Hedging and Hedge Funds: Why an Islamic Alternative?
Dr. Mohammed Burhan
Arbouna,
Shari’a
Board Member
United International Bank‐
Bahrain
A paper presented at International Islamic Capital Market Forum on 13 November 2008.Organized by securities commission Malaysia.
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Presentation Outline
• The concept of hedge and hedging• The benefits and growing need to Islamic hedging
techniques• Ruling and conditions of acceptable hedging • General issues of hedging instruments• Analysing derivatives instruments under Islamic
contracts• Some Shari’a Issues of Hedge Funds• Shari’a Alternatives of hedging tools • Underlying Assets of hedging • Shari’a Advisor’s or Boards role in hedge funds
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The concept of hedge and hedging
• Hedging
is a strategy
designed by using and choosing contracts and structures which aim at minimizing
exposure to such business risk.
• Hedge funds do not necessarily mean protection, but, hedging or hedge funds are about taking higher risks
for higher returns for which they need to manage these risks.
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Ruling of hedging
• The concept of hedging is about management of manageable risks.
In this sense, hedging is acceptable for the following:– matches with a number of Islamic contracts that aimed at minimizing
risks and unwanted circumstances.
– Matches one of the general objective of Shari’a: Protection of Wealth.
A hedging against risks is a core Shari’a risk management
requirements for investments. We noted that
• The Shari’a clearly required protection of contracts that are prone
to risks by taking necessary protective measures, such writing
down the deal, personal proof and guarantees.
• The Shari disapproved submitting wealth to minors. The reason is
simple as that the risk of doing so is beyond residual or inherent
risks and withholding the minor’s wealth against his or her will
concur to the concept of risk management.
• the mudarib
is liable when investing without due diligent required
from professional person in the normal course of business and
investment.
Al‐Abbass Ibn Abdul Mutallib’s case is a clear
evidence of risk management and hedging.
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The two dimension of hedging
• The hedging involved two perspective:– Investors perspective‐
where investors hedge
against losses of their investment with hedge funds.
– Hedge funds’
cross hedging to ensure that the returns promised are achieved.
– Therefore, the mechanics of cross hedging need to scrutiny from Shari’a perspective.
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Analyzing derivatives instruments under Shari’a principles
• It
noted
that
the
majority
of
hedge
funds
risk management
instruments
are
derivatives
instruments. • Some
Islamic
concepts
are
cited
in
many
occasion
to
justify
the
acceptability
or
compatibility
of
these instruments to Islamic principles.
• The
following
10
slides
discussed
matching
and differring
points
of
Islamic
contracts
and
the
following derivates:– Forward Contracts– Options
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Salam Contracts and Forward Contracts
• Can Salam be cited as an evidence for allowing Forward Contracts?
• This
question
is
raised
due
to
the
fact
that
Forward
Contract
is
a
deferred delivery contract like Salam Contract.
• There
are
differences
between
Forward
Contract
and
Salam
Contract as follows:
– In Salam, the purchaser pays the entire salam price on the date
of
signing
the
contract.
In
forward
contracts
delivery
of
price
and goods take place in the future.
– In
Salam,
the
source
of
the
subject
matter
should
not
be
identified. In forward contracts the source of the subject matter
is identified.
8
Istisnaa and Forward Contract
• Istisnaa
is
the
closest
contract
to
Forward Contract,
because
Istisnaa
is
forward
delivery
without the requirement to pay price now.
• The
difference
between
Istisnaa
and
Forward Contracts is:
– Istisnaa
relates
to
manufacturing
on
description unlike
forward
contract
which
is
based
on
ordinary
sale that may amount to dispute or litigation.
– Istisnaa ownership of countervalue is established by signature of the istisnaa contract.
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Financial Options
• Financial options contracts convey the right to buy or sell at a pre‐determined
and agreed price.
• The attaempt to compare Options and Khiyar al‐Shart was not successful due to
the following:– The Shari’a options are meant to:– manage damage or loss that may occur as a result of hastiness in
exchanging
an offer and acceptance.
– The
Shari’a
introduced
options
to
deal
with
regret,
damage
of
injudicious
decisions and unpleasant effects and outcome of sale and purchase.
– These
options
are
meant
to
avoid
risk
of
fraud
(ghabn),
misrepresentation
(tadlees) and misconduct, among others. These options give a party to a contract
a
legal
or
contractual
right
to
terminate
the
contract
after
its
conclusion
when
it
appears not serving the purpose of such a party.
– some of these options give one of the contracting parties, probably the buyer, a right
to acquire discount for defects or a right of settlement.
– The
Islamic
banks
need
these
options
to
meet
its
desire
to
avoid
risks
and
manage
unpleasant situations of supply and demand. The bank may stipulate these options to
manage
the
risks
of
trust‐based
modes
of
financing,
such
as
murabaha
where
the
client
may,
in
certain
circumstances,
decline
to
conclude
the
contract
due
to
non‐
binding nature of this mode of financing.
10
The Risk Management of Shari’a Options
• The
above
basic
features
of
Shari’a
options
suggest that these options, if put together, mange a wide range of risks including the following:
‐ Fraud risk (khiyar al‐ghabn)
‐ Misrepresentation risk (khiyar al‐tadlees)
‐ Ownership risk (khiyar mulk)
‐ Price risk (khiyar al‐naqd)
‐ Market risk
‐ Commodity risk (khiyar al‐a’ib)
‐ Default risk (khiyar al‐ta’khir)
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Similarities of Shari’a and Financial Options
• There
are
similarities
between
financial
options
and
Shari’a
options as in the following:– The Shari’a and financial options agree on providing a right to
either
of
the
parties
or
both
to
confirm
or
to
cancel
the
contract within a stipulated period.– The
Shari’a
and
financial
options
are
mainly
intended
to
manage a wide range of risks.– The
Shari’a
options
are
created
as
a
result
of
asset‐based
contractual relationship. This also exists in the transactions of
financial options that involve shares.– The
Shari’a
options
and
financial
options
agree
on
that
both
give
the
buyer
an
upper
hand
to
decide
on
the
direction
of
the contract.
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Differences Between Shari’a and Financial Options
• A
Shari’a
option
consists
of
three
components,
namely the option itself, the
contract
and
the
underlying
assets.
• The
subject
matter
of
financial
option
is
intangible event
against
the
seller
created
by
a
contract
of
obligation.
• Shari’a
options
are
not
subject
of
speculation
and gambling. The option contracts are prone to be used as a gambling
mechanism.
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Differences Between Shari’a and Financial Options
• The
investors
use
financial
options
to
hedge
against potential
price
risks
or
losses
by
using
the
premium
as
consideration for the party who accepts to bear such risk or losses.
• The
financial
options
are
mechanisms
of
investment whereby investors
depend
on
their
expectation
of
the
market and issue or buy such options. This is not the case in Shari’a
options.
• The
period
of
option
in
financial
options
is
actually
not part of the
contract because it precedes the contract.
The
period
in
Shari’a
options
is
an
integral
part
of
the contract.
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Similarities Between Arboon sale and Options
• The
arboon
concepts
is
usually
compared
to
Options
for the following reasons:
– Arboon
contract
consists
of
an
option
that
is
exchanged
with
money
in
case
the
contract
over
an
asset
or
usufruct
is
not
concluded.
– Among
the
objectives
of
arboon
contract
is
the
management
of market risk or price risks.
– The arboon
sale entitles the buyer to gain a binding offer from
the
seller
while
the
buyer
is
at
discretion
to
accept
or
reject
the
offer
within
the
period
of
offer
in
consideration
for
the
arboon.
This
is
similar
to
the
call
option
where
the
option
holder is entitled to buy shares or refrain from doing so against
losing the paid premium.
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Differences between Arboon sale and financial Options
• However,
there
are
major
differences
between Arboon and Options as follows:
–The
amount
that
is
described
as
arboon
form
part
and
parcel of the price of the sold item
whereas
the
premium of financial options is not
considered
part
of
the price, but rather a
consideration for granting an option
to buy or
sell.
–In
the
arboon
contract,
there
exists
a
contract whereas the
contract in financial options would be
categorized
under
Shari’a
principles
as
a
mere promise
because it does not fulfill the requirements
of sale contract.–The
arboon
is
not
tradable
and
financial
options
may be traded.
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Some Shari’a Issues of Hedge Funds • The compliance of a hedge fund requires that the
hedge fund technique and tools are free from the following:
(1)
Guarantee of the investment by the hedge fund manager, because of:
‐ The guarantee converts the operation of the fund to
lending and borrowing in which case any amount paid
as profit is considered interest.
(2)
Hedging through non‐Shari’a compliant contracts and mechanics, such as interest rate swaps,
derivatives, bond and conventional insurance.
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Some Shari’a Issues of Hedge Funds
(3)
Non‐equality in terms of bearing losses: Preferred stocks.
(4)
Non possession and taking daman of sold goods (short selling).
(5)
Non‐Shari’a compliant elements in the agreements and contracts .
(6)
Sale of borrowed shares (not owned). (7)
Elements of gambling
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Shari’a Alternatives for hedging
• It
becomes
acceptable
among
the
Shari’a
scholars that
some
Shari’a
contracts
and
concepts
may
be
used as hedging tools.
• The
following
are
some
Shari’a
alternative
hedging techniques:
– Salam:
entering
into
salam
contract
and
payment
of
the
price
in
advance.
Salam
is
applicable
to
goods
to
produced
from
cultivation
or
to
be
bought
from
the
market.
Therefore,
salam
may
be
applicable
to
shares
provided
that
only
rating
of
the
shares
is
identified
and
not the company.
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Sharia alternatives for hedging– Arboon:
entering
into
real
sale
and
purchase
of
shares
or
goods
and
payment
of
arboon
to
fix
the
price.
The
concept
of
capital
protected
funds are also based on the arboon as follows:
• 93%
of
the
funds
is
invested
in
fixed
profit
transactions,
such
as
Murabaha, ijara and sukuk, at a profit margin of 7 = 100 (capital is
protected).
• 7%
is
paid
as
arboon
on
trade
date
for
purchasing
shares
of
a
company
today
with
the
delivery
to
take
place
at
maturity.
On
maturity, if the shares are performing the shares are collected and
resold with higher price. If the shares under perform, the purchase
will forfeit the shares.
• Some
times
the
hedge
is
arrived
by
a
combination
of
debt‐based
contracts
and
direct
share
trading
without
payment
of
arboon
(combination of debt‐based contract and partnership).
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Shari’a alternatives for hedging
–Parallel
Wa’d:
Some
few
scholars
approved by
the
structure
of
parallel
promises
for
sale
and
purchase
at
different
benchmarks. This
structure
ends
up
with
the
fund
manager
guaranteeing
purchase
of
the shares at nominal value for which a number of scholars do not agree on this structure of hedging.
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Sharia alternatives for hedging– Structured Guarantee:
• some Islamic hedge funds used the concept of structured
guarantee
• a
fund
manager
will
design
investment
analysis
models
using
mathematical
analysis
which
will
make
the
fund
manager achieve returns promised to the clients.
• The
model
designer
guarantees
the
capital
but
on
condition
that
the
fund
manager
adhere
to
the
model
designers’
instructions
as
to
when
to
invest
or
halt
an
investment.
This
structure
is
accepted
by
some
scholars
based
on
the
fact
that
the
fund
manager
is
doing
business
based
on
the advice of the model designer. If the model designers
analysis
appears
wrong,
then
the
model
designer
shall
be liable.
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Sharia alternatives for hedging
– sale
and
buy
back:
this
mechanism
is
similar
to
short
selling concept.
– conditional
option
(khiyar
al‐shart):
unlike
in
arboon,
in
conditional
option,
the
option
holder
does
not
pay
premium.
– Profit
Setoff
(Profit
rate
swap):
Under
the
parallel
commodity
sale
and
purchase,
the
fund
managers
to
hedge currency risks.
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Sharia alternatives for hedging
– Usufruct
exchange/swap
(mutual
loan
exchange): This is used for currency risk management.
– exchange
of
debts
for
commodity:
The
scholars are unanimous that receivables and debts may be sold
in
exchange
for
real
commodity,
even
if
the
price of the commodity is higher than the value of the debt/receivables.
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Underlying Assets of Hedging
• As a principle, the Shari’a compliant assets are potential assets for hedging purposes. The underlying assets of
hedge funds or hedging may be classified into two:– Category A: are assets that are created using non‐Shari’a
compliant activity. The examples of this category are the
following:• Bonds and interest based Securities: this asset becomes out of the
assets of Islamic hedging because of its interest nature.
• Debts and receivables‐
the majority of scholars consider tripartite
trade of receivables is not acceptable.
• Conventional insurance• Trading of risks
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Underlying Assets of Hedging– Category B: are assets of hedging that are created through
an acceptable Sharia contract and activity. The example of
this category are as follows:• Shares, stocks and unit trusts‐
purchasing shares for hedging
purpose will depend on the activities of the company the shares
represent
• Commodity‐
is an acceptable mode for hedging except that the
contract used to execute it may render the hedging unacceptable,
not the commodity itself.
• Sukuks are certificates that represent an ownership in assets. They
may form an acceptable hedge funds assets.
• Real estate
– Thus, the determination of assets of hedging lies on the
Shari’a compliant of the assets.
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What Shari’a Advisors look for compliance of hedge funds?
• The hedging tools, strategies and techniques are nothing but management issues. The evil is in the means that created these techniques.
• role of the Shari’a Boards may be summarized as follows:
– Examination of the fund structure– Modification approach and ensuring compliance– Examination of the underlying instruments, assets and
principles of hedging.– Examining the agreements and contracts – Cross hedging compliance– Accurate implementation of the suggested structure.
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Thank You