arrangement have tended to accept it since they do not see it as comprising
the prohibited bilateral promise that resembles the contract. That is because only one
promise will be implemented, and it will not be possible for the two promises to be
implemented at one time.
All praise is due to Allah, the Lord of the universe.

21