_Final FD Report

7/23/2019 _Final FD Report

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Financial Derivatives

ves: Its uses and Implications in the Real World

imra !ashmi-1"##$

M)ra Ra*i-1$#$2

!assan ,han-127(#

6 %ati I+&al-1$(12

Submitted to:


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Acknowledgement

First o all /e /ould li0e to than0 %ll Miht) %llah reat entit) that helped usto et throuh this report sael) the one /ho /as al/a)s there /hen no one/as3

We /ould li0e to pa) tri&ute to our lovin parents and teachers /hoseinvalua&le pra)s salutar) admire and em&od)in attitude 0ept our spirit aliveto strive or 0no/lede and interit) /hich ena&le us to reach milestone /e/ould also li0e to e4press enormous ratitude to m) respecta&le teacher

5Sir Fahid Fahim

Who /as al/a)s there to help and uide us /henever /e needed help hisperceptive criticism 0ept me /or0in to ma0e this proect &etter. We arethan0ul to him or his encourain and valua&le support. Wor0in under him/as an e4tremel) 0no/ledea&le and enrichin e4perience or us. We arever) than0ul to him or all the value addition and enhancement done to us.We also ac0no/lede the help and pleasant atherin o all m) class ello/s.We are also than0ul to all o those people /ho helped us in accomplishinthis report.


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EXECUTIVE SUMMARY

I one /ere to sinle out an area o derivative tradin /hich can nd support

in the relevant evidence o Shari8ah it /ould un+uestiona&l) &e the

commodit) utures. 9his is &ecause utures and options that derive rom

commodities especiall) aricultural commodities and ood rains can &e

used or a variet) o &enecial purposes. ommodit) utures can &e used as

hedin devices that protect armers and the ood production industr)

aainst the price ris0 over a period o time.

Futures and options can also &e used in the interest o e;ective plannin &)

the mar0et pla)ers in aricultural and industrial sectors that ma) /ish to

have the securit) o sellin in advance instead o acin the uncertainties o

mar0etin at short notice especiall) or commodities that can onl) &e stored

over a period o months rather than )ears. 9he reatest &enet o tradin in

utures and options is that the) acilitate ris0 manaement and ris0

reduction.

%ll o these /ould all rom the Shari8ah point o vie/ /ithin the &road scope

o pu&lic interest or maslahah /hich is a reconi*ed proo and &asis o

udment in Shari8ah. !o/ever the validit) o maslahah in areas and issues/hich have iven rise to controvers) need to &e esta&lished throuh valid

Shari8ah evidence. 9his is the nature o the challene that /e ace

concernin tradin in derivatives.


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Table of Content:

1- onventional Derivatives:i- Introduction


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2. % futu"e# cont"actis a contract &et/een t/o parties to &u) or sell anasset or a price areed upon toda) Cthe utures price /ith deliver)and pa)ment occurrin at a uture point the deliver) date.

".9he #wa$areement denes the dates /hen the cash Go/s are to &epaid and the /a) the) are accrued and calculated. Specicall) t/o

counterparties aree to e4chane one stream o cash Go/s aainstanother stream. 9hese streams are called the les o the s/ap.

'. %n o$tion# cont"actis an areement &et/een a &u)er and seller thatives the purchaser o the option the riht to &u) or sell a particularasset at a later date at an areed upon price. Aptions contracts areoten used in securities commodities and real estate transactions.

=ses o Derivatives:

1. orporations use nancial derivatives to reduce the volatilit) o their earnins

stream &) hedin e4posures to interest rate e4chane rate and commodit)

price ris0s.

2. In /orld a&out one-third o pu&licl) listed rms use nancial derivatives. 9he

use o derivatives is /idespread across all sectors o the econom) and

increases durin periods o reater uncertaint).

". on-nancial rms that use derivatives are t)picall) larer and moreprota&le and have lo/er volatilit) o earnins than those that do not use

derivatives. Averall the rm characteristics o heders seem to &e consistent

/ith those ound in other urisdictions.

I#lamic de"iatie#:

Introduction:

% num&er o instrumentsBcontracts e4ist in Islamic nance that could &e

considered a &asis or or/ardButures contracts /ithin an Islamic rame/or0.

We /ill e4amine three such contracts. 9hese a"e %i& t'e Salam Cont"act(

%ii& t'e I#ti#na Cont"act and %iii& )oa*la Cont"act+ Each o these


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contracts concern deerred transactions and /ould &e applica&le or

di;erent situations. 9he rst and pro&a&l) the most relevant o these to

modern da) or/ardButures contracts /ould &e the Salam ontract or Ha@i

Salam.

9)pes o Islamic Derivatives:

,+ -a*i Salam

Salam is essentiall) a transaction /here t/o parties aree to carr) out a

saleBpurchase o an underl)in asset at a predetermined uture date &ut at a

price determined and ull) paid or toda). 9his is similar to a conventional

or/ard contract ho/ever the &i di;erence is that in a Salam sale the

&u)er pa)s the entire amount in full at the time the contract is initiated.

9he contract also stipulates that the pa)ment must &e in cash orm.

Since there is ull prepa)ment a Salam sale is clearl) &enecial to the seller.

%s such the predetermined price is normall)lower

than the prevailin spotprice. 9his price &ehavior is certainl) di;erent rom that o conventional

utures contracts /here the utures price is t)picall) hiher than the spot

price &) the amount o the carr)in cost.

9hus Ha@i Salam is su&ect to several conditions:


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i Full pa)ment &) &u)er at the time o e;ectin sale.ii 9he underl)in asset must &e standardi*a&le easil) +uantia&le

and o determinate +ualit).

iii annot &e &ased on a uni+uel) identied underl)in.iv ?uantit) ?ualit) Maturit) date and lace o deliver) must &e

clearl) enumerated.

.+ I#ti#na and )oala Cont"act#

9here are t/o other contracts /here a transaction is made on a 5)et to

e4ist underl)in assets. 9hese are the I#ti#naand)oalacontracts.


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9he I#ti#naontract has as its underl)in a product to &e manuactured.

Essentiall) in an Istisna a &u)er contracts /ith a manuacturer to

manuacture a needed product to his specications. 9he price or the product

is areed upon and 4ed. While the areement ma) &e cancelled &) either

part) &eore production &eins it cannot &e cancelled unilaterall) once the

manuacturer &eins production. =nli0e the Salam ontract the pa)ment

here is not made in advance. 9he time o deliver) too is not 4ed. Ji0e Ha@i

Salam a parallel contract is oten allo/ed or in Istisna.

9he )oala ontract is essentiall) aIstisna &ut applica&le or services as

opposed to a manuactured product.

Aptions in Islamic Finance


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Recall our earlier arument that to &e accepta&le an instrumentBinvestment

must &e ree o harar and not have *ero ris0 in order to provide some

positive return.

9he I#ti/"a"ontract is a recentl) introduced Islamic nancin instrument.9he contract has em&edded options that could &e triered i an underl)inasset@s price e4ceeds certain &ounds. 9he contract is comple4 in that it

constitutes a com&ination o options averae prices and Murabahaor costplus nancin. 9he Istirar involves t/o parties a &u)er /hich could &e acompan) see0in nancin to purchase the underl)in asset and a nancialinstitution.

%t the initiation o the contract to &oth parties aree on the ollo/in

t/o items Ci in the predetermined Mura&aha price K and Cii an upperand lo/er &ound around the o. CHan0@s purchase price at to.

/here o

L9he price that &an0 pa)s to purchaseunderl)in commodit).

K LMura&aha price K L oC1r.


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0'y Conentional !e"iatie# a"e 'a"am in I#lam1

9he concept o &usiness trade and nance is ver) di;erent in Islam than the

one /e 0no/ /hich is not Islamic and is ri&&ah Cinterest &ased. %JJ%! s/t

has prohi&ited the dealin in ri&&ah this is a /ell 0no/n act. Hut there arecertain other &usiness related activities /hich /e do not 0no/ and so indule

ourselves in the illeal &usiness activities /hich are not illeal in the e)es o

the modern s)stem o nancin &ut are surel) aainst ?uran and Sunnah.

9here is a /ide use o nancial derivative in the current nance mar0ets. 9he

derivatives are those nancial instruments that derive their value rom an

underl)in actual asset and these are actuall) the contracts made &et/een

parties &ased on some uture deliver) dates.

9hose derivatives that involve an) 0ind o ri&&ah Cinterest &ased

transactions are alread) out o the Islamic nancial s)stem &ecause dealin

in interest is haram Cprohi&ited act in Islam. Heore oin into the

discussion rst ta0e a loo0 at a hadith Csa)in o M=!%MM%D S.%.W.W

reardin tradin In advance and then the discussion on the derivative@s use

/ill &e urthered.


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Some %ha@hadiths reardin to Ri&ah:

Sa'i'buk'a"i: Volume 2( -ook 23( 4umbe" 53,:4a""ated Abu Al6-ak'ta"i:

5I as0ed I&n =mar a&out Salam Cthe ruits o date-palms. !e replied N9herophet or&ade the sale o dates till their &enet &ecomes evident and t oreatin and also the sale o silver Cor old on credit.N I as0ed I&n 8%&&as

a&out Salam or dates and he replied N9he rophet or&ade the sale o datestill the) /ere t or eatin and could &e estimated.NSumma"y:9he hadith mentioned a&ove tal0s a&out one ver) &asic and importantaspect o tradin. We cannot sell /hat /e do not have. !o/ can /e selldates /hen the) are not ripened )et or /hen the) are still on treesOSimilarl) /e cannot sell or &u) an asset /hich /e do not possess or a&out/hich /e are uncertain. 9his hadith tells us that do the trade o that tani&leasset that )ou have in hand and that )ou measure or at least tr).

Sa'i'buk'a"i: Volume 2( -ook 23( 4umbe" 552:4a""ated Ibn 7Abba#:9he rophet came to Medina and the people used to pa) in advance theprice o dates to &e delivered /ithin t/o or three )ears. !e said Cto themNWhoever pa)s in advance the price o a thin to &e delivered later shouldpa) it or a specied measure at specied /eiht or a specied period.N

8oly 9u"analso spea0s a&out the contracts made &ased on uturetransactions. It is mentioned in:

#u"a' Al6bak"a': .:..:

9he verse spea0s a&out t/o aspects num&er one is to /rite do/n a /rittenand tani&le contract /henever one underoes into an) &usiness deal orde&t second is the thin descri&ed is that there is no need o /ritin do/n odail) transactions that are made as a dail) matter.

Apinion o Scholars

We 0no/ that all the uture transactions &ased on nancial derivativesinvolve at least one ris0. 9he most common ris0 in such trades is the ris0 odeault. Second thin is that these deals are even made /hen one part) doesnot have in hand the asset or /hich it is dealin /hich increases the ris0 toa reat e4tent. 9he ris0 actor /henever involved in the &usiness or in an)deal ma0es it uncertain. 9his uncertaint) has &een addressed &) di;erentschools o thouht as &elo/.

9he !ol) ?ur@an prohi&its am&lin Cames o chance involvin mone) and5&a)u al-harar Ctradin in ris0 /here the /ord harar is ta0en to mean5ris0. Di;erent schools have di;erin interpretations o /hich the threemaor interpretations are:


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9he 8ana;mad'abCleal school in Islam denes 5harar as 5that /hoseconse+uences are hidden9he Sa leal school dened 5harar as 5that/hose nature and conse+uences are hidden or 5that /hich admits t/opossi&ilities /ith the less desira&le one &ein more li0el) and 9he !an&alischool dened it as 5that /hose conse+uences are un0no/n or 5that /hichis undelivera&le /hether it e4ists or not.

9he modern scholar o Islam(


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some/hat o an un0no/n +uantit) perhaps. evertheless the derivatives

mar0et ma) not &e aced /ith the same 0ind o dualit). Whereas the essence

o the distinction &et/een the conventional and Islamic &an0s &oils do/n to

an internal disareement over principles namel) that o interestBriba,no

sinle actor as such is li0el) to pla) a ocal rolein the derivatives. We ma)

thereore e4pect that in some areas o derivatives tradin especiall) in the

commoditiesutures and options the lineso division &et/een the Islamic

and conventional nancial instruments/ill hardl) &e noticea&le as &oth /illpro&a&l) operate over the same underl)in assets. We also e4pect that the

Islamic &an0in e4perience /ill encourae pu&lic support or derivatives.

While the derivatives mar0et is an arena mainl) or institutional pla)ers the

Islamic &an0in sector and institutions in Mala)sia are li0el) to support it. %

successul Islamic derivatives mar0et in Mala)sia is also li0el) to attract

participants rom other Muslim countries /here this acilit) is enerall)

a&sent. Hut the challenes ahead are li0el) to &e shared &) the Islamic and

conventional components o the derivatives mar0et: &oth /ill &e preoccupied

/ith issues o via&ilit) and diversication not onl) in the Mala)sian conte4t&ut also in the hihl) sophisticated and competitive international mar0et.

%nd in Mala)sia itsel as I said earlier success in one o the t/o components

o the derivatives mar0et is li0el) to encourae the other. 9he inherent

diversit) o the derivatives mar0et ma0es it potentiall) more versatile than

the &an0in sector.

Diversi)in the commodit) utures and options and providin an ade+uate

mi4 o products is a challenin prospect not onl) in the Islamic components

o derivatives mar0et &ut or derivatives enerall). %s /e are a/are ne/

contracts are oten introduced &ut ail to ta0e o; the round and areeventuall) a&andoned or lac0 o li+uidit) and volume. Islamic derivatives

/ill re+uire sustained e;ort and careul enineerin. % selective process is

li0el) to &e involved so as to identi) and pu&lici*e derivative instruments

/hose underl)in assets are clear o riba, am&lin and tradin in prohi&ited

su&stances.

9herane and num&er o derivative instruments and products are on the

/hole not e4pected to &e lare or reasons o&viousl) o standardi*ation and

volume. 9he rane here is not nearl) as /ide or diverse as that o the stoc0

mar0et /here standardi*ation and &ul0 trade is not amon the mar0et

imperatives. I ma) reer here to a recent development in the Mala)sian

capital mar0et /hich relates to our discussion over the potential o Islamic

derivatives. 9his is the identication in the stoc0 mar0et o the so-called


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halal counters. % lare num&er o such counters have &een recentl) veried

and 0no/n as such either directl) or throuh the process o cleansin. 9his

development can &e seen as a step or/ard in the eneral prospects or

Islamic derivatives. Since tradin in the desinated halal counters is deemed

permissi&le the derivatives instruments that are &ased upon them /ould

also &e deemed permissi&le.

9o the e4tent that the current economic do/nturn in Mala)sia has a;ectedtradin volumes in securities this is o&viousl) e4pected to have a

dampenin e;ect on the prospects o tradin volume and li+uidit) in the

relevant sectors o derivatives tradin such as the stoc0 inde4 utures in the

halalcounters - i one /ere to introduce utures and options over them.

9radin in commodit) utures such as in palm oil contracts in the ,JE and

other possi&le candidates o a similar t)pe ma) not &e necessaril) a;ected

in the same /a). 9he current economic do/nturn is ver) much a nancial

one and not a production or commodit)-related crisis. We have seen or

instance tradin in palm oil utures to have eno)ed unprecedented

&uo)anc) in &oth volume and price.

Conclu#ion:


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Derivatives instruments re+uire an unusuall) hih level o tradin volume

and /ide-ranin participation and Islamic derivative instruments /ould &e

no e4ception to this. 9o encourae Muslim participation and involvement in

the uture development o such instruments it is necessar) that /e come to

rips /ith the Shari8ah-related concerns a&out them especiall) as

derivatives tradin is a relativel) ne/ phenomenon in Mala)sia and the rest

o the Muslim /orld outside Mala)sia.

I hope that this &rie anal)sis o the issues /ill urther encourae an itihad

-oriented discourse that merits credi&ilit) and reconition &) our Shari@ah

scholars and all those /ho are concerned /ith the economic success and

prosperit) o the ummah.

Refe"ence#:1. %li Saleha&adi Q Mohammad %ram. Islamic ustication o Derivatives

Instruments. International ournal o Financial Services. >ol ' o. " Act- Dec

2##2.

2. Dar !. C2##$. Innovation in Islamic nance: marriae o conventional and

Islamic contracts. Islamic Finance e/s 2 no. 7

". Du&os0) D Aptions and Financial Futures Mcra/-!ill 1((2


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'. Dusu0i %. W. C2##(. Shariah parameters on Islamic orein e4chane

s/ap as a hedin mechanism in Islamic nance. ISR% International ournal o

Islamic Finance 1 no. 1: 77.

$. !ans R. Stoll and Ro&ert E. Whale) C1((" Futures and Aptions 9heor)

and %pplications Ahio: South-Western u&lishin o.

6. ,ah C2##6 5Innovation and ris0 Manaement in Islamic Finance: Shariahonsideration. Seventh !arvard International Forum on Islamic Finance %pril

22-2" 2##6

7. ,amali C1((( T9he ermissi&ilit) and otential o Developin Islamic

Derivatives as Financial InstrumentsU II=M ournal o Economics

QManaement 7C2 7"-P6

P. ,han M. %0ram C1(PP Nommodit) E4chane and E4chane in Islamic

Econom)N the %merican ournal o Islamic Social Science >ol. $ o. 1

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