Mahyuddin Khalid

emkay@salam.uitm.edu.my
ISLAMIC INVESTMENT

Derivatives in Islamic Finance

 Topic Outline
2

 What is Derivatives
 Rationale: Why do we need derivatives?
 Shariah Compliant Derivative Instrument
 Forward
 Futures
 Option
 Swap
 What Is a Derivative?
3

Financial
Options
instrument that
derives its value
from the value
of its underlying
asset. Swaps Futures

Definition Types
 What Is a Derivative?
4

A derivative can be define as a financial

instrument whose value depends on (or
derives from) the values of other, more
basic, underlying variables.
Very often the variables
underlying derivatives
are the prices of traded
assets.

However, derivatives
can be dependent on
almost any variable.
 Use of Derivative Instruments
5

Reduced
Risk Regulatory
Speculation transaction
management arbitrage
costs

• Hedging (e.g. farmer • Essentially making • Sometimes cheaper • Tax loopholes, etc.
with corn forward) bets on the price of than manipulating
something cash portfolios
 The Main Players in Derivatives Market
6

•Hedgers use derivatives markets to manage or reduce risk

•They are typically business that use derivatives to offset exposure resulting from their activities

Hedgers

•Arbitrage is a process of trying to take advantage of price differentials between markets.

•Arbitrageurs closely follow quoted price of the same asset/instruments in different market looking for price
divergence.
•Should the price be divergent enough to make profit, they would buy on the market with lower price and sell on
the market where the quoted price is higher.
Arbitrageurs •Most financial market integrated by computer networks, arbitrage opportunities can quickly disappear, hence
quick action is needed.

•Take position in assets or markets without taking offsetting position.

•E.g. If they expect a certain asset to fall in value, they would short the asset.
Should their expectation come true they would make profit from having shorted in asset.
•Hope profit from taking risk.
Speculators
 Types of Derivatives
7

Exchange-Traded
(ETD)
• Contracts that are traded
on derivatives exchanges.
• Contracts traded are
standardized as defined by
the exchange.
• Derivatives exchange acts
as a counter-party to all
contracts.

Over-the-Counter
(OTC)
• Contracts that are
privately negotiated and
traded directly between
two parties.
• OTC market is the largest
market for derivatives.
 Evolution of Derivative Markets/ Instruments
8

 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.
 Rationale: Why do we need derivatives?
9

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

financial innovation.
 Innovation that responded to the existing need to help manage risk.
 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 movements (unlike lock-in)
 managing contingent claims/liabilities.
 The objective of all these innovation is Risk Management.
 Derivatives and Risk Management
10

 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.
 Derivatives and Risk Management
11

Off Balance On Balance

Sheet Sheet
All risk management techniques involving On Balance Sheet technique is one where a
derivatives are Off Balance Sheet. transaction is structured in such a way as to
manage the inherent risk.

The hedging mechanism/method is “detached”

from the underlying transaction.

E.g.: Malaysian Exporter; Foreign Customer.

Advantage: No need to change the way one
does business. No loss of competitiveness,
customer convenience etc.
On Balance Sheet Technique
•Quote only in Ringgit (HC)
Despite the popularity of derivatives based off •Increase the FC price equivalent to cover risk (pricing
Balance-Sheet techniques; Islamic Jurists have strategy)
•CRSA (Currency Risk Sharing Agreement)
generally not been in favor.
 Shariah Compliant Derivative Instrument
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 All Islamic financial instruments in general must meet a number

of criteria in order to be considered halal (permissible).
 At a primary level all financial instruments and transactions must
be free of at least the following items:
 Riba (usury)
 Gharar (uncertainty)
 Maysir (gambling)
 Other undue practices.
 Shariah Compliant Derivative Instrument
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• Riba can be in different forms and is prohibited in all its forms

• E.g. Riba can also occur when one gets a positive return without taking any risk.
Riba

• As for gharar, there appears to be no consensus on what gharar means.

• It has been taken to mean, unnecessary risk, deception or intentionally induced uncertainty.
• In the context of financial transactions, gharar could be thought of as looseness of the
Gharar underlying contract such that one or both parties are uncertain about possible outcomes.

• Maysir from a financial instrument viewpoint would be one where the outcome is purely
dependent on chance alone – as in gambling.

Maysir
 Shariah Compliant Derivative Instrument
14

Islamic Financial The type of Islamic

Service Act 2013 define Derivatives that
Islamic Derivatives as: currently in use are:
Any agreement, including an option, a swap,
Islamic FX forwards (IFF)
futures or forward contract,

Islamic swaps (Islamic FX swaps, Islamic Cross

Made in accordance with Shariah,
Country swaps and Islamic Profit Rate swaps)

Whose market price, value, delivery or

Islamic options
payment obligations

Is derived from, referenced to or based on, but

not limited to, Islamic securities, commodities,
Futures contract
assets, rates (including profit rates or
exchange rates) or indices
 Shariah Compliant Derivative Instrument
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 There are numbers of muamalah contract that have features

resembles derivatives and can be used for hedging such as
salam, istisna, urbun and Hamish jiddiyah.
 The muamalah contract that are used to create products which
have features similar to forwards, futures, options and swaps
are commodity murabahah, musawamah, bay’ al-’inah, BBA,
tawarruq and wa’ad.
 In addition to these requirements for financial instruments, the
shariah has some basic conditions with regards to the sale of an
asset (in this case a real asset as opposed to financial assets).
 Shariah Compliant Derivative Instrument
16

 According to the shariah for a sale to be valid,

 the commodity or underlying asset must currently exist in its
physical sellable form
 the seller should have legal ownership of the asset in its final form.
 These conditions for the validity of a sale would obviously render
impossible the trading of derivatives.
 However, the shariah provides exceptions to these general
principles to enable deferred sale where needed.
 Forward contracts
17

 Forward Contracts
 Definition: a contract between two parties for one party to buy
something from the other at a later date at a price agreed upon
today
 It can be contrasted with a spot contract, which is an agreement
to buy or sell an asset today.
 A forward contract is traded in the over-the-counter market—
usually between two financial institutions or between a financial
institution and one of its clients.
 Forward contracts
18

 Function in financial operation: hedge risk; as a means of

speculation; or to allow a party to take advantage of quality of
the underlying instrument which is time sensitive.
 In this contract, both parties (buyer and seller) eliminate the
price risk by “locking in” the price at which they would carry out
the transaction at the future date.
 Example:
 Futures contracts
19

 Futures Contract:
 Definition: A futures contract is an agreement between two parties
to buy or sell an asset at a certain time in the future for a specified
price.
 Unlike forward contracts, futures contracts are normally traded
on an exchange.
 To make trading possible, the exchange specifies certain
standardized features of the contract.
 Forward and Futures in Islamic Finance
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 Main Issues of forward and futures is deferment in price and

asset to a future date.
 A number of instruments/contracts exist in Islamic finance that
could be considered a basis for forward/futures contracts within
an Islamic framework. These are Salam Contract, Istisna Contract
and Jualah Contract.
 Each of these contracts concern deferred transactions, and
would be applicable for different situations.
 However to defer both price and asset to future date is
problematic due to issue of Gharar.
 Salam Contract and Future
21

 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
 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.
 The lower Salam price compared to spot is the “compensation” by
the seller to the buyer for the privilege given him.
 Thus, Salam contract is subject to several conditions:
 Full payment by buyer at the time of effecting sale.
 The underlying asset must be standardizable, easily quantifiable and of
determinate quality.
 Cannot be based on an uniquely identified underlying.
 Quantity, Quality, Maturity date and Place of delivery must be clearly
enumerated.
 Forward and Futures in Islamic Finance
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 OIC Fiqh Academy ruled that defer both the counter-values in the
trading of commodities (forward contract) is not permissible, but
recommended that such commodity trading follow Salam rules in
order to be permissible.
 It follows that forwards and futures contract may use Salam contract
but this requires full payment of the asset price at the time of
contract.
 Specification of the reference must be clearly made; quantity,
type & date delivery
 The first and probably the most relevant of these to modern day
forward/futures contracts would be the Salam Contract. If Salam
rules followed, then should be approves by all scholar
 Forward and Futures in Islamic Finance
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 Closing Out & Margin Trading

 In futures, buyer and seller are required to take or make physical or
cash settlement delivery upon expiry of the time specified, unless
they close their position
 Close position: re-sell the futures before its expiry. This normally
happen when the parties feel that the contract has risen or fallen in
their favour.
 E.g. Trader bought future contract, he will sell it to close out when the
price is gone up. On the other hand, if a trader has sold a futures contract
he will buy back to close out when the price goes down.
 OIC Fiqh Academy: Practice of closing out is not permissible.
 Traders of futures don’t need a lot of money to start because they
are only obliged to pay a percentage of the contract value. If the
price swings are in their favour, they stand to gain an amount of
profit that is calculated based on the whole contract value. But if it
unfavourable, they stand to lose huge amount base on contract
value.
 Forward and Futures in Islamic Finance
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 Views on Permissiblity of Futures contract:

 Imam Al-Haramaini Al-Jauwaini
 Futures Trading is permissible if the practice is based on Darurah and the
Needs of the Ummah
 Shariah Advisory Council (SAC) of Securities Commission
 Futures trading of commodities is approved as long as underlying asset is
halal.
 Crude Palm Oil Futures Contracts are approved for trading.
 Forward and Futures in Islamic Finance
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 Stock Index Futures (SIF) contract

 SAC of SC
 SIF is permissible. However since the current Bursa Malaysia based SIF has
non-shariah compliant stocks, it is not approved.
 SAC decided that an index futures should free from element gambling,
jahalah and gharar, should be allowed especially when it is a maslahah of
people and economy.
 Ahmad Allam of OIC Islamic Fiqh Academy (14/5/1992)
 SIF trading is prohibited, since some of the underlying stocks are not halal.
 Until and unless the underlying asset or basket of securities in the SIF is all
shariah-compliant; SIF trading is not approved.
 Mufti Taqi Usmani
 Futures transactions not permissible, for 2 reasons;
 According to shariah, sale or purchase cannot be affected for a future date.
 In most futures transactions delivery or possession is not intended.
 Options
26

 Option contract:
 Definition: financial instruments that convey a right, but not an
obligation, to engage in a future transaction on some underlying
securities, or in futures contract.
 Options are traded both on exchanges and in the over-the-
counter market.
 There are two types of option:
 Call option gives the holder the right to buy the underlying asset by a
certain date for a certain price.
 Put option gives the holder the right to sell the underlying asset by a
certain date for a certain price.
 The price in the contract is known as the exercise price or strike
price.
 The date in the contract is known as the expiration date or
maturity.
 Options in Islamic Finance
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 When viewed solely as a promise to buy or sell an asset at a

predetermined price within a stipulated period, shariah scholars
find nothing objectionable with options.
 It is in the trading of these promises and the charging of
premiums that objections are raised.
 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.
 Ahmad Muhayyuddin Hassan (1986)
 Option trading contract is prohibited, for 2 reasons
 Maturity beyond three days as in al-khiyarat is not acceptable.
 The buyer gets more benefits than the seller – injustice.
 Options in Islamic Finance
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 Abu Sulayman of OIC Islamic Fiqh Academy

 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.
 Mufti Taqi Usmani of OIC Islamic Fiqh Academy
 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.
 Options in Islamic Finance
29

 Hashim Kamali (1998)

 Options trading is 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)
 Shariah Advisory Council (SAC) of Securities Commission
 Though no formal opinion on stock or Index Options, the SAC has allowed
other option-like instruments.
 Warrants
 TSRs
 Call Warrants
 Each of these are really option like instruments.
 E.g. Call Warrants are simply long dated Call Options. Have similar risk/payoff
profile.
Swaps and Other Derivatives

 Swap:
 A bilateral contract where the parties agree to exchange a series of cash
flows at fixed periodic intervals based on the underlying asset.
 Features of Swap:
 Exclusively over-the-counter
 Other types of derivatives include swaptions and hybrids.
 Their creation is a process called financial engineering.
 The Underlying Asset
 Called the underlying
 A derivative derives its value from the underlying.
 Five generic types of Swaps:
 Interest rates swaps
 Currency swaps
 Credit Swaps
 Commodity Swaps
 Equity Swaps
 Issues and Challenges in Islamic Derivatives
31

Product Use of the

Shariah Issues structuring Product

Lack of Enforceability
Legal Issues standardization of Wa’ad

Regulatory Lack of
regulatory
Issues framework

Ethical and Speculation

Maysir, Qimar
Moral Issues and Gharar

Conventional
mindset of Mindset of
derivatives banker
user
 Conclusion
32

 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.
 Summary
33

What is Derivatives

Shariah Compliant
In this Derivative Instrument

chapter Forward
you have
learned Futures

about: Option

Swap
34 Thank you