KULLIYYAH OF ECONOMICS AND MANAGEMENT SCIENCESINTERNATIONAL ISLAMIC UNIVERSITY MALAYSIA
FINANCIAL DERIVATIVES (FIN 6820) SEMESTER 2, 2017/2018
ABDULRAHIM NASIRI G1722229
KHAN AFAF G1718958
MAMADY KABA G1713683
MOHAMMAD MUNIR SHAMS G1721397
TABLE OF CONTENTS
TOPIC PAGE NO.
CRITICAL ANALYSIS 2-7
A derivative is a financial asset whose value is dependent on the value of an underlying asset. The underlying asset could be a basic financial asset like common stocks, bonds, currencies or commodities.Since by this definition, a derivative is a “claim on a claim” the value of the derivative will depend on the value of the asset (stocks, bonds, etc.) on which it has a claim.
Despite the significant progress made in the Islamic Banking and Finance, derivative instruments especially the use of financial derivatives is still a controversy. The issue is further clouded by the often contradictory stand of Islamic Jurists and scholars with regards to the acceptability of derivative instruments. There are a number of Islamic financial instruments/contracts which have derivative like features such as the Bay’ Salam, Istisna, Ju’ala and the Istijrar Contracts.In addition to these there are the recently developed Islamic Profit Rate Swaps, and shariah compliant derivative instruments that are based on wa’ad and sukuks with embedded options. This is because the market players have moved ahead in using such derivative instruments without the consensus of the shari’ah scholars regarding the permissibility of such instruments.
In our opinion, derivative contracts and markets should not be part of an Islamic financial and economic system.All Islamic financial instruments in general must meet a certain criteria to be considered Halal (permissible).At a primary level all financial instruments and transactions must be free of at least the following five items: (1) riba (usury), (2) rishwah (corruption), (3) maysir (gambling), (4)gharar (unnecessary risk) and (5) jahl (ignorance).
The shar’iah also has some basic conditions regarding the sale of an asset:
The sale is valid only if the commodity or the underlying asset exists in its physical form.
The seller should also have the ownership of the asset/ commodity at the time of the sale.
These conditions for the validity of a sale would apply to the trading of derivatives as well, making it difficult to be permissible in Islam. However, the shariah provides exceptions to these general principles to enable deferred sale where needed.
Hedging is a mechanism to reduce risk. There are a number of risks involved in finance; such as market risk, credit risk, investment risk, operational risk, liquidity risk etc. Hedging allows the investors to reduce the losses resulting from such risks. The instruments used for hedging are derivatives.
Looking from an Islamic perspective, In Islamic finance risks are inevitable, in the sense that
risk cannot be separated from the ownership of goods and services. Profits are obtained by taking up risks. In a simple sale contract, the trader takes the risk of the commodity in terms of its price, transportation, quality, defect as well any external dangers that may affect the good. If any harm comes to the good the trader will incur losses but in the event the trade is successful, the trader will earn profit on the sale.
It can be said that risks is a condition to earn profit. In Islamic finance there are two renowned legal maxims ; al- kharaj bi al-daman( benefit goes with liability) and al-ghurm bi al-ghunm ( liability accompanies gain). These maxims were derived from these Hadith:
“Any profit goes to the one who bears responsibility”- ( Ibn Hajar al- Asqalani, 1993:180)
“Nothing ventured nothing gained” is the first principle of investment. (Al-Suwailem, 2006b).
The Muslim Jurists consider risk and risk taking in finance. /A hedge is a position that attempts to reduce the exposure to the price risk of an equal but opposite obligation or position in another market. (Dr. Lahsen OUBDI et. Al, 2017)
Hedging is only acceptable when it sticks to conditions that are aligned to the Islamic contracts and aimed at minimizing risks and strictly follows the general objective of the Shari’ah.
In conventional finance, hedging takes place by transfer of risk, under Islamic economics, the muslims scholars have designed a structure that is based on risk sharing rather than risk transferring. Options are also a risk management tool which provides the holder protection against adverse price movements for a minimal cost.Options are more flexible than forwards. With an option the customer can get the same protection if prices move against him, but he is not obligated to exercise if prices move in his favour. This means that the customer is able to benefit on the underlying position without having his profits reduced by the hedging instrument except for a small deduction due to the premium.
Islamic Hedging instruments include:
A conventional option is traded as a separate contract. The contract allows the holder to purchase or sell the underlying asset within or at the end of a specified period of time. (Dr. Lahsen OUBDI et. Al, 2017)Options are mostly unacceptable in the Shari’ah as it is problematic because it includes gamblic (maysir), unnecessary risk taking ( Gharar), it also includes an element of ignorance (jahl). The option must be of permissible goods only and the mutual consent of the parties regarding the contract should be properly stated.
One of the examples of Islamic options is Bay’ Al-Urban. Urbun is a sale in which the buyer deposits the earnest money with the seller as an advance payment and promises the seller that in case of any default in payment the seller can keep the deposit.
Islamic FX forward contract:
The concept of wa’ad (promise) is used in such type of contracts. The Shari’ah council of AAOIFI stated that the hokum for currency transaction is permissible. It can be considered as one of the sources of income. But, the shariah council of AAOIFI decided that the promise in currency exchange is prohibited according to the consensual opinion of the scholars; because the promise is mulzim in nature, therefore, it will become a binding contract by both the parties making it impermissible. If the promise is done by one party then it is permissible as it is mulzim in nature.
(Dr. Lahsen OUBDI et. Al, 2017)
A normal futures contract can be questionable in terms of its permissibility in Islam. Futures contracts are always ambiguous in terms of its nature as it may lead to deferment of both counter values. It is a sale of a non-existent/ non-possessed commodity and it is a sale of debt. All of this adds up to its impermissibility in Islamic transactions.
Although, In Malaysia, Crude Palm Oil Future(CPOF) is the only shari’ah compliant future as declared by the SAC. The SAC argues that there is no element of gharar for CPOF because when the offer is made the quantity, price and delivery date is known to the players. It also argues that the element of gharar is removed because the contract can be settled before the maturity by paying cash or by the delivery of it on maturity date, thereby removing any uncertainty from the contract. On the issue of sale of non-existent commodity, the SAC argues that the prohibition of sale is due to the element of uncertainty in handing over the products. In case of CPOF, the SAC refer to it as salam and istisna contract, where the subject matter is non-existent at the time of istisna but it may not be at the time of salam contract. (Dr. Lahsen OUBDI et. Al, 2017)
Following are the three main objections to the contracts:
Gambling (Maysir) and Excessive Uncertainty (Gharar)
The first SharI’ah objection to conventional options is that they involve gambling. Whenever the buyer exercises the option contract because it is favourable to him it will result in a corresponding loss to the seller. The gain of one party is equal to the loss of the other part. In economics this is known as a zero-sum game.
Obaidullah (Obaidullah, 1998, p. 84) asserts that in options the buyer and seller have diametrically opposite expectations. Depending on the actual outcome, one of them will win at the expense of the other. The gains are therefore in the nature of maysir, and maysir cannot occur without the existence of gharar, being a subset of that larger category.
The discussion below show sufficiently the presence of maysir and Gharar in the Crude Palm Oil Futures Contract:
There are completely two different opinions and point of views regarding the permissibility and impermissibility of Crude Palm Oil future contract. Based on Shariah Advisory Council of securities commission Malaysia (SAC), the Crude Palm Oil Futures Contract is in accordance with Shariah principles and it is free from any Maysir activities (Suhaida Kasri 2013). However, some opponents such as IFA-MWL, AAOIFI international Islamic organizations are in opposition that the Crude Palm Oil Futures Contract is in conflicts with Shariah and transgresses the philosophies and fundamentals of the Shar??ah. Based on their opinion, when a future contract is considered as permissible it must be pure as well as free from any features of gambling or Maysir (Suhaida Kasri 2013). There are two substantial components of the futures margin system such as initial margin and marking to market, which has revealed that these mechanisms facilitate gambling by the contracting parties. They permit contractors to bet and make profit as a result of change in the price of crude palm oil and not by the exchange of counter-values.
In contrast to (IFA-MWL) and (AAOIFI) beliefs, the SAC raises the arguments that the crude palm oil futures contract is exempted from gambling. They disagree that the initial margin payment is a forbidden bet since the fluctuation of the value happens because of the variation in demand in the crude palm oil futures markets. It is also a common phenomenon in the trading world. It is not suitable to critic a contract whose value alters due to the changing demands for crude palm oil futures market as a gambling activity. This is for the reason that gambling activities rely merely on luck and are not associated to demand and offer. In addition, Kamali (2000: 176) “contends that the margin payment is allowed as it indicates a margin deposit, an equivalent to a good faith deposit. This margin, which is deposited into the broker’s account, is to certify that the integrity of the transaction is protected”.
Furthermore, the initial margin is said to be a security tool rather than betting tool for an effective futures market that works along with marking to market to make sure that the parties do not default when the price of the underlying is unfavorable towards them. In contrast, the IFA-MWL’s objection to the commodity futures contract as being tainted with elements of gambling as most of the contracts are paper transactions instead of genuine purchases and they do not comprise any real delivery or possession of the underlying commodities. Consequently, Maysir concentrate on elements of chance, betting, and the gain of one party occurring by the other party’s loss, the unlawful acquisition of wealth and this cause hatred and enmity (Suhaida Kasri 2013).
Shar??ah scholars are not in contrast to the commodity futures contract being used as a risk management tool; they only objective to its usage as a gambling tool. The evidence has established that the commodity futures market has failed to satisfy its purpose as a mechanism of risk management and price discovery. Based on the analysis and in line with the perception that all maysir activities?including those that are tainted by maysir?are banned, the research has established that, contrary to the SAC resolution, the crude palm oil futures contract is not free from any of the elements of maysir.
Gharar in futures contract of crude palm oil:
According to Shariah Advisory Council (SAC) the futures contract of crude palm oil is in line with shariah principles. There is no existence of gharar (uncertainty) in crude palm oil futures contracts in case if there is any sign of gharar, it is already overcame by the trading regulations.
In specific, the SAC also claims the crude palm oil is free from any element of gharar, it is because everything made clear for the market players before the contracts take place, such as the quantity, price and the date of delivery. There is another point made by the SAC says that the contact can be settled in cash before the maturity date as result the gharar will be eliminated or no gharar. (Noor Suhaida and Riaz Ansary 2013)
On the other hand, Islam does not allow the sell and buy of something does not exist (bay? ma?d?m), but the SAC argues that bay? ma?d?m is not a relevant shariah issue in relation to the crude palm oil futures contract. As they following the opinion of Ibn al-Qayyim and says that the prohibition of bay? ma?d?m is because of the element of gharar in delivering the sold goods not because of the non-existence of goods at the time binding the contract. The SAC support this argument by referring to salam and istisna contact where the subject matter is not exist at the time of contact being made. Hence, the bay? ma?d?m is not allowed because of the existence of gharar in handing over rather than the nonexistence of subject at the time of contract. (Noor Suhaida and Riaz Ansary 2013)
However, in 2004 the AAOIFI issued a ruling which opposed the view of the SAC, prohibiting the futures contract of commodity unconditionally. The definition of commodity futures contract according to the AAOIFI is the “contracts whose legal effects take place at a determined future date either through liquidation between the parties, or cash settlement or through counter-contracts, but they rarely end in actual delivery and possession” (2010: 363). The futures contract of commodity determined as prohibited contract in the shariah both forming and trading them are prohibited. It is because, the contracts involve with uncertainty as the seller does not have the object or asset in which the deferred contract being made. The contract is only a paper transaction and not an actual buying and selling and there is no real delivery and the existence of the underlying asset. (Noor Suhaida and Riaz Ansary 2013)
“It also contains the elements of gambling, exploitation and unlawful devouring of the property of others” (as cited in al-Amine, 2008: 14)
The verse in S?rah al-Nis?’ (4:29) in which Allah says:
O you who believe, do not consume your property among yourselves by injustice, but let there be amongst you traffic and trade by mutual consent.
In addition, the commodity futures contract does not qualify a salam because in salam the buyer must pay the price during the contract being made. In opposite, in futures contract the buyer does not deliver the price in the contract session. In futures contract the handing over of the underlying asset is very unlikely to happen but in salam it does happen.
Mostly the process ends up by netting of offsetting contracts, in this situation, the two parties are assumed to gamble by taking risk or speculating on present and future price differences of the underlying asset. Thus, that is one of the strong reasons the, AAOIFI, IFM-MWL and IFA-OIC made it clear that the commodity futures contract is not compliant with shariah as the delivery of counter values is deferred. “In 1985, the IFA-MWL resolved that, despite commodity futures contract engendering benefits viewed as public interest, their trading involves transactions forbidden in the Shar??ah”. The IFA-MWL supported its prohibition based on the hadith (statement) of the prophet (pbuh), “Do not sell what is not in your possession” and prophet (pbuh) prohibited the sale of purchased commodities unless the sellers already possess the goods and move them to their own site. (Noor Suhaida and Riaz Ansary 2013)
The delay issue of al-badalayn in commodity forward and futures contract where the asset and price cause the gharar issue. The uncertainties arises in the delivery of goods which is delayed as result the gharar happens whether the contracting parties can conclude the contract or not. It also can be argued that the role of clearing house is vital in futures contract where it acts as a regulator in order to prevent any default happens in delivery of goods and the payment. However, the clearing house does not do any delivery if there is a breach of contract, where the existence of gharar arises but minimal gharar. In contrast, in forward contract there is no regulator and the gharar can happen from both parties where the buyer doesn’t pay the price or the seller could not deliver the commodity. This case happened in 2008 when the prices dropped and the buyer refused to pay the agreed prices of futures contract.(Nordin, Daud, Ahmad, Abu bakar and Ali 2015)Next, according to the resolutions of the AAOIFI, the IFA-MWL, the IFA-OIC and the SAC, there is gharar visible in the commodity futures contract. “According to Ibn Rushd (2003: 189), the majority of jurists agree that the underlying cause for the prohibition of the exchange of one debt for another is gharar, owing to the possible lack of delivery from both parties, not to riba ” On the other hand , almost all Muslim scholars did not allowed the deferment of the price in salam and not any of them allow a contract where both counter values are delayed. (Noor Suhaida and Riaz Ansary 2013)
In short, we can conclude that in commodity’s forward and futures contracts the existence of gharar cannot be denied where both counter values are in deferment and non of muslim scholar allowed such contracts. Majority of Islamic organization also resolved the futures contracts as prohibited contracts due to uncertainty. Thus, commodity forward and futures contract are classified similar to bay’ ma’dun by a number of muslim scholar which is prohibited in Islam. It is because the contract may cause enmity and expose losses to the buyer because of the non-existence of the commodity. ( Nordin, Daud, Ahmad, Abu bakar and Ali 2015)
They are often used for excessive speculation
In finance, speculation is defined as the practice of making investments or going into business that involves risk.It is different from investment, since investment is supposed to describe more stable or less risky operations, with long term rewards, that involve economic growth, whereas speculation denotes shorter term investments and quick gains. Speculators are often accused of recklessly betting on the rise of certain stocks or other underlying assets, a process involving excessive risk and gambling (Tickell, 2000).
However, there are proponents of options who believe that because of their usefulness they should not be dismissed because of the elements of gambling and speculation (Smolarski, Schapek & Tahir, 2006, p.425-443). These proponents claim that the presence of speculators in the market enhances liquidity and provides hedgers with parties they can pass their risk on to (Kamali, 1999) (Smolarski, Schapek & Tahir, 2006). In other words, without speculators, hedging would be very difficult or even impossible (Al-Amine, 2008, p.114). A more general argument by analogy is that derivatives are only tools; fiqh rulings are based on how a tool is used, e.g., a knife can be used as a weapon or as cutlery (Mirakhor, 2009).
The premium paid for the right to buy or sell an option contract is impermissible
Payment of a premium is required in an option contract for the right given to buy (or sell) the underlying asset at a predetermined exercise price. Contemporary Muslim jurists are divided as to whether it is lawful to charge a fee for this right.
When viewed solely as a promise to buy or sell an asset at a predetermined price within a stipulated period, shari’ah scholars find nothing objectionable with options. It is in the trading of these promises and the charging of premiums that objections are raised.
It can be noted that Promises as part of a contract is acceptable in Shariah, however the trading and charging of a premium for the promise is not acceptable.
Based on our studies the financial derivative instruments are not in line with the shari’ah principles. The scholars have not been able to come to a unanimous decision regarding the permissibility of such contracts, hence it is safe to assume that such contracts are impermissible in Islam.
The permissibility of such derivative contracts are still a topic of discussion amongst the scholars. The main challenge in the Islamic world is to identify the behaviour of existing conventional instruments and filtering it or modifying it to better suit the Islamic validation. Heavily relying on the already existing instruments can impede or blur the vision of a dominant Islamic financial economics. Therefore, there is dire need to venture out and develop new models of Islamic financial contracts that are Shari’ah compliant and help in benefitting the people and their welfare
Kasri, D. S. (2013). Maysir in the Crude Palm Oil Futures Contract: A Critical Analysis of the Resolution of the Malaysian Securities Commission Shariah Advisory Council – Part I. 1-43.
Kasri, D. S. (n.d.). A CRITICAL ANALYSIS OF THE RESOLUTION OF THE SHAR??AH ADVISORY COUNCIL OF SECURITIES COMMISSION MALAYSIA: A CASE STUDY OF THE CRUDE PALM OIL FUTURES CONTRACT. Retrieved from https://platform.almanhal.com/Reader/2/42602Kamali, Mohammad Hashim. (2000). “The Sharia Perspective on Futures”, in Siddiqi, Asma (ed) Anthology of Islamic Banking. London: Institute of Islamic Banking and Insurance.
Kasri, D. S. (2013). Maysir in the Crude Palm Oil Futures Contract: A Critical Analysis of the Resolution of the Malaysian Securities Commission Shariah Advisory Council – Part I. 1-43.
Noor Suhaida and Riaz Ansary 2013, Gharar in the Crude Palm Oil Futures Contract: A Critical Analysis of the Resolution of the Malaysian Securities Commission Shariah Advisory Council.
Nordin, Daud, Ahmad, Abu bakar and Ali 2015, Gharar in Forward and Futures Contracts?
Dr. Lahsen OUBDI et. Al. An Overview on the Practice and Issues of Hedging in Islamic Finance
Application of options in islamic finance pages 3,9,10,11
2-Islamic capital market Unit 9: Derivative instruments: products and applications pages 6,7,47,48
3-Derivative in islamic finance : Obiyathulla Ismath Bacha pages 8,9,10,11,12,13,14