Islamic DerivativesA Research Report By:

Kumail Rizvi (12768), Ghansham Kessani (15155)Abdul Haseeb (12742), Shaza Zulfiqar (13080)Tehreem Sohail 14986), Abdul Rafay (15953)Nimra Fakhar (15048), Moaz Afridi (11391) & Murad (16059)

Financial DerivativesSubmitted to: Sir Fahad Fahim

Islamic Derivatives

Introduction:

A derivative is a contract that derives its value from the performance of an underlying entity.

This underlying entity can be an asset, index, or interest rate, and is often called the

"underlying". Derivatives can be used for a number of purposes, including insuring against price

movements (hedging), increasing exposure to price movements for speculation or getting access

to otherwise hard-to-trade assets or markets. Some of the more common derivatives

include forwards, futures, options, swaps, and variations of these such as synthetic collateralized

debt obligations and credit default swaps. Most derivatives are traded over-the-counter (off-

exchange) or on an exchange such as the Pakistan Mercantile Exchange. Derivatives are one of

the three main categories of financial instruments, the other two being stocks (i.e., equities or

shares) and debt (i.e., bonds and mortgages).

Types of Derivatives:

Forward: a forward contract or simply a forward is a non-standardized contract between two

parties to buy or to sell an asset at a specified future time at a price agreed upon today, making it

a type of derivative instrument.

Future: A futures contract is a standardized contract between two parties to buy or sell a

specified asset of standardized quantity and quality for a price agreed upon today (the futures

price) with delivery and payment occurring at a specified future date, the delivery date, making it

a derivative product (i.e. a financial product that is derived from an underlying asset).

Options: An option is a contract which gives the buyer (the owner) the right, but not the

obligation, to buy or sell an underlying asset or instrument at a specified strike price on or before

a specified date. The seller has the corresponding obligation to fulfill the transaction that is to

sell or buy if the buyer exercises the option

Swaps: A swap is an agreement to interchange cash flows from different assets. Through a swap an investor is able to convert his floating investment or liability into fixed and vice versa.

Conventional Derivatives:

The conventional options, swaps and futures stem from debts and involve sale and purchase of debts/liabilities. As a group, products such as interest-rate swaps, stock options and futures, currency futures etc are called derivatives i.e. instruments derived from the expected future performance of the respective underlying assets. These are very complex and risky contracts having present market value of trillions of dollars over the world. Global financial market is becoming increasingly fragile as more and more derivatives and ‘hedging’ instruments emerge.

Study derivatives market reveals that it has the potential to cause a serious breakdown in the financial system. The degrees of leverage that are afforded by option contracts can be so high that large unpredictable market moves in underlying prices may one day lead to the insolvency of a major financial institution. Liabilities cannot be perfectly hedged even if that is the intention, and some traders deliberately do not hedge their option portfolios because such action would limit the potential for high returns.

The Black-Scholes formula proposes that since an option can be perfectly hedged through constant trading in the underlying asset, the option position should be riskless and hence earn the buyer the risk free rate of interest on the premium that was paid for it.

Why derivatives are considered Haram?

Despite their demonstrable importance for financial sector development, derivatives are few and far between in countries where capital market transactions are governed by Islamic law. From the standpoint of Islamic jurisprudence (fiqh al-muamalat), financial contracts must satisfy a number of requirements, which seem absent in the use and trading of conventional derivatives. Since risk-shifting violates basic principles of shari’ah law, derivatives are not readily accepted by shari’ah scholars as permissible financial instruments due to their often speculative and unfunded nature.

Islamic finance is governed by the Shari[ah, which bans interest, short selling and speculation, and stipulates that income must be derived as profits from shared business risk rather than guaranteed return. Notwithstanding these religious constraints and legal uncertainty surrounding the enforceability of investor interest under Islamic jurisprudence, Islamic finance can synthesize close equivalents to equity, mortgages, and derivatives known in conventional finance. To this end, it relies on structural arrangements of asset transfer between borrowers and lenders to emulate traditional interest-bearing financial contracts.

The concept of business, trade and finance is very different in Islam than the one we know which is not Islamic and is ribbah (interest) based. ALLAH swt has prohibited the dealing inRibbah this is a well known fact. But there are certain other business related activities which we do not know and so indulge ourselves in the illegal business activities which are not illegal in the eyes of the modern system of financing but are surely against Quran and sunnah.

Those derivatives that involve any kind of ribbah (interest) based transactions are already out of the Islamic financial system because dealing in interest is haram (prohibited) act in Islam.

Sahih bukhari: Volume 3, Book 35, Number 451:Narrated Abu Al-Bakhtari:

I asked Ibn Umar about Salam (the fruits of) date-palms. He replied, "The Prophet forbade the sale of dates till their benefit becomes evident and fit for eating and also the sale of silver (for gold) on credit." I asked Ibn 'Abbas about Salam for dates and he replied, "The Prophet forbade the sale of dates till they were fit for eating and could be estimated."

The hadith mentioned above talks about one very basic and important aspect of trading. We cannot sell what we do not have. How can we sell dates when they are not ripened yet, or when they are still on trees? Similarly, we cannot sell or buy an asset which we do not possess or about which we are uncertain. This hadith tells us that do the trade of that tangible asset that you have in hand and that you measure or at least try.

Why are futures Haram?

Selling what you don’t have possession of: Futures is generally a debt-inducing contract; the buyer sells you something they don’t have (but intend to buy at a cheap price). Sometimes, the commodity being sold doesn’t exist, and it may exist later on (at the date of the contract). In either case, the buyer is selling something that they don’t own! And that’s not permissible in Islam!

Debt for debt: Even if you own the commodity in the exchange that you’re selling (or buying) in a futures contract, it becomes a debt for a debt. You owe some money, and the seller owes some commodity. Again, not permissible.

So how can we make a futures contract halal?

1. Buy and sell what exists. Make sure that, whatever the commodity is, be it stocks, or currency, it already exists in the world.

2. Make it a promise, not a transaction. If you consider the deal a legally binding transaction, then it’s haram; but if it’s just a promise to buy at a later date (spiritually, but not legally, binding) then it becomes permissible. Practically, this means you CAN (but shouldn’t) back out of the deal when the time comes; and that you cannot take to court, in an Islamic system, the other party.

3. Pay a deposit. Another solution to the debt-for-debt transaction is to pay a down-payment up-front; at least then, something has exchanged hands, and it’s not a debt-for-debt transaction anymore, but a proper, legally-binding transaction.

4. No reselling. If you bought a futures contract and paid money, that contract entitles you to some commodity. Can you resell that commodity? No! Because you don’t physically have possession of it!

Development of Islamic derivatives in Malaysia:

In April 2006, Standard Chartered first in South East Asia had launched a comprehensive Islamic derivatives solution based on a globally acceptable Islamic concept to ensure that customers have access to hedge profit rates risks while enhancing their balance sheet management. The Islamic derivatives solution comprises Islamic Profit Rate Swap, Islamic Cross Currency Swap and Islamic Forward Rate Agreement.

In July 2006, Standard Charted Bank Malaysia Berhad executed US$10 million Islamic Cross Currency Swap with Bank Muamalat Malaysia Berhad, the first Islamic cross currency swap in Malaysia and probably in the world. The currency swap allows Bank Muamalat to hedge the currency and interest rate risks of its investment in foreign currency denominated assets. The facility allows the parties involved to exchange a series of profit principled payments in one currency for another denominated in a different currency, based on a notional principal amount over an agreed period.

In 2007, the CIMB Islamic Bank Berhad (Malaysia) launched the Islamic Foreign Exchange with Shari’ah Compliant Option Features or FXOP-i, Cross Currencies Profit Rate Swap (CCPRS-i) and Islamic Profit Rate Swap (PRS-i) that allow customers to hedge their foreign exchange risk. The CIMB Islamic Profit Rate Swap has been recognized as the world’s first Islamic derivative product. In recognition for this innovation, the CIMB’s Islamic Profit Rate Swap has been conferred the Islamic Finance Product of the year in 2005 by Euro money. The product is basically an agreement to exchange profit rates between a fixed rate party and a floating party or vice versa implemented through the execution of a series of underlying contracts to trade certain assets under the shari’ah contracts. (Azmi & Associates 2008).

In 2008, Kuwait Finance House Malaysia introduced its KFH Ijarah Rental Swap-i product. This is a shari’ah compliant hedging contract suitable for corporate customers who have ijarah financing arrangements which are subjected to fluctuations of the reference rates such as costs of funds or fixed over the ijarah lease facility period. The product aims at protecting customers against profit rate volatility and can be used to hedge risks in any variable or fixed ijarah based facility such as ijarah contract financing, ijarah project financing, ijarah auto financing, ijarah asset acquisition financing or even ijarah based sukuk. Companies can convert either the fixed or floating rate commitments into a more manageable rate exposure thus minimizing the occurrence of any negative impact to volatility and uncertainty in rate over a period of time (Azmi & Associates, 2008).

RHB Islamic Bank Berhad had also approved Islamic Promissory Forward Currency contract based on wa’d mulzim. In this contract, the customer will promise to buy foreign currency in specific agreed period based on agreed rate. Later, the bank will arrange murabahah contract

(tawarruq) with third party based on currency needed by the customer to do mismatch arrangement (Ahmad Suhaimi 2008).

Derivative market in Pakistan

Cash-Settled Futures (CSF) at the KSE – Yet to Gain Popularity

Introduced early in 2007, CSF, did not gained popularity at all. Presently 15 companies are available for these cash-settled futures. Standard contract is of 30, 60 and 90 day duration, with daily marked-to market of losses & gains. There are necessarily an equal number of buyers and sellers in the market and thus smooth settlement on the last day of the contract is ensured.

Stock Future in PakistanStock Futures were introduced at local bourses in September 2001. At beginning, investor’s awareness in Pakistan was obviously low but gradually investor understanding regarding stock futures has increased and current stock futures are frequently used as a source of leveraging at KSE, Fixed income funds size …. During 2007-2008 average daily volume in future counter has been 26.81% of the total volume traded at ready markets, Currently 42 stocks are trading on the futures counter at KSE.

Conclusion:The purpose of the research article is to highlight contemporary study which has taken place on Islamic derivatives. This research paper contains work of many renowned scholars in this regard. After critically analyzing the facts we do agree on the fact that conventional derivatives are non-shariah compliant financial instruments. They are based on elements such as interest and speculations which have been out rightly declared as unlawful in Quran and Sunnah.

The development of Islamic derivative in Malaysia is commendable. They are able to reap the benefits of derivatives in the form of hedging risk and are also simultaneously confining it to Islamic laws.

As per our study on the derivative market of Pakistan, it is our opinion that we for now must encourage the use of conventional derivatives. The first argument to support our opinion is that the contemporary derivative market in Pakistan is in its infancy stage. All the relevant stakeholders such as brokers, corporations and investors first need to realize the importance of derivative as an effective tool for risk management. The second reason to support our opinion is the quantum of Islamic finance. Currently Islamic banking represents 10% of the entire system in Pakistan. Although this percentage is expected to grow in future considering the fact that after the court ruling no new conventional bank can now operate in Pakistan. However for now the use of Islamic derivative in Pakistan will be very limited and hence will also lack the desired liquidity.

References:

http://www.mfaridalam.com/downloads/Derivative-Pakistan%20perspective.pdf

http://www.arifirfanullah.com/articles/derivatives-in-pakistan

http://www.cimbislamic.com/index.php?tpt=islamic

(www.muamalat.com.my

http://www.rhb.com.my/islamic_banking/main/main.html

http://www.db.com/malaysia/