dr obi paper derivatives in islamic finance - an overview- bank negara-24th june 05

7/24/2019 Dr Obi Paper Derivatives in Islamic Finance - An Overview- Bank Negara-24th June 05

1/35

11

Derivatives in Islamic

Finance An Overview

Derivatives in Islamic

Finance An Overview

Obiyathulla Ismath BachaManagement Centre,

International Islamic University, Malaysia


2/35

2

What are derivatives?

A derivative security is a financial asset whose value isdependent on the value of an underlying asset. Theunderlying asset could be a basic financial asset likecommon stocks, bonds, currencies or commodities.

Since by this definition, a derivative is a "claim on a

claim" the value of the derivative will depend on thevalue of the asset (stocks, bonds, etc on which it has aclaim.

!ommon forms #orwards, #utures, $ptions, Swaps.

Also, e%otics like, Swaptions& 'A)s, !*$s etc.

At a basic level& derivatives enable the avoidance ofunnecessary risks.


3/35

+

volution of erivative *arkets-nstruments

volution of erivative *arkets-nstruments

f one e%amines the evolution of derivative markets and

instruments the progression has been as follows

Forward Contracts

Options

Futures Contracts

Synthetic Instruments

Exotic Options

Swaps etc.

Financial Engineering


4/35

/

As with any other financial product, derivatives were the result of financial

innovation. nnovation that responded to the e%isting need to help managerisk in increasingly sophisticated business environments.

0hile forward contracts were originally innovated for risk1management ofagro1based products, the later instruments were needed as risk environmentschanged.

ach step down the evolutionary chain& added value.

#orward #utures& reduced

'i3uidity risk

!ounterparty risk

Avoid price s3uee4e etc.

#utures $ptions ncreased fle%ibility

Ability to take advantage of favourable price movts (unlike lock-in)

5managing contingent claims-liabilities.

The ob6ective of all these innovation is Risk Management.

Rationale: Why do we need derivatives?

Rationale: Why do we need derivatives?


5/35

7

Risk, from a #inance viewpoint, refers to the uncertainties associatedwith returns from an investment. These uncertainties would translateinto volatility or fluctuation of returns from an investment. *easuredby std. deviation.

An asset that does not come with 8guaranteed9 fi%ed returns hassome amount of uncertainty. nfact even a 8guaranteed9 instrumenthas risks if the issuer:s credibility is 3uestionable.

Risk-Management;refers to the process-techni3ues of reducing therisks faced in an investment.

t generally involves three broad steps&

dentifying the source and type of risk. *easuring the e%tent of the risk. etermining the appropriate response (either on ;alance Sheet or $ff

;alance Sheet methods.

0hat makes risk management challenging is the fact that risks andreturns are generally positively correlated. Thus, the risk1returntradeoff.

The challenge of risk1management is to protect the e%pected returnswhile simultaneously reducing or laying1off the risks.


6/35

uote only in ?inggit (HC) ncrease the #! price e3uivalent to cover risk (pricing strateg) !?SA !(Currenc Risk Sharing "greement)

Off Balance Sheetvs On Balance Sheettechni3ues of risk

management.

Off Balance Sheetvs On Balance Sheettechni3ues of risk

management.


7/35

@

#orwards&Short #C for$ard contracts!

#utures& Short #C futures contracts!$ptions& %ong #C &ut Options!Swaps& #C paer' HC receier

$ff ;alance Sheet techni3ues have becometremendously popular&

!heap and fle%ible =o inconvenience to customer

!an enhance competitiveness

espite the popularity of derivatives based offBalance-Sheet techni3ues& slamic urists havegenerally not been in favor.

$ff ;alance Sheet


8/35

B

All slamic financial instruments in general must meet a number of critiera inorder to be considered halal (acceptable.

At a primary level all financial instruments and transactions must be free ofat least the following five items (i ria (usury, (ii rish$ah(corruption,(iii masir (gambling, (iv gharar (unnecessary risk and (v *ahl(ignorance.

Ria can be in different forms and is prohibited in all its forms. #ore%ample, ?iba can also occur when one gets a positive return withouttaking any risk.

As for gharar, there appears to be no consensus on what gharar means. thas been taken to mean, unnecessary risk, deception or intentionallinduced uncertaint!

n the conte%t of financial transactions, gharar could be thought of aslooseness of the underlying contract such that one or both parties areuncertain about possible outcomes.

Masir from a financial instrument viewpoint would be one where theoutcome is purely dependent on chance alone C as in gambling.

#inally, *ahl refers to ignorance. #rom a financial transaction viewpoint, itwould be unacceptable if one party to the transaction gains because of the

other party:s ignorance.

Requisites for a hariah !ompliant Derivative Instrument


9/35

D

n addition to these re3uirements for financialinstruments, the shariah has some basic conditionswith regards to the sale of an asset (in this case a real

asset as opposed to financial assets.

According to the shariah for a sale to be valid, (a thecommodity or underlying asset must currently e%ist inits physical sellable form and (b the seller should havelegal ownership of the asset in its final form.

These conditions for the validity of a sale wouldobviously render impossible the trading of derivatives.

Eowever, the shariah provides e%ceptions to thesegeneral principles to enable deferred sale whereneeded.


10/35

FG

A number of instruments-contracts e%ist in slamic financethat could be considered a basis for forward-futurescontracts within an slamic framework.

0e will e%amine three such contracts. These are (i the

Salam !ontract, (ii the stisna !ontract and (iii oa:la!ontract.

ach of these contracts concern deferred transactions,and would be applicable for different situations. The firstand probably the most relevant of these to modern dayforward-futures contracts would be the Salam !ontract or;a:i Salam.

Futures !ontracts and Islamic Finance


11/35

FF

Salam is essentially a transaction where two parties agree to carryout a sale-purchase of an underlying asset at a predeterminedfuture date but at a price determined andfully paidfor today

This is similar to a conventional forward contract however, the bigdifference is that in a Salam sale, the buyer pays the entire amountin full at the time the contract is initiated. The contract alsostipulates that the payment must be in cash form.

The idea behind such a Hprepayment: re3uirement has to do withthe fact that the ob6ective in a ;a:i Salam contract is to help needyfarmers 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 lowerthanthe prevailing spot price.

This price behavior is certainly different from that of conventionalfutures contracts where the futures price is typically higher than thespot price by the amount of the carrying cost.

"a#i alam


12/35

F2

The lower Salam price compared to spot is the 8compensation9 bythe seller to the buyer for the privilege given him.

espite allowing Salam sale, Salam is still an e%ception within theslamic financial system which generally discourages forwardsales, particularly of foodstuff.

Thus, ;a:i Salam is sub6ect to several conditions

i #ull payment by buyer at the time of effecting sale.

ii The underlying asset must be standardi4able, easily3uantifiable and of determinate 3uality.

iii !annot be based on an uni3uely identified underlying.

iv >uantity, >uality, *aturity date and )lace of delivery must beclearly enumerated.


13/35

F+

t should be clear that current e%change traded futureswould conform to these conditions with the e%ception of thefirst, which re3uires full advance payment by the buyer.

Iiven the customi4ed nature of ;a:i Salam, it would moreclosely resemble forwards rather than futures. Thus, someof the problems of forwards& namely 8double1coincidence9,negotiated price and counterparty risk can e%ist in theSalam sale.

!ounterparty risk however would be one sided. Since thebuyer has paid in full, it is the buyer who faces the seller:sdefault risk and not both ways as in forwards-futures.

n order to overcome the potential for default on the part ofthe seller, the shariah allows for the buyer to reuiresecurity which may be in the form of a guarantee ormortgage.


14/35

F/

$he alam !ontract % Islamic Financial

Institutions

$he alam !ontract % Islamic Financial

Institutions

Since the Salam !ontract involves transacting

in the underlying asset and financial institutions

may not want to be transacting in theunderlying asset, there are a number of

alternatives available. These are in the form of

parallelSalam !ontracts.

(urists however are not all in agreement of the

permissibility.


15/35

F7

( )arallel with Seller( )arallel with Seller

Eere, after entering into the original Salam !ontract, thebank can get into a parallel Salam sale to sell theunderlying commodity after a time lapse for the samematurity date.

The resale price would be higher and considered 6ustifiablesince there has been a time lapse. The difference betweenthe 2 prices would constitute the bank:s profit. The shorterthe time left to maturity, the higher would be the price.

;oth transactions should be independent of each other.The original transaction should not have been priced withthe intention to do a subse3uent parallel Salam


16/35

F

dr obi paper derivatives in islamic finance - an overview- bank negara-24th june 05

Documents