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DR Obi Paper Derivatives in Islamic Finance - An Overview - Bank Negara-24th June 05
DR Obi Paper Derivatives in Islamic Finance - An Overview - Bank Negara-24th June 05
Derivatives in
in Islamic
Islamic
Finance
Finance An
An Overview
Overview
1
What are derivatives?
2
Evolution of Derivative Markets/Instruments
If one examines the evolution of derivative markets and
instruments the progression has been as follows:
Forward Contracts
Futures Contracts
Options
Financial Engineering
Exotic Options
Synthetic Instruments
Swaps etc.
3
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 in increasingly sophisticated business environments.
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 movts (unlike lock-in)
*managing contingent claims/liabilities.
The objective of all these innovation is Risk Management.
4
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.
An asset that does not come with guaranteed fixed returns has
some amount of uncertainty. Infact even a guaranteed instrument
has risks if the issuers credibility is questionable.
Risk-Management; refers to the process/techniques of reducing the
risks faced in an investment.
It generally involves three broad steps;
Identifying the source and type of risk.
Measuring the extent of the risk.
Determining the appropriate response (either on Balance Sheet or Off
Balance Sheet) methods.
What makes risk management challenging is the fact that risks and
returns are generally positively correlated. Thus, the risk-return
tradeoff.
The challenge of risk-management is to protect the expected returns
while simultaneously reducing or laying-off the risks.
5
Off Balance Sheet vs On Balance Sheet techniques of risk
management.
6
Off Balance Sheet
Forwards; Short FC forward contracts.
Futures; Short FC futures contracts.
Options; Long FC Put Options.
Swaps; FC payer, HC receiver
Off Balance Sheet techniques have become
tremendously popular;
Cheap and flexible
No inconvenience to customer
Can enhance competitiveness
9
Futures Contracts and Islamic Finance
10
Bai Salam
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
This is similar to a conventional forward contract however, the big
difference is that in a Salam sale, the buyer pays the entire amount
in full at the time the contract is initiated. The contract also
stipulates that the payment must be in cash form.
The idea behind such a prepayment requirement has to do with
the fact that the objective in a Bai Salam contract is to help needy
farmers and small businesses with working capital financing.
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.
11
The lower Salam price compared to spot is the compensation by
the seller to the buyer for the privilege given him.
12
It should be clear that current exchange traded futures
would conform to these conditions with the exception of the
first, which requires full advance payment by the buyer.
Given the customized nature of Bai Salam, it would more
closely resemble forwards rather than futures. Thus, some
of the problems of forwards; namely double-coincidence,
negotiated price and counterparty risk can exist in the
Salam sale.
13
The
The Salam
Salam Contract
Contract &
& Islamic
Islamic Financial
Financial
Institutions
Institutions
14
(I)
(I) Parallel
Parallel with
with Seller
Seller
15
(II)
(II) Offsetting
Offsetting Transaction
Transaction with
with Third
Third
Party
Party
Here, the bank which had gone into an original Salam Contract
enters into a contract promising to sell the commodity to a third
party on the delivery date.
Since this is not a Salam Contract the bank does not receive
advance payment.
16
Istisna and Joala Contracts
The price for the product is agreed upon and fixed. While the
agreement may be cancelled by either party before production
begins, it cannot be cancelled unilaterally once the manufacturer
begins production.
17
Unlike the Salam Contract, the payment
here is not made in advance. The time of
delivery too is not fixed.
18
The
The Baibil-wafa
Baibil-wafa &
& Bai
Bai bil
bil Istighlal
Istighlal Contracts
Contracts
Under this contract, one party sells an asset to a buyer who pledges to sell
back the asset to the original owner at a predetermined future date.
The rahnu (pledge) being to sell back to the owner and not to a third party.
Looks like a REPO? Except that the resale price must be the same as the
original purchase price.
But like a REPO, the buyer has rights to benefits from ownership of the
asset.
The Bai bil-Istighlal is really a combination of the Bai wafa and Ijarah.
20
Overview
Overview of
of Istijrar
Istijrar
The Istijrar involves two parties, a buyer which could be a company
seeking financing to purchase the underlying asset and a financial
institution.
22
PLB P0 P* PUB
24
Payoff
Payoff to
to Istijrar
Istijrar
If Pt upper bound
25
FUQAHA (JURISTS)
VIEWPOINTS ON
CONVENTIONAL DERIVATIVE
INSTRUMENTS
26
Future
s) Fatwa of Omam Al-Haramaini Al-Jauwaini
1
Until and unless the underlying asset or basket of securities in the SIF
is all Halal; SIF trading is not approved.
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.
29
2) Abu Sulayman (1992) (Fiqh Academy Jeddah)
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.
3) Mufti Taqi Usmani (Fiqh Academy Jeddah)
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.
30
4) Hashim Kamali (1998)
Finds options 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)
31
5) Shariah Advisory Council; Securities
Commission
Though no formal opinion on stock or Index Options,
the SAC has allowed other option-like instruments.
Warrants
TSRs
Call Warrants
32
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.
Key Problem: Evaluation has always been from a purely juridical
viewpoint. And like most juristic evaluation, have relied on
precedence? But there isnt a precedence nor equivalence for
the kind of risk-management problems faced today.
When extrapolating/inferring : template may be wrong.
The object of juridical analysis appears to be a micro
examination of each and every feature of a derivative instrument
to see if it passes, a often subjective religious filter.
33
The overall intended use of the instrument nor the
societal benefits that could accrue do not seem to have
been given due consideration.
Aside from individual interpretation, the differing
opinions among mazhabs/imams complicates the
situation further. Thus, an options contract may be
found objectionable for exactly opposite reasons.
While some mazhabs like the Hanbalis have been
broader in their acceptance, the Shafi and Hanafis
have been less so. The Hanbalis for example are
somewhat liberal when it comes to Option of stipulation
(Khiyar-al-Shart).
The Hanbalis hold that stipulations that remove a
hardship, fulfills a legitimate need, provide a benefit or
convenience, or facilitate the smooth flow of commercial
transactions are generally valid as a matter of principle.
34
Obvious need for a more coordinated
evaluation; need based rather than purely
juristic/precedent driven.
35