Use of derivatives as hedging instruments in Islamic finance

Published: January 14, 2013

It must be emphasised that trading in options (rights to buy and sell), forwards and futures contracts is not permissible under Shariah.

LONDON: Given the increasing importance of Islamic banking and finance in Pakistan, it is important to deepen the Islamic financial market in the country. One way of doing so is by developing a market for Islamic hedging instruments, which are known as derivative contracts in conventional finance. It is, however, important to understand the difference between Islamic derivatives and their conventional counterparts.

Financial engineering in Islamic banking and finance has resulted in a number of Islamic options, forward and futures contracts that may be used for risk management and hedging. It must, however, be emphasised that trading in options (rights to buy and sell), forwards and futures contracts is not permissible under Shariah. The use of such contracts is permissible solely for hedging purposes, and not for pure speculative reasons. Consider the following example:

Party A is a Pakistan-based commodity broker who has bought soya beans from a US-based commodity broker for a price of $3 million, to be paid in thirty days, ie, T30. Party A would like to hedge against this foreign exchange (dollar) exposure in a Shariah-compliant manner. This can be done in various Shariah-compliant ways including the following structure:

This structure is based on two promissory arrangements:

Promise 1 is given by the bank to Party A at time T0 to buy Rs300 million for a price of 1 cent per rupee on a future date T30.

Promise 2 is given by Party A to the bank at time T0 to sell Rs300m for a price of Rs99 per dollar (or a price of Rs1 for $0.0101) on a future date T30.

The following are important Shariah considerations for promises:

Firstly, promises in Islamic law are not like contracts – ie, while contracts are binding on both the transacting parties, promises are binding only on the promisor if the promisee decides to call upon it.

Secondly, only unilateral promises (or two or more unequal and non-diagonal promises) are binding.

Thirdly, two equal and diagonal promises are considered as a contract, and if such an arrangement gives rise to a binding forward sale contract, this is deemed not in compliance with Shariah.

Two promises are considered as equal and diagonal (also known as opposite) if they are given by the same two parties on the same object for the same price exercisable at the same time (or during the same period) – but one of them is a promise to purchase and the other is a promise to sell. Thus if Party A gives a promise to Party B to buy from it a stock X for a price of $1 on a future date T1, and at the same time Party B gives a promise to Party A to sell to it a stock X for a price of $1 on a future date, the two promises will be considered as equal and diagonal. In such a case, they will be considered as equal to a binding forward contract, which is not in compliance with Shariah.

Two promises are considered not equal and diagonal if at least one of the following conditions is not met: the two promises are given by the same two parties; the two promises are given on the same object; the two promises are given for the same price; the two promises are given for the same date (or period); and one promise is to purchase and the other promise is to sell.

In the above example, the two promises are not given for the same price, as the agreed exchange rates differ (Rs1 = 1 cent versus Rs1 = 1.01 cent). Hence, they are not equal and diagonal, and are therefore not considered together as a binding forward sale contract.

A contract in Shariah is not considered as a binding forward sale contract if it can be established that, in some cases, it will not be in the best interest of at least one of the transacting parties to execute a deal voluntarily. In the context of the above example, consider the following scenarios:

The future exchange rate can see the rupee strengthen, in which case the bank will call on Party A to enforce its promise. On the contrary, the rupee may weaken in the future, in which case Party A will want the bank to enforce its promise. Finally, the rupee may be valued in a band between 1.01 cents per rupee and 1 cent per rupee, in which case neither party will seek to enforce the promise. In the last case, therefore, no promise will be called upon – leading to a situation in which there is no possibility of a certain forward sale taking place pursuant to one of the promises being called upon.

This is one example of structuring derivatives (or foreign exchange hedging instruments) in conformity with Shariah. It is important to stress that such instruments must strictly be used in conjunction with some real trades in goods and services and not merely speculative tools, which have brought down a number of financial institutions in the west in the recent past.

THE WRITER IS AN ECONOMIST AND A PHD FROM CAMBRIDGE UNIVERSITY

Published in The Express Tribune, January 14th, 2013.

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