Hedging

in
Islamic Finance

Sami Al-Suwailem
Safar 1427 - March 2006
Objectives
 Explore dimensions of risk
 Develop criteria for acceptable risks
 Outline strategy for product design
 Derive Islamic instruments for hedging

Hedging 2
State of Risk
 Markets are becoming more volatile
 Economic instabilities are rising
 Solutions?

Hedging 3
 Dow Jones
300

250

200

150

100

50

0
02/01/1990 02/01/1993 02/01/1996 02/01/1999 02/01/2002 02/01/2005

Hedging 4
 Commodities
160

140

120

100

80

60

40

20

0
Dece July-93 January- July-96 January- July-99 January- July-02 January- July-05
mber-91 95 98 01 04

Hedging 5
Currencies: USD
180

160

140

120

100

80

60

40

20

0
29/12/1989 29/12/1992 29/12/1995 29/12/1998 29/12/2001 29/12/2004

Hedging 6
Rising Instabilities
1990-1994 2000-2004
mean median mean median
DJ 38.6 27 159.4 199
S&P 500 52.1 36 156 176
FTSE 53.9 57 158.9 174
Commodities 57 52 123 124
USD 106.5 100.5 134.4 138

Hedging 7
Experts’ Views
Bernstein (1996):
• Volatilities seems to be proliferating rather than
diminishing.
Krugman (1999):
• The world economy has turned out to be a much
dangerous place than we imagined.
Tumpel-Gugerell (2003):
• Volatility of leading stock markets has doubled
since 1997. Financial volatility is transmuted into
volatility of real output.

Hedging 8
Derivatives
 Exponential growth
 Controversial impact
 Questionable validity

Hedging 9
 Size of Derivatives
350,000

300,000

250,000

200,000

150,000

100,000

50,000

0
Jun-98 Dec. Jun-99 Dec. Jun-00 Dec. Jun-01 Dec. Jun-02 Dec. Jun-03 Dec. Jun-04 Dec. Jun-05
1998 1999 2000 2001 2002 2003 2004

OTC OE

Hedging 10
Structure of Derivatives
 Zero-sum games
 Separate risk from ownership
 Allow hedging only through speculation
 Dominated by speculators
 Threaten system stability

Hedging 11
Market Distribution
Speculation:
97.30%

Hedging:
2.70%

Hedging 12
Risk Dilemma
 Economic activities always involve risk
 Excessive risk hurdles performance
 Pure risk trading transforms into
wagering

Hedging 13
Unresolved Issues
Ken Arrow (2003):
• Derivatives can be used to reduce risk but
people gamble on them.
• Speculators are adding to the swings rather
than reducing them.

Hedging 14
Unresolved Issues…
Kreitner (2000):
• No analytical formula could distinguish
gambling from risk allocation.
• The question of gambling was eventually
swallowed and internalized, as if the
problem were solved.
• The contract law stopped worrying and
learned to love risk.

Hedging 15
The Challenge
 How to have hedging without
unproductive speculation?
 How to distinguish legitimate risk
taking from gambling?
 Where to draw the line?

Hedging 16
Islamic Framework
 Acceptable risk (ex ante):
• Minor, likelihood of success is high
• Inevitable, inseparable from real activities
 Payoff structure (ex post):
• Non-zero-sum-game

Hedging 17
Statistical Measure
 Expected utility is a statistical mean
 Allows for gambling
 Statistical median:
• Excludes low probability events
• Immune to outliers
• Consistent with Islamic concept of gharar

Hedging 18
Payoff Structure
 Zero-sum games: conflict of interest
 Positive sum games: cooperative
 Non-zero-sum games: mixed
 Mixed games are acceptable if the
positive outcome is dominant

Hedging 19
Zero-sum Games
(A, B)

(– ، +) (+ ، –)

Hedging 20
Positive Games
(A, B)

(– , –) (+ , +)

Hedging 21
Mixed Games
(A, B)

(– ، +) (+ ، +)

Hedging 22
Product Design
 Mixed games allow risk transfer with
win-win outcome
 Combine best of both worlds

Hedging 23
Islamic Product Development
 Strategies for product development
 Imitation dilutes values
 Islamic finance becomes a follower

Hedging 24
Hedging Instruments
Instrument Risks Hedged
Asset-Liability alignment General
Delta-hedging General
Mutual hedging General
Bilateral mutual adjustment Rate of return
Conditional mudharabah Capital, misreporting
Combining musharakah and Capital, rate of return
deferred sale
Third party hedging Capital, rate of return
Diversified deferred price Capital, rate of return, liquidity
Value-based hybrid salam Capital, rate of return, liquidity

Hedging 25
Natural Hedge
 Align costs and revenues
 Shift some operations to the same
region
 Borrow in the same currency

Hedging 26
Cooperative Hedge
 Non-profit arrangements
 No legal guarantee
 Risk is shared by members
 Suite all kinds of risks

Hedging 27
Bilateral Adjustment
 Murabaha cannot have a changing rate
 Adjust installment but keep total debt
fixed
• If market rate is up: increase installment,
reduce balance
• If market rate is down: reduce installment,
increase balance
• Done with mutual agreement

Hedging 28
Diversified Deferred Price
 Also for murabaha
 Have the price in two components:
• Principal: in money
• Markup: in liquid assets
 Allow return to adjust to market
 If markup is large, total price becomes
tradable

Hedging 29
Parallel Murabaha
 Replaces currency forwards
 Integrates currency hedge with goods
traded
 Murabaha can be for financing or for
hedging
 Integrates risk transfer with value-
creation

Hedging 30
Conclusion
 Strategies for product development
 Vision for the value of the industry
 Capitalize on Islamic principles

Hedging 31