Islamic Capital MarketsIB1006 CIFP1

PreExamination Session12th April 2009

Maytower Hotel and Apartment, KLProf. Saiful Azhar Rosly, Ph.D

International Center for Education in Islamic Finance (INCEIF)

saiful@inceif.org

Final Examination (80%)

• Part 1 : MCQ 20 questions 20 marks

• Part 2: Short-Essays 5 questions 5 x 4 = 20 marks

• Part 3:Long Essays 3/5 = 3 x 20 = 60 marks

Pre-exam sessions

• Definition capital market• Demand and Supply of capital• CAPM• Stocks• Unit trust• Sukuk• REITS• Derivatives

Global Financial Turmoil

Islamic Banking Challanges

Subprime Crises: Lessons for Islamic Finance

Islamic Financial Market

5 Basic Shariah Principles in Financial Transactions

#1 Prohibition of Riba

Islamic Bonds

Role of Sukuk in Economic Development

Corporate Finance – Demand for Capital

Cost of Capital

Capital Structure

Sukuk – Moving Forward

Shariah Compliance: Consistency is Critical

‘AQADPrinciples

LEGAL/CONTRACT DOCUMENTATIONProtection of Rights

MAQASIDBenefits vs disbenefits

FINANCIALREPORTINGAAOIFI/IFSB/IFRS

Shariah Compliant Parameters

• Aqad-based – Contract-based• Maqasid al-Shariah (purpose of the Law) –

impact on society• Financial Reporting – actual strength and

performance of companies• Legal documentation – identification and

recognition of rights and obligations of contracting parties.

Approved Islamic Finance Products• BBA Home Financing• Bay Inah Home Financing• Bay Inah Personal Financing/Overdraft/credit card• Tawaruk munazam personal financing• Commodity murabaha• Ijarah thumma al-bay• Bai-bithaman Ajil Islamic Debt Securities (BAIDS)• Discounted Bay al-dayn MuNif• Sukuk Ijarah• Sukuk Musharakah

Challenging issues in AQAD-based Islamic Finance Products

• Benchmaking profit rate against interest rate (LIBOR,KLIBOR).• Profit Equalization Reserve (PER) – displaced commercial risk• Sale with condition to buyback at predetermined price

between two and three parties.• Profit generated over installment payments – time value of

money• Penalties on delayed payments• Benchmaking sukuk rates against LIBOR• Musharakah with Purchase undertakings – fixed profit to

one party only.• Ijarah Sukuk - Sale with repurchase agreement at par value

and not mark-to market• Ijarah Sukuk – Ownership of asset by SPV• Profit-rate swaps – speculation or gambling?

#1 AQAD Method

Contract of Sale• Example: Murabaha/BBA Sale

1. Buyer and Sellereg. Seller owns asset/subject matter before making sale

2. Subject mattereg. Mal mutaqawim – property with usurfruct

3. Priceeg. Set on the spot

4. Offer & Acceptanceeg. Verbal or in writing

Method #2: Maqasid al-Shariah/Objective of Shariah

To protect the interest of the public (society)- maslahah al-ammah by:

1. removing the harm ( ibqa)2. securing of benefits (tahsil)

#2 Maqasid Method

Objective of Shariah

Islamic financial products as defined by AQAD methodology, should contain more benefits (masalih) and less or no harm (madarah).

“ in gambling (maisir) and liqour (qimar), there are some sins and some profits. But the sins are greater than the profits” (Al-Baqarah: 168).

“ in Gambling (maisir) and Liqour (qimar), there are some sins and some profits. But the sins are greater than the profits” (Al-Baqarah: 168).

Riba

FinancingBBA

Downside (Madarrah) of Credit-Financing

MACRO MICRO

Economic Bubbles Bankruptcy

Subprime Loans Foreclosure

Financial Turmoil Unemployment

The upside (Manfaat) of Credit-Financing

MACRO MICRO

Allocation of Capital Wealth creation

Economic Growth Rich becoming richer

Leisure, luxury and lifestyle

Maqasid

• To analyse(theoretical) and measure( empirical) impacts of financial intermediation based on aqad-based Shariah compliant products.

1. Efficiency studies2. Profitability studies3. Studies on Consumer welfare and protection4. Studies on Financial stability

Maqasid – protecting public interest.

• Aqad-based products (ABP) SHOULD contain more benefits and less harm.

• What if, it was proven than they (ABP) contain more harm than good?eg. Abandon projects – customer cannot make recourse against bank as selling party?Defaulted BBA customer are required to make settlement based on the selling price.Sale with no transfer of ownership.Giving away clean inah personal financing at high profit rates– a way towards subprime inah?

Conflict between Aqad and Maqasid?

Method #3: Financial Reporting• Proper recording of transactions to evident TRUE SALE.• BBA – bank must put BBA asset on balance sheet prior to

sale. I week, 1 month it depends.• Once sold, it is recorded as BBA receivables.• AITAB assets should be on banking book as leasing assets

but now treated as “financing and advances”.• External auditors (PWC, KPMG etc.) are not required by

the authority to conduct Shariah audit. And they may not be not capable to do so.

Conflict between AQAD and financial reporting?

Islamic Bank Average Balance SheetAssets Liabilities

Murabaha/BBA Wadiah Dhamanah deposits

AITAB Profit Sharing Investment Acct

Islamic Securities/Sukuk Capital

Assets Liabilities

FIXED ASSET

1. BBA asset

1. 1/9/2008 Bank purchases Property from Vendor for $200,000

1. 15/9/2008 Bank Sells Property to Customer for $280,000

Assets Liabilities

CURRENT ASSET

2. BBA Receivables

1st October 2008

15 October 2008

BBA Legal Documentation

1. Sale and Purchase Agreement (SPA)2. Property Purchase Agreement (PPA)3. Property Sale Agreement (PSA)4. Deeds of assignment/Charge

2. Bank do not have legal + beneficial ownership of property to make a valid sale

‘Do not Sell what you don not Own” Hadith (Sahih Bukhari)

High Court Judge Datuk Abdul Wahab Patail says that the sale element in BBA sale is not a bona fide sale

1. No transfer of title from Customer to Bank

Basel II and IFSB

• High risk-weights for Musharakah Financing to imply that bank bears business risk and the general investment account holders (GIA) do not.

• Recent PSIA guidelines will test risk appetite of depositors.

Method #4: Legal Documentation

• BBA should be documented as a true sale and not as a loan. (Dato’ Nik vs. BIMB)

• Ijarah should be documented as operating lease and not a loan (Tinta Press vs. BIMB)

• Islamic bank has not practice fairness compared with conventional bank (Affin bank vs Zulkifli).

Conflict between AQAD and documentation of AQAD?

BBA Legal Documentation

1. Sale and Purchase Agreement (SPA)2. Property Purchase Agreement (PPA)3. Property Sale Agreement (PSA)4. Deeds of assignment/Charge

2. Bank do not have legal + beneficial ownership of property to make a valid sale

‘Do not Sell what you don not Own” Hadith (Sahih Bukhari)

High Court Judge Datuk Abdul Wahab Patail says that the sale element in BBA sale is not a bona fide sale

1. No transfer of title from Customer to Bank

Shariah Compliance: Consistency is Critical

‘AQADPrinciples

LEGAL/CONTRACT DOCUMENTATIONProtection of Rights

MAQASIDBenefits vs disbenefits

FINANCIALREPORTINGAAOIFI/IFSB/IFRS

Islamic Finance

Islamic Way of Life in Business

Islamic Way of Life in Business

Against Islamic Norms

Islamic Bonds and Sukuk

ABC Balance SheetCurrent AssetCash $8,000Account receivable $120,000Marketable securities $20,000Inventory $110,000Fixed Asset $250,000Total Asset $508,000

Current Liabilities $108,000

Long-term liabilities $190,000Owner’s Equity $210,000Total liabilities and Owner’sequity $508,000

Financial Screening

• Capital structure(Long-term debt/ total asset) < 33%• Interest-bearing asset(Account receivables/total asset) < 45%• Interest income(interest from FD and securities/total operating

income) < 5%

Islamic Securitization in Malaysia

True sale criteria

• Transfer of equity ownership to SPV and then pass on to Investors.

• Creditors running after Originator hold no claims on the Underlying Asset.

• Legal ownership : control over company• Beneficial ownership: right to sell/dispose of

underlying assets.

Sukuk-Definition

Investment Sukuk are certificates of equal value representing undivided shares in ownership of tangible assets, usufruct and services or (in the ownership of) the assets of particular projects

Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI)

Sukuks & Common Stocks

Common Stocks Sukuks

Investment Sukuk are certificates of equal value representing undivided shares in ownership of tangible assets, usufruct and services or (in the ownership of) the assets of particular projects

“No guaranteed Income and Capital Preservation”“Al-Kharaj bil Daman” “Al-Ghorm bil Ghonm”

Two Prominent Sukuk Structures

1. Sukuk Al-Ijaraha. Guaranteesb.Sale and Repurchase agreementc. Pricing of Sukukd.Ownership of asset – latest!!!

2. Sukuk Al-Musharakaha. Purchase undertakings

Sukuk Al-Ijarah

a. Guarantees – Sale and Repurchase Agreement

c. Pricing of Sukukd. Ownership of asset – latest!!!

ORIGINATOR SPECIAL PURPOSEVEHICLE

INVESTORS

(1) Sells physical asset

(4) Paymentsfromcashproceeds

(2) IssuesSukuks

(3) Payments

(7)Paymentsof dividends

(10)Redemptionof IABS

(5) Lease to Originator

(6) Rental payments

(8)Sale of asset

(9) Payment

Sukuk Al-IjarahSukuk Al-Ijarah

Pressing Issue : Ownership of Underlying Asset

Who Own Underlying Assets?More than 80% of current Sukuks do not comply with

the Ownership Requirement.

Special Purpose VehicleOwner?

InvestorsOwner??

Issues SukuksPayments

AAOIFI June 2007 1st Statement1. Sukuk, to be tradable, must be owned by Sukuk

holders, with allrights and obligations of ownership, in real assets,

whether tangible,usufructs or services, capable of being owned and sold

legally as wellas in accordance with the rules of Shari'ah, in accordance

with Articles(2)1 and (5/1/2)2 of the AAOIFI Shari'ah Standard (17) on

Investment1 2.

2nd Statement

The Manager (SPV) issuing Sukuk must certify the transfer of ownership of such assets in its (Sukuk) books, and must not keep them as his own assets.

Sukuk Ijarah

• SPV holds legal and beneficial ownership• Legal ownership – title of asset ownership

registered under buyer’s name.• Beneficial ownership – right of disposal/right

to sell the assets by owner.

Interest-bearing Loan

• Decoupling of legal ownership from beneficial ownership.

• Borrower holds legal ownership of the property.

• Bank puts a charge on the property and holds beneficial right.

Interest-Bearing Loans

• Decoupling legal ownership from beneficial ownership.• Borrower holds legal ownership of the property.• Bank puts a charge on the property and holds beneficial right.

Legal + BeneficialOwnership

LegalOwnership(Customer)

BeneficialOwnership

(Bank)

Sale on Cash Basis

• Buyer hold complete ownership

CompleteOwnership

Milkiyah Mutlakah

LegalOwnership(Customer)

BeneficialOwnership

(Bank)

Sale on credit basis – Murabahah/BBA

• Decoupling legal ownership from beneficial ownership.• Buyer holds legal ownership of the property.• Bank puts a charge on the property and holds beneficial right.

Legal + BeneficialOwnership

LegalOwnership(Customer)

BeneficialOwnership

(Bank)

Guarantees

Profit + Principle

1. Sukuk Al-Ijarah• Guarantee on Sukuk Issues• Originator establishes SPV that will issue the Sukuk.• Originator provide a guarantee against any shortfalls.• Fiqh academy resolution 30(3/4) – third independent party

(ie independent to the contract) to guarantee at no consideration (ie free of charge).

• AAOIFI Shariah Standard no.17 – “the prospectus must not include any statement to the effect that the issuer of the certificates accepts the liability to compensate the owner of the certificate up to the nominal value of the certificates in situations other than torts and negligence not that the guarantee a fixed percentage of profit.

Guarantee the Principle

• Third party guarantee1.Government

a. private sukuk – not permissibleb. government sukuk - permissible

1.Private company No text prohibiting a guarantee from a third party.

Guarantees - Examples

1. Islamic Development Bank Sukuk• Trust certificates issued by Solidarity Trust

Services Limited (SPV)• Originator – IDB2. Malaysia• Trust certificates issued by SPV Malaysian

Global Sukuk• Originator – Ministry of Finance

Guarantees of Principle by Sale and Buy-Back Structure

• Bay al-Wafa• Allowed by minority but rejected by the

majority and Islamic Fiqh Academy resolutions passed in 1992.

• Sale and leaseback is bay al-inah – Rejected by Islamic Fiqh Academy.

Sale with Repurchase Agreement

SPV

Investors

Originator

(3) At maturity Sells x

(4) Payments $600m

(1) Sells x

(2) Payments $600m

$600mPaymentsForRedemptionsOf Sukuk

Musharakah Sukuk

Musharakah al-Aqd – profit sharingMusharakah al-milk – not for

business

Musharakah sukuk (MS)• SPV enters into Musharakah agreement with Originator.• SPV represents SukukHolders through issuances of MS.• SPV contributes $X cash• Originator contributed $land,equipment,building,vehicles• Proceed of MS will be used by SPV as its capital contribution $X.• Profit distributed according to respective capital contribution.• Originator will undertake management role as Manager under

separate agreement.• Profit that exceeded certain % belongs to the Manager• The Originator gives an irrevocable undertaking to purchase the

units of the SPV in the Musharakah face value at pre-agreed price (and not at market price). -Purchase Undertaking Contract

Musharakah Sukuk

Middle-East - GCC

RAKIA Sukuk

Extract of Termsheet:– Issuer: RAKIA Sukuk Company Limited– Issue purpose: The proceeds to be used in part to

purchase the Project Land and in part for the completion of the Works

– Issue size: US$325 million– Maturity: 5 years– Profit: 3 month LIBOR + 150 bps– Guarantor: Government of Ras Al Khaimah

RAKIA Sukuk

The development will consist of four islands of varied sizes in addition to a peninsula together measuring 2.30 million square metres. The development will extend four kilometres linearly into the sea and approximately three kilometres along the coast of Ras Al Kh aimah. The ‘‘Peninsula’’ and ‘‘Island 1’’ are intended to form the hospitality gateway to the development, covering an area of 0.26 million square metres and 0.12 million square metres respect ivel y. ‘‘Island 2’’ is envisioned as being residential in nature. The total area of ‘‘Island 2’’ will be 0 .50 million square metres. ‘‘Island 3’’ is intended to contain sports and commercial facilities covering an area of 0.35 mil lion square metres. ‘Island 4’’ has been designated for hotel and resort developments covering an area of 1.07 million square metr es.

RAKIA Sukuk

Issuer(SPV)

Investors

RAKIA

Sale of

Project Land

Purchase

Price for Project

Land

Sukuk IssueSukuk Proceeds

RAKIA Sukuk

Issuer(SPV)

Investors

Sukuk Assets

RAKIARAKIA

Income

Exercise Price

Sukuk Redemption

Periodic Distribution

Income

Liquidity Payments

Incentive Fees

Ongoing Maturity or Dissolution

Purchase Undertaking

• The Originator gives an irrevocable undertaking to purchase the units of the SPV in the Musharakah face value at pre-agreed price (and not at market price). -Purchase Undertaking Contract

• Through the Purchase Undertaking Contract, Partner A effectively guarantee capital of Partner B.

• In a Musharakah contract a Partner A cannot guarantee the capital of Partner B

Musharakah Sukuk

• Sukuk al-Musharakah issued in 2005 by Dubai Metals & Commodities Company (DMCC) Authority

• Proceeds of sukuk were used to build Almas Tower and the Au Tower and the AG Tower in the DMCC Free Trade Zones.

Musharakah sukuk

• Sukuk al-Musharakah issued by Wings FZCO on behalf of Emirates Airlines in 2005 $824million.

• Landmark musharakah sukuk – Dubai ports, Customs and Free Zone Corporation (PCFC) for $2.8 billion

• Subscribers1. 70% banks2. 7% high net worth individuals3. 13% fund managers

Malaysian Musharakah Sukuk

Khazanah Exchangeble SukukKL Sentral Sukuk

Khazanah Exchangeable Sukuk

Investors

Cherating Capital(Issuer)

Cempaka Capital(SPV)

Khazanah Nasional(Obligor)

Plus ExpresswayBerhad

Sale of Equity Pool

Sale Price (Nominal)

Sale of Equity PoolSale Price (Nomina)

Sukuk ProceedSukuk

Cash PaymentPurchase Right Deed

Purchase Undertaking Deed

KL Sentral Sukuk

Islamic Capital Market: Derivatives from Islamic Perspective

• Hedging – buy or sell futures contracts in order to reduce losses from price movements.

• Speculation – buy and sell futures contracts in in order to make big gains.

• Hedging is part of risk management.

Risk-Taking and Risk Management• Risk is potential loss• Risk-taking – Taking risk with an expectation to make

gains.• Risk-taking is one aspect of risk-aversion• Risk-aversion – will take no risk unless rewarded• Risk-neutral – take more risk without any expectation

to make more or less gains• Risk-loving – more risk with less expectation to make

more gains. • Risk-avoidance - Expectation to make gains without

taking any risk - HARAM

Risk Management• Once you have chosen to take the RISK, you must be ready to face losses as well as

making gains.• Price risk : Potential loss from changes in price due to market volatilities i.e.

changes in demand and supply.• Changes in price will affect revenues.• How to take on price risk?• Transfer the risk?• To Whom?• Who is willing to carry your risk?• Is it for free? Or at a price?• Does Shariah allow risk transfer?• Why transfer risk? why not carry it yourself since you have chosen to take the risk

and make money out of it. • Since you have chosen to take risk, you must face the consequences!• Derivatives – transferring price risk to another party.

Derivatives and ‘Aqad

• Buyer and Seller• Objective • Subject matter1.price2.possession3.mal mutaqawim• Offer and Acceptance

Shariah Issues• Gambling• Gharar• Al-Mal• Manfaat & Mudarat• Sell futures contract – short selling.• Currency futures – treated as commodities• Arbun • Trading of arbun?• Option• Trading of option• Value of call option gets higher as market price falls lower than

strike price

Shariah issues• Arbun: Down payment; non-refundable deposit

paid by a buyer retaining a right to confirm or cancel a sales contract.

• Bay’ Istijrar – a contract between a supplier and a client whereby the supplier supplies a particular item on an ongoing basis on a agreed mode of payment until they terminate the contract. It is also applied between a wholesaler and a retailer for the supply of a number of agreed items.

• Khiyar al-Shart- option to cancel contract under specified condition

Salam Contract

• Price set on the spot• Future delivery• Financing and not hedging• Can we transfer price risk at a price?

Futures• In finance, a futures contract is a standardized contract, traded on a futures exchange, to buy or

sell a standardized quantity of a specified commodity of standardized quality (which, in many cases, may be such non-traditional "commodities" as foreign currencies, commercial or government paper [e.g., bonds], or "baskets" of corporate equity ["stock indices"] or other financial instruments) at a certain date in the future, at a price (the futures price) determined by the instantaneous equilibrium between the forces of supply and demand among competing buy and sell orders on the exchange at the time of the purchase or sale of the contract. The future date is called the delivery date or final settlement date. The official price of the futures contract at the end of a day's trading session on the exchange is called the settlement price for that day of business on the exchange.

• A futures contract gives the holder the obligation to make or take delivery under the terms of the contract, whereas an option grants the buyer the right, but not the obligation, to establish a position previously held by the seller of the option. In other words, the owner of an options contract may exercise the contract, but both parties of a "futures contract" must fulfill the contract on the settlement date. The seller delivers the underlying asset to the buyer, or, if it is a cash-settled futures contract, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures position has to offset his/her position by either selling a long position or buying back (covering) a short position, effectively closing out the futures position and its contract obligations.

• Futures contracts, or simply futures, (but not future or future contract) are exchange traded derivatives. The exchange's clearinghouse acts as counterparty on all contracts, sets margin requirements, and crucially also provides a mechanism for settlement. [1]

Futures

• Obligation to buy or sell commodities/financial assets.

• Buy futures (long futures)• Sell futures (short futures)• Strike price – contract price is set on the spot

– known price• Market price – unknown price• Delivery - Future

Hedging

• Futures: • Hedges are created by combining a long and

short position in the same asset to reduce or eliminate price fluctuation risk.

• Short position: sell futures• Long position: buy futures

Example 1 : Perfect Hedge• Jim, a Kansas wheat farmer, ex[pects to harvest 40,000 metric ton of wheat in

early August. In June 15, the price of wheat is $3.50 per bushel. Jim is concerned that the price of the wheat will fall below $3.50 before his August delivery date. A friend told Jim that he should HEDGE his position by selling August wheat futures.

• By selling wheat futures, Jim can lock in the August price of $3.45 per bushel. Jim took his friend’s advice and sold eight 5,000 bushels of August wheat futures.

• When August came, the price of wheat had fallen to $3.00 per bushel. However, Jim hedge covered his losses because what he lost on the cash crop was offset by his gain on the futures contract minus a small transaction charge.

• He value of the hedge position was calculated as follows:

1. Revenue from the sales of physical wheat: $3.00 x 40,000 = $120,000.2. Sale of 8 wheat futures contract = 8 x $3.45 x 5,000 = $138,000.3. Purchase of 8 wheat futures contract = 8 x $3.00 x 5,000 = $120,000.4. Gain on futures contract = $18,000 ($138,000 - $120,000)5. Jim net cash flow for August was $138,000 ($120,000 + $18,000), which is $3.45

per bushel of wheat.

Example 2• Frank, the farmer expects to harvest 50,000 bushels of soybeans in September. On

April 1, the September futures contract for soybeans is $7.00 per bushel.1. If Frank would like to lock in the $7.00 per bushel soybeans price, what should he

do?ANSWER: Since Frank is concerned with a falling price, he should enter into a selling

hedge. Frank should sell 10 (50,000/5,000) September contracts for $7.00 per bushel.

2. If soybeans price increases to $8.00 per bushel, show Frank’s position at harvest time:

ANSWER: 1. Revenue from the harvest of soybeans = $8.00 x 50,000 = $400,000.2. Sale of 10 soybeans futures contract = 10 x 50,000 x $7.00 = $350,000.3. Purchase of 10 soybeans futures contract = 10 x 50,000 x $8.00 = $400,0004. Frank made $50,000 in the cash market but lost $50,000 in the futures market. 5. He is better of if he had not taken the hedge. But he did not know in advance

(except Allah swt) what would happen to the soybeans in September.

Speculation with commodities

• With hedging, an investor is trying to minimize price risk.

• However, with speculation, the investor is willing to assume price fluctuation risk in order to have a chance to make a large gain.

• Gains and losses can be magnified by using margin (i.e leverage).

Example: Speculation • Marcus believes that the price of corn will go from its

current June price of $3.00 per bushel to$4.00 per bushel in the next 3 months.

• September corn futures are currently selling for $3.25 per bushel and Marcus bullishly purchases 10 contracts on margin.

• The initial margin requirement is 15% and commission rates for a round trip are $40 per contract. Marcus was optimistic.

• 3 months later corn futures prices fell to $2.75 per bushel and Marcus reversed out of his position and made a loss of $25,400.

Calculations I - LOSS• Purchased 10 September corn futures for $3.25

per bushel = $3.25 x 10 x5,000 = $162,500.• Margin deposit of 15% = $24,375 (.15 x

$162,0000cost]• Sold 10 September corn futures for $2.75 per

bushel = 10 x $2.75 x 5,000 = $137,500 revenue.• Gross profit ($137,500 - $162,500) = -$25,000

loss• Minus round trip commission ($40 x 10) = -$400• Net loss = $25,400.

Calculation II - GAIN

• If the corn price had increased to $3.90 per bushel over the 3 month period.

• Sold 10 September corn futures for $3.90 = 10 x 5,000 x $3.90 = $195,000 revenue

• Gross profit ($195,000 - $162,500) = $32,500• Minus round-trip commission = -$400• Net profit = $32,100.

Stock futures contract

• Stock futures are futures contract on market indexes.

• 1 contract = $250• S & P500 future index value = 1200• S&P500 Index =1000• sell 20 futures contract = (20 x 1200 x $250)

Example - Stock futures• Barry Shorter is managing 1 $60 million common stock portfolio for

the Jones Investment company.• Barry is concerned that the market is going to fall over the next 3

months and as a result of the market decline, he expects the common stock portfolio that he is managing to fall in value.

• Barry notes that the 3-months S&P futures index value is currently at 1200.

• QUESTION: What should Barry do hedge his positions?• ANSWER: Barry should short hedge (sell futures) to protect the

falling value of his stock portfolio. He should sell enough S&P500 futures contracts to cover his common stock portfolio. One contract is equal to $300,000 ($250 x 1200). Since he has a $60 million portfolio, he needs 200 S&P500 futures contract. ($60m/$300,000).

Stock futures• If the common stock portfolio falls in value to $48 million

over the next 3 months, what would be the ending value of Barry’s position if he was fully hedged? Assume that the S&P500 simultaneously falls to 960.

• ANSWER:• Barry should sell 200 June S&P futures contract for $60m.• Three months later he should buy 200 June S&P500 for

$48million ($250 x 960 x 200) to reverse his position.• His stock portfolio declined in value by $12m over the 3

month period.• However, he made $12 million on the stock futures ($60m -

$48m). Therefore he fully hedge his position and has an overall loss of zero on his hedge position.

Options

• An option is an agreement that gives the holder the right (but not the obligation) to buy or sell specified securities at a given price (called an exercise price or striking price) during a specified period of time.

• Call option – the right to buy a designated security, say 100 shares of common stock.

• Put option – the right to sell the security.

Example I• Jerry paid a premium of $4 per share for one 6-month call

option contract (total of $400 for 100 shares) of the Mahony Corporations.

• At the time of the purchase, Mahony stock was selling for $56 per share and the exercise price of the call option was $55.

• Question 1: Determine Jerry’s profit or loss if the price of Mahony’s stock is $54 when the option is exercised?

• Answer 1: Cost of call = $4 premium x 100 = $400• Ending value = (-$400 cost) + 0 gain = $400 loss.• The option was worthless because the stock’s price is less

than the exercise price at maturity.

Example 1

• Question 2: What is Jerry’s profit or loss if the price of Mahony’s stock is $62 when the option is exercised?

• Answer 2: • Cost of call of option = $400• Ending value = -$400 + ($62 -55)100 = -$400 +

$700 = $300 gain.

Options values or premiums are a function of 5 variables

1. the underlying asset value2. the risk-free rate3. the standard deviation of the return of the

asset4. the option’s time to maturity5. the option’s exercise price.

Rules on Call option.

• When Pm > Ps, exercise call option• When Pm < Ps, option has no value

Put Options• John Poston is bearish on the stock of the Goji Corporation. Thus,

John purchases 4 put options contracts on Goji stock for a premium of $3.

• The option’s striking price is $40 and it has a maturity of 3 months. Goji has a current market price of $39.

• If John is correct and Goji’s price falls to $30, how much profit will he earn over the 3-month period.

• Answer: Cost of Put = $3 per share x 100 shares x 4 contracts = $1,200.

• Put’s intrinsic value = Striking price – ending price = $40 - $30 = $10 per share.

• Total valaue at maturity $10 per share x 100 shares x 4 contract = $4,000.

• Net gain = $4,000 - $1,200 = $2,800.

Khiyar al-Shart – option of conditions – Option to cancel the contract due to gharar in subject matter

• Khiyar al-ayb – option from defect • Khiyar al-ruyat – option of inspection • Khiyar al-tayeen - option of determination

matter • Khiyar al-majlis – option of meeting

Foreign Currency futures• Sandra Fleets believes that the British pound sterling is going to fall

in value relative to the dollar.• Sandra plans to act on her belief by selling four 3-month futures

contract now and then reversing out of her position in 3 months. • Each British pound sterling futures contracts comes in unit of

62,500 pound. • Since the current price for the pound sterling futures contract is

$1.50 per pound, the contract she sells are worth $375,000 ($1.50 x 4 x62,500).

• In 3 months, the pound fell to $1.40 and Sandra reversed her position by purchasing four British pound futures contract for $350,000 ($1.40 x 62,500).

• She made a gross profit of $25,000 ($375,000- $350,000).

Conclusion

• Compliance Issue must move beyond AQAD methodology.

• Sale without Ownership transfer• Sale with Ownership transfer to the Wrong

Party.• Sukuk Ijarah: Capital Protection via Sale and

Repurchase Agreement.• Sukuk Musharakah: Capital Protection via

Purchase Undertaking

Thank You

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