Islamic derivatives


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Islamic derivatives

  1. 1. ISLAMIC DERIVATIVES <ul><li>P resented by : </li></ul><ul><ul><ul><ul><li>A LVEENA R EHMAN S HAH </li></ul></ul></ul></ul>
  2. 2. INTRODUCTION <ul><li>WHAT IS ISLAMIC BANKING? </li></ul><ul><li>Modes Of ISLAMIC BANKING </li></ul><ul><ul><li>Mudarabah (Profit sharing) </li></ul></ul><ul><ul><li>Wadiah (Safekeeping) </li></ul></ul><ul><ul><li>Musharaka (Joint venture) </li></ul></ul><ul><ul><li>Murabaha (Cost plus) </li></ul></ul><ul><ul><li>Ijara (Leasing) </li></ul></ul>
  3. 3. Islamic Methodology towards Innovation Permanent (Al-Thawabit) Changeable ( Al-Mutaghayyarat )
  4. 4. ISLAMIC DERIVATIVES <ul><li>What are derivatives? </li></ul><ul><li>Requisites For A Shariah Compliant Derivative Instruments </li></ul><ul><ul><ul><li>Riba (usury) </li></ul></ul></ul><ul><ul><ul><li>Rishwah (corruption) </li></ul></ul></ul><ul><ul><ul><li>Maysir (gambling) </li></ul></ul></ul><ul><ul><ul><li>Gharar (unnecessary risk) </li></ul></ul></ul><ul><ul><ul><li>Jahl (ignorance) </li></ul></ul></ul>
  5. 5. Hedging Products <ul><ul><li>Profit rate swap </li></ul></ul><ul><ul><li>Forward Rate agreements </li></ul></ul><ul><ul><li>Islamic Options </li></ul></ul><ul><ul><li>Cross Currency Swap </li></ul></ul>
  6. 6. PROFIT RATE SWAP <ul><li>Interest Rate Swap </li></ul><ul><li>Islamic Profit Rate Swap (IPRS) </li></ul><ul><ul><ul><ul><li>Definition </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Reason </li></ul></ul></ul></ul>
  7. 7. ISLAMIC PROFIT RATE SWAP <ul><li>Objectives of IPRS </li></ul><ul><li>To match funding rates with return rates </li></ul><ul><li>To achieve lower cost of funding </li></ul><ul><li>To restructure existing debt profile </li></ul><ul><li>To manage exposure to interest rate </li></ul><ul><li>To deepen Islamic Financial Market </li></ul>
  8. 8. THE DYNAMICS OF IPRS <ul><li>ABC </li></ul>Receives fixed returns Financial Liabilities Financial Assets Islamic Swap Counter Party Receives floating profit rate Pays floating obligations Pays fixed profit rate
  9. 9. <ul><li>STAGE 1: Fixed Profit Rate </li></ul>ABC Islamic Swap Counter Party ASSET STEP 1 ABC sells Asset to Islamic Swap counter Party at notional principal of RM500k. STEP 2 Islamic Swap Counter Party sells Asset to ABC at notional principal RM500k + mark-up based on fixed profit rate STEP 3 Notional principal amount of RM500k owed by both ABC and Islamic Swap party to each other is set off STEP 4 The net difference i.e. the fixed profit rate in Step 2 is paid to Islamic Swap counter Party by ABC at the agreed interval payment date of say 6 month
  10. 10. <ul><li>STAGE 2: Floating Profit Rate </li></ul>STEP 1 ABC sells Asset to Islamic Swap counter Party at notional principal RM500k + floating profit rate. STEP 2 Islamic Swap counter Party sells Asset to ABC at notional principal of RM500k. STEP 3 Notional principal amount of RM500k owed by both ABC and Islamic Swap party to each other is set off STEP 4 The net difference i.e. the floating rate profit in Step 1 is paid to ABC by Islamic Swap counter Party at the agreed interval payment date of say 6 month ABC Islamic Swap Counter Party ASSET
  11. 11. <ul><li>STAGE 3 – Determination of Subsequent Floating Rate </li></ul>Floating Profit Rate (Stage 2) is repeated every 6 months until maturity. 6 MONTHS 6 MONTHS 6 MONTHS 6 MONTHS MATURIT Y ABC Islamic Swap Counter Party ASSET
  12. 12. ISLAMIC PROFIT RATE SWAP <ul><li>General Observation 1 </li></ul><ul><li>Floating rate </li></ul><ul><ul><li>Entering into a new contract </li></ul></ul><ul><ul><li>(Murabaha or Ijara ) </li></ul></ul>
  13. 13. ISLAMIC PROFIT RATE SWAP <ul><li>General Observation 2 </li></ul><ul><ul><li>No actual payment of Principal </li></ul></ul><ul><ul><li>Principle of Muqasa (set-off) </li></ul></ul><ul><ul><li>“ Contractual rate agreement entered into between two counterparties under which each party agrees to make periodic payment to the other for an agreed period of time based upon a notional amount of principal” </li></ul></ul>
  14. 14. FUTURE CONTRACT & ISLAMIC FINANCE <ul><li>The following three contracts in Islamic finance can be considered as future/forward contracts </li></ul><ul><ul><ul><ul><li>The Salam Contract </li></ul></ul></ul></ul><ul><ul><ul><ul><li>The Istisna Contract and </li></ul></ul></ul></ul><ul><ul><ul><ul><li>The Joa’la Contract </li></ul></ul></ul></ul>
  15. 15. Features of Ba’i Salam <ul><li>“ Two parties sale/purchase an underlying asset at a predetermined future date but at a price determined and fully paid for today ” </li></ul>Objective Difference
  16. 16. <ul><li>‘ The lower Salam price compared to spot is the “compensation” by the seller to the buyer for the privilege given to him’ </li></ul>Features of Ba’i Salam Beneficial to the seller The predetermined price is normally lower than the prevailing spot price
  17. 17. <ul><li>“ To overcome the potential for default on the part of the seller, the Shari'ah allows for the buyer to require security which may be in the form of a guarantee or mortgage” </li></ul>Features of Ba’i Salam One sided-Counter party risk It is the buyer who faces the seller’s default risk .
  18. 18. Features of Istisna <ul><li>“ A buyer contracts with a manufacturer to manufacture a needed product to his specifications ” </li></ul>Price of Product Agreed upon & Fixed . Termination Cancelled before production begins . Payment Time of Delivery
  19. 19. Joala Contracts <ul><li>“ The Joala Contract is essentially an Istisna but applicable for services as opposed to a manufactured product.” </li></ul>
  20. 20. <ul><li>DEFINITION:- </li></ul><ul><li>“ A cross currency (CC) swap is a foreign exchange agreement between two parties to exchange a given amount of one currency for another ” </li></ul>CROSS CURRENCY SWAP
  21. 21. Terms and Conditions <ul><li>Trade-able currency combinations </li></ul><ul><li>Minimum Principal (EUR 1 million) </li></ul><ul><li>Standard terms (1-10 years) </li></ul><ul><li>Financial contract that can be traded separately </li></ul><ul><li>Interest flows in different currencies </li></ul><ul><li>Principal amounts are Swapped at the beginning & end of the term </li></ul>
  22. 22. Three Stages of CCS 1)- Spot Exchange of Principal 3)- Re-exchange of principal at the maturity of the contract 2)- A continuing exchange of interest payments during the swap's life
  23. 23. <ul><li>Islamic Cross Currency Swap </li></ul><ul><li>Two simultaneous Murabaha transactions: </li></ul><ul><ul><li>Term Murabaha </li></ul></ul><ul><ul><li>Reverse Murabaha </li></ul></ul><ul><ul><li>Murabaha </li></ul></ul><ul><ul><li>“ A murabaha is a sale arrangement whereby a financier purchases goods from a supplier and then on-sells them to a counterparty at a deferred price that is marked-up to include the financier's profit margin” </li></ul></ul>
  24. 24. <ul><ul><li>“ A method where the financial institution , either directly or indirectly, will buy an asset and immediately sell it to a customer on a deferred payment basis. The customer then sells the same asset to a third party for immediate delivery and payment, the end result being that the customer receives a cash amount and has a deferred payment obligation for the marked-up price to the financial institution ” </li></ul></ul>Reverse Murabaha(Tawarruq)
  25. 25. OPTIONS IN ISLAMIC FINANCE <ul><li>Overview of Istijrar </li></ul><ul><li>Istijrar involves two parties </li></ul><ul><li>Bank purchases on behalf of its customer </li></ul><ul><li>The difference in price is bank’s earning/return </li></ul><ul><li>P*=Po(1+r) </li></ul><ul><li>Istijrar could be P* or an average price of commodity between the period t 0 an t 90 . </li></ul><ul><li>4. Which party chooses to “fix” the settlement price— embedded option </li></ul>
  26. 26. <ul><li>5. Both parties agree on following two items </li></ul><ul><li>a) Predetermined murabaha price P* </li></ul><ul><li>b) Upper and lower bound </li></ul><ul><li>Po = the price that bank pays to purchase underlying commodity </li></ul><ul><li>P* = Murabaha price; P* = Po (1+r). </li></ul><ul><li>P LB = the lower bound price </li></ul><ul><li>P UB = the Upper bound price </li></ul>P LB P 0 P * P UB
  27. 27. <ul><li>At Maturity: </li></ul><ul><li>Ps = Avg price ; if the underlying asset price remained within the bounds. </li></ul><ul><li>Ps = P*; if the underlying asset exceeds the bounds and one of the parties chooses to exercise its option and use P* as the price at which to settle at maturity. </li></ul>OPTIONS IN ISLAMIC FINANCE
  28. 28. <ul><li>Basic Idea: </li></ul>OPTIONS IN ISLAMIC FINANCE Not A Zero Sum Game Contract avoids “Riba and Gharar”
  29. 29. C ONCLUSION <ul><li>“ T hese instruments could easily be used for speculation appears to be the key reason for objection. That derivatives form the basis of risk-management appears to have been lost ” </li></ul>Evaluation on precedence Absent for the risk management problems faced today Objective Micro-examination instead of intend and societal benefit Differing Sects Convergence Required
  30. 30. <ul><li>T H A N K Y O U !!! </li></ul>