Islamic derivative asgmnt


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Islamic derivative asgmnt

  3. 3. ACKNOWLEDGEMENTSAll praise to Allah (swt) the most Gracious and most Merciful, by whose grace and blessing toEncik Mohd Rizal Ab. Karim, our lecture of subject Futures and Options, due to theopportunities to us in discussing about Islamic view of current day derivative instruments.We also thankfully to our college (Selangor International Islamic University College) forallowed us to learn and have the knowledge in this subject matter. And to all the Librarians ofour university college in their co-operations helping us regarding some journal and books IslamicDerivative.We also take this opportunity, while relying on the instruction of the Prophet to the effect that:“whoever does not thank people does not thank Allah”We are indebted to our discussion from online journal, articles and books as supporting to theidea and get all the information from it while writing the assignment.We have given all our effort to this paper work and we hope that this paper work will providelessons and information which will complete the need of this assignment and also answering allthe question of Islamic derivative.May Allah (Almighty) reward them all for their contribution and consider our efforts for his sakeonly. 3
  4. 4. 2. INTRODUCTION The conventional options, swaps and futures stem from debts and involve sale andpurchase of debts or liabilities. As a group, products such as interest-rate swaps, stock optionsand futures, currency futures etc are called derivatives which are instruments derived from theexpected future performance of the respective underlying assets. These are very complex andrisky contracts having present market value of trillions of dollars over the world. According to anarticle published in the Economist, some $ 128 trillion of over the counter derivatives wereoutstanding in June 2002, a 28% increase over a year earlier1. It has been observed, however,that global financial market is becoming increasingly fragile as more and more derivatives and„hedging‟ instruments emerge. The development of derivative markets in emerging markets plays a special role in thiscontext as more institutional money is dedicated to emerging markets, which requires theavailability of financial instruments to manage market, credit and interest rate risks in largelyunderdeveloped local capital markets. Derivatives in general are financial contracts whoseinherent values derive from, and exist by reference to, a pre-determined payoff structure ofsecurities, interest rates, commodities, credit risk, and foreign exchange or any other tradableassets, indices thereof and/or baskets of any combination of the above with varied maturities.Derivatives assume economic gains from both risk shifting and efficient price discovery byproviding hedging and low-cost arbitrage opportunities. 4
  5. 5. 2.1 AN ASSESSMENT OF THE ARGUMENTS AGAINST DERIVATIVES This final section is intended to evaluate some of the arguments and reservations put forthby Islamic scholars, from a conventional finance viewpoint. The objective is to clarify why thetrading mechanism and other processes in derivative markets are the way they are. Beforeproceeding, it must be kept in mind that contemporary derivative markets have in placeprocesses and trading systems that have been fine tuned over years of practice, There have beenmany past failures and exchanges and markets have had painful lessons. They have responded bytightening regulation, redesigning instruments and trading methods and added new controlfeatures. It would be absurd to brush aside all of these experiential learning.i. Trading Volume The first issue that will be address here is the argument often put forth that the hugetrading volume of derivative markets is indicative of extensive speculation, that the marketattract and accentuates speculative behavior. While it cannot be denied that there is plenty ofspeculative activity, there are logical reasons for why the total trading volume is often muchlarger than underlying asset volume. Often 10 or 15 times higher, this huge divergence betweenunderlying assets and trading volume has to do with risk dissipation.ii. The Issue of Non Delivery Issue that causes uneasiness among ulama‟s is the fact that a large portion of thosetrading in derivative markets have no intention of either making or taking delivery of theunderlying asset. The implication is that since there is no intention of delivery, these peoplemust all be speculators. There are however many situations in which even genuine hedgers worldnot want to take or make delivery.iii. Cash Settlement The issue of cash settlement is yet another contentious point. Some have alleged that cashsettlement was designed in order 10 enhance speculative activity. Far from being intended tohelp speculators, cash settlement is used for the many advantages it has. Cash settlement isnormally though not exclusively used with financial futures and options as for example such asstock index futures and index options. 5
  6. 6. 3.1. FORWARD A derivative instrument is simply a financial instrument or asset that derives its valuefrom the value of some other underlying asset. The first derivative instrument was probably theforward contract. Not surprisingly, forwards was also the simplest type of derivatives. In aforward contract two parties undertake to complete a transaction at a future date but at a pricedetermined today. Forward in the terms of its benefits based on Fiqh Academy resolution are mainlycontracts that provide the opportunity for industrial and commercial institutions to finance theirprojects through the issuance and sale of stocks and financial instruments. Besides that, it alsoprovides a permanent venue for traders in commercial instruments and commodities. However,there are some objections to forward contract which are: 1) Its contracts are by and large paper transactions and not genuine purchases and sales as they do not involve the delivery or taking of possession of their underlying commodities. 2) Entail oppressive practices on the part of those who engage in them through a kind of monopoly by making large sales and purchases of contracts in commodities to force smaller traders to take a loss and suffer hardship as a result. 3) Bring price distortion. Price is not entirely the function of market forces of supply and demand or genuine purchases and sales by parties who need to conclude a certain transaction. Although spot trading is basically a contract for the physical delivery, sometimes thecontract may involve some elements of forwarding. 6
  7. 7. SALAM AND THE FORWARD CONTRACT. It is the closet among the contracts in Islamic law to the conventional forward contracts.Some scholars have considered it as the Islamic alternative to the forward contracts. Sudin Haronsaid: Forward markets exist in Islamic financial system but only on a limited scale. In case offorward markets for money there is a divergence of opinion pertaining to the legality of suchtransaction from the point of view of shariah. Forward markets for commodities are aloowed byshariah under the principle of bay’ al-salam (advance purchase) and istisna (contract tomanufacture). Here, the outstanding issue is that in bay‟ al-salam full payment at the time of agreementis a requirement according to the majority of Muslim jurists which is not the case in the forwardcontract. Other issue concern related to bay‟ al-salam and the forward contract is the claim madeby many scholars that bay‟ al-salam accepted in Islamic law but not in accordance to the norms,rather its acceptance is considered to be an exception. It is not possible to make an analogybetween salam and any new contract. It is also need to be addressed in connection with thelegality of the forward contract. Zamir Iqbal had stated that bay‟ al-salam to be the closetsubstitute for the forward contract. He acknowledged that bay‟ al-salam is not practiced in thefinancial market for two reasons that are first compared to the western forward contract, bay‟ al-salam requires full payment at the time of agreement. Second, since interest is incorporated inthe determination of the forward contract price it is synonym with paying or receiving interest.He then concluded that a forward contract may not incorporate the element of interest as it isprohibited. It may submitted that the issues related to salam in connection to the forward contractwhich need to be discussed are the issue if full payment at the time of agreement in salam andother is possibility of drawing an analogy and not against it. Lastly, based on other argument andthe fact that salam is in line with qiyas and not against it, it can be understand that the modernforward contract is a valid contract by way of analogy to salam. 7
  8. 8. ISTISNA AND THE FORWARD CONTRACT It is a contract for selling a manufacturable thing with an undertaking by the seller topresent it manufactuered from the person own material with a specified descriptions and at adetermined price. Several conditions should be fulfilled that are: a) The object of the contract must be precisely determined both in its essence and quality. b) The time of delivery must be specified (short and long) to avoid confusion of date of delivery, which may otherwise lead to conflict between the parties. c) The manufacturer should supply the material. If the material is supplied by the buyer, the contract is ijara and not istisna. d) The place of delivery should be specified if the commodity needs loading or transportation expenses. In istisna, not a condition to advance the payment though it is permissible to do so. Otherwise it could be deferred or made in instalments. Moreover, it is not a condition that the seller be an expert in manufacturing. However, istisna is more in line with the conventional forward contract where the price isnot paid in advance as well. Majority of Muslim jurists, istisna cannot be applied to commoditiesthat are normally available in the market. Thus, a seller agreeing to provide a product in thefuture under istisna will have to be a producer or have to establish a parallel contract with aproducer. It is clear from the contractual specifications of istisna that is almost the same as themodern forward contract. The deferment of price in istisna according to the classical scholars isallowed on the basis of istihsan and need rather than norms. The difference between istisna as aproduction contract and the modern forward contract as a trading contract should not be used asan excuse to reject the forward contract. Under bay‟ al-istisna the two parties can agree on the sale of a nonexistent product as it iselaborated. A certain percentage of the sale price as an advance is permissible. Istisna achievedsome of the benefits of the conventional forward contract. There is a need for the adoption f theforward contract in Islamic finance. 8
  9. 9. IBTIDA’ AL-DAYN AND THE FORWARD CONTRACT The sale of debt for debt called by the Malikis ibtida‟ al-dayn bi al-dayn (deferment ofboth countervalues) is at the core of forward trading. The different schools of law haveprohibited this form of sale of debt. Some of the sales involves riba‟ while for others it is gharar.The Malikis consider this as one of the lesser evils. Rafiq al-Masri argued that no extra gharar isinvolved in deferring both countervalues compared to the deferment of one of them only. Inother words, if one of the countervalues has been delivered while the other is deferred for afuture date or both of them are deferred, the level of risk is the same and there is no possibility ofextra gharar. However the objective of the forward contract or uqud al-tawrid is to satisfy theneed of some public institutions, factories and construction companies which are in need ofcertain materials on a specific date and may not be need of the money at the time of contract.BAY’ AL-SIFAH AND THE FORWARD CONTRACT’ Is the sale of something that is not present at the time of contract but will be delivered inthe future. The Hanafis validate the sale by description or bay‟ al-sifah and the guarantee thebuyer the option of inspection whether the subject matter of the contract is presented accordingto the agreed upon condition or not. The Malikis and Hanbalis guarantee the buyer the right ofthe option of inspection only when the commodity is presented without fulfilling the conditionsrequired. On the possibility of accommodating the conventional forward contract as a kind of bay‟al-sifah, Abd al-Wahhab Abu Sulaiman maintained that first it is bay al-sifah and then forwardcontract based on a detailed description of the subject matter, relying on previous observation.Second, in both contracts the subject matter is absent and the parties have a real intention to fulfilthe contract and want it to be executed according to the time and place specified. Lastly are bothcontracts countervalues are deferred although the price could be paid by instalments as well. The close similarities between the two contracts and the fact that the conventionalforward contract is immune from riba and gharar, which are the most commonly advancedarguments to invalidate it, it could stated the forward contract is a valid contract in Islamic law.Similarly there is no risk regarding the subject matter of the contract since it is well defined. 9
  10. 10. 3.2 FUTURES CONTRACT3.2.1 DEFINITION OF FUTURES CONTRACTIn finance, a futures contract is a standardized contract between two parties to buy or sell aspecified asset of standardized quantity and quality at a specified future date at a price agreedtoday). The contracts are traded on a futures exchange. Futures contracts are not "direct"securities like stocks, bonds, rights or warrants. The party agreeing to buy the underlying asset inthe future assumes a long position, and the party agreeing to sell the asset in the future assumesa short position.The price is determined by the instantaneous equilibrium between the forces of supply anddemand among competing buy and sell orders on the exchange at the time of the purchase or saleof the contract.Futures contract is the evolutions of forward contract for aims as multiple coincidences,restriction to restrict often lies in the way the forward price is arrived and as counterparty risk. Itquite similar to forward, except that they are standardize. Quantity, quality, deliveries, location,are all standardize. Price is the only variable which is decides through the forces of supply anddemand. Unlike forward contract, futures are traded in organized markets. 10
  11. 11. 3.2.2 THE IMPORTANT OF FUTURES CONTRACT IN MODERN FINANCIALFutures trading markets deals in almost all the basic commodities worldwide such as corn,wheat, cotton, crude oil, heating oil, gasoline, cocoa, palm oil, timber, rubber, aluminum copper,zinc, nickel, tin, coffee, sugar etc, and other of goods. Oil is one of the examples of the mostimportant commodities goods which it is impossible to conduct world commerce because itsprice is generally determined by the use of oil derivatives transactions.Therefore futures contract are important to modern financial because its make the market moreliquid, bridging the gap between present and future as well as providing information about theimpact of current events on the future prices and also provide the hedgers financial protectionagainst price volatility for commercial firms. Besides that future can be used to control rise andto adjust risk expositor of a portfolio to new economic information with the existence of futurecontract, the market can be absorb greater volume of transaction without adverse effect oncurrent or future commodity prices.However according to Resolution of the Securities Commission Shariah Advisory Council,Second Edition, page 79 a composite index futures contract is one of the instruments categorizedas a financial commodity futures contract. There are two types of financial futures contracts inthe futures industry in Malaysia. These are the Kuala Lumpur Composite Index (KLCI) futurescontracts and KLIBOR futures contracts which are traded on Bursa Malaysia Derivate Bhd andthe Shariah Advisory Council has decided that both of these contracts are not permissible byShariah. Stock index trading is allowed as long as it is Shariah compliant and this is done byensuring that the index component is made up of Shariah Compliant securities so this is the mainissue that will be discus in this chapter. 11
  12. 12. 3.2.3 SHARIAH OBJECTION ON CONVENTIONAL FUTURES CONTRACTThere are two objections by Shariah which implied the prohibition of futures contract thatpractices in present modern finance and the objection is in term of payment of commodities andalso bought and sold time of commodities. PAYMENTAn essential part of the futures program as practiced in organized markets, is that sellers andbuyers only pay a small percentage of the total price. Even then such percentage is paid only paidto the cleaning house and not to the counterpart. Therefore, a futures contract will not beaccepted by Shariah. As require by Shariah, full price must be paid immediately at the time ofthe contracting. It is a well-recognized principle of Sharia that a sale or a purchase cannot beeffective in a future date. There is a hadith (saying quoted) from Prophet Mohammad (PBUH)that such transactions are not permissible. As mention that there are four types of businesstransactions and three of which are permissible under Islamic law as follows:1. Spot2. Deferred3. Salam4. FutureIn spot or cash trading both commodity and money changed simultaneously and immediately. Inthe deferred transaction the commodity is delivered but money payment is deferred. Salam is aform of business dealing in which money is paid but commodity will be delivered later in afuture date. These three types are islamically accepted. The forth type is futures transaction inwhich delivery of money and commodity as well are to be done in a future date are as it appearsnot an accepted type dealing. 12
  13. 13. BOUGHT AND SOLD COMODITIES TIMESAccording to the majority of jurists a commodity bought on Salam basis can‟t be disposed of bysales before actual delivery. Where future matter contract is affected, buyer must wait untildelivery in order to be able to sell it. However, this is not what happens in the future market.Commodities, in the organized futures market, are bought and sold in several time before actualdelivery, otherwise the market will fail to provide liquidity, which is essential part of themechanism. But from Shari‟ah perspective even in standard sales contract it is not permitted thatthe buyer sale before actual receipt of the purchased items.In most of the futures transactions delivery of commodity or their possession is not intended. Inmost cases, these transactions are closed with settlement of difference in prices, more precisely itis used for speculation purpose, and speculation being some sort of gambling as it is perceived,and therefore, forbidden in Islam. Hence based on these reasoning a futures transaction is notallowed under Islamic Shari‟ah.3.2.4 FUTURES CONTRACT IN ISLAMIC SCHOLAR PERSPECTIVEAccording to the Shafii and Hanbali schools, the usufruct of an asset (in other words, thebenefit arising from the use of that asset) can be considered as property and thus can be subjectedto an exchange transaction, whereas the Hanafi and Maliki schools do not share this view.However most scholars of later periods side with the Shafii and Hanbali schools on this matter.A sale by public auction (bay`a muzayadah) in which an item is sold to the highest bidder, isdisallowed by many jurists apparently on the basis that auctions may be rigged by a small groupof well informed insiders.Whatever the truth of this particular matter, such a view does not seemto prohibit the making of a public offer to sell at a given price. 13
  14. 14. The Shari`ah permits making public offer with fixed deadlines for acceptance, binding theofferor to abide by the deadline he has fixed. According to many jurists, a contract of sale mustrelate to only one transaction. Hence, rather than signing a single contract to cover more than oneseparately identifiable transaction, individuals should instead enter into each transaction under aseparate contract. There is important condition which if followed strictly, it helps to preventusurious agreements being constructed from a set of underlying contracts that may, inthemselves, be quite acceptable. The condition is in term of price agreed and also prohibited ofdebt. PRICE AGREED AT IGNITION TIMEThe price agreed must be fixed at the time of contracting the exchange transaction, andownership remains with the seller until delivery is made. In this respect, there should be a formalevent that signifies the point at which a contract is concluded, for example a handshake or asignature.Though a sale cannot be made conditional upon a future event, conditions may beimposed upon the sale, for example the implementation of a service contract on a manufactureditem sold to a buyer, or the availability of a warranty against defective goods (daman). PROHIBITED SALE OF DEBTIt is important to note that Muslim scholars have traditionally prohibited the sale of a debt (bay`aal-dayn) at anything other than face value. Thus, if person B lends person A £100, B cannot thensell this debt to person C for anything other than £100. (If B sold the debt to C for, say £90, thenC would effectively be earning interest of £10 on a loan of £90 made to A).Among the achievements of the Islamic Fiqh Academy (affiliated to the OIC) was the issuing ofa detailed decision ... for deeds based on debts, which shall be non-negotiable except wheretransfer is made with the exchange of the face value of that debt. If they are purchased for lessthan their face value this would be the same principle as is applied to discounting of bills ofexchange which is prohibited. 14
  15. 15. 3.2.5 FUTURES CONTRACT IN SHARIAH PERSPECTIVEBai Salam is the Shari‟ah injunctions on futures trading or the synthetic futures contract packagethat is financially engineered by combining futures contract on islamically permissiblecommodities and Islamic cost-plus sale contract (Bai‟ Murabahah). This financially engineeredpackage meets all the requirements of Islamic jurisprudence and dominates Islamic forwardcontract on efficiency and welfare issues.As futures contract Bai salam is a contract in which advance payment is made for goods to bedelivered later on. The seller undertakes to supply some specific goods to the buyer at a futuredate in exchange of an advance price fully paid at the time of contract. However it is necessarythat the quality of the commodity intended to be purchased is fully specified leaving noambiguity leading to dispute and the objects of this sale are goods and cannot be gold, silver, orcurrencies based on these metals. Barring this, Bai Salam covers almost everything that iscapable of being definitely described as to quantity, quality, and workmanship. Therefore thereare difference between modern futures contract and islamically futures contract (Bai Salam) interm basis feature and condition which is show as below. 15
  16. 16. 3.3: OPTION3.3.1 Concept of optionOption is an alternative way. Through futures contract it have handle forward overcomeproblem. Futures enabled easy hedging by locking in the price at which one could buy or sell,being locked-in also means that one could not benefit from subsequent favorable pricemovement. “Wouldn‟t it be wonderful to have an instrument that protects you from unfavorableprice movements while at the same time enables you to take advantage of favorable pricemovements?” This is precisely what option do.Option has three advantage over forward and option. First, option may provide downsideprotection (bearish) and upside potential (bullish). Second, option is extremely flexible and canbe combined in various ways to achieve different objective or cash flows. And the last but notleast option can handle business risk that cannot be handle by forward and futures contract.3.3.2 Definition of option“An option is a contract between two parties in which one party (the buyer) has the right, but notobligation, to buy or sell a specified asset at a specified price, at or before a specified date, fromthe other party (the seller). The seller of the option, therefore, has a contingent liability or anobligation, which is activated if the buyer exercise that right.” Thus, “An option contract conveysthe right to buy or sell an underlying commodity at a specified price within a specified period oftime.”Means that buyer of the option is not obliged to complete the deal, and will do so only if changesin price make it profit for him. The buyer of the option is protected from unfavorable marketmovements, yet he is able to profit from movement in the buyer‟s favor. The risk of loss iscarried by the seller, who charges the buyer fee for taking this risk. This fee is called thepremium. 16
  17. 17. Now the question is: if options are permitted under Islamic law?3.3.3 Economic benefits of optionIn particular, options have the following benefits state by Muslims economist:1. They bring about an increase in the liquidity of the market. It is noted that one of the main advantages of the stock market is its ability to provide investment opportunity while financing long-term projects. It can short-term to the investor, which will increase the overall investment. The negotiable nature of options contracts leads to further accomplishment of this objective.2. Option contracts lead to a reduction in the effect of fluctuations in the price of securities.3. Investing in the stock market involve a high level of commercial risk due to price fluctuations and the influence of the moods of investors on the market. The current political and economic development also affects stock market investment.4. Stock market are totally depends on futures forecasts, any event influence the economic situation will necessary affect the market trends. Option can play a role as nature insurance and investors may minimize its adverse effects.5. Option give the investor the opportunity to rearrange his investment portfolio by choosing the most appropriate position for his preferences related to the risk return trade off. 17
  18. 18. Some Muslims economist opinion regarding to the benefit of options:1. El-Gari He stressed that: “There are many legitimate and Islamically desirable uses of options in stock markets. In particularly, the hedging aspect of options is quite in line with the recognized need of individuals, which is not contradictory to the shariah. The fact remains however, that an option contract should not have an existence independent of sale or lease contract.”2. Fuad al-Omar and Muhammed „Abdel Haq They suggested that “with the basic considerations in view, it is proposed that certain types of derivatives, mainly modified forms of options in stocks and Islamic financial certificates, will continue to render useful functions under Islamic financing. The modifications are needed to ensure that the price paid for any option is, in fact, the price of the underlying asset paid in advance, rather than the price of the option itself. This is necessitated by the fact that in Islamic financing, an option by itself, is not recognized as a marketable asset. Derivatives may also play other useful role within the framework of Islamic financing. To work out fully such benefits, and make use of them, substantial practical and conceptual effort would be required.”3. Obiyathullah He held the view that “the option is an important tool of financial engineering. Financial engineers often use options in the design of new financial contracts or in developing innovative strategies for financial problems, such as, management of risk.”Some Muslim jurists, in Islamic Fiqh Academy concluded that there is no need for option inIslamic economics because they do not serve any benefit. In such a situation the opinion ofMuslim economist is the one which should be considered because they have knowledge aboutthis particularly field. 18
  19. 19. 3.3.4 Option in IslamFirst view of option has examined their validity under the fiqh doctrine of al-khiyarat orcontractual stipulations.Second, while others have drawn parallels between options and bai-al-urbun; urbun being atransaction in which a buyer places a initial good faith deposit with the seller.Should the buyer decide to go ahead with the transaction, the payment is adjusted for the initialdeposit, but is nonrefundable if the buyers decided not to proceed with the transaction.A third view has been to examine options in the light of gharar or uncertainty.In at least one other situation (Abu Sulayman 1992) options have been viewed as totallydetached from the underlying asset.When viewed solely as a promise to buy or sell an asset at a predetermined price within astipulated period, Shariah scholars find nothing objectionable with options. However, it is in thetrading of this promise and the charging of premiums that objections are raised.3.3.5 Shcolar view of optionA number of scholars, notably Ahmad Muhayyuddin Hasan (1986), Abu Sulayman (1992) andTaqi Usmani ( 1996) have all found options objectionable. Each of these scholars have objectedfor a different reason.Ahmad Myhayyuddjn HasanHe objects on two grounds, firstly, that maturity beyond three days as per khiyar-al:.shart (optionof stipulation) is unacceptable. And second, that the buyer of an option is granted much morebenefits than the seller and that "this is oppression and injustice". Abu Sulayman (1992) of theFiqh Academy of Jeddah, finds options acceptable when viewed in the light of bai- al-urbun butconcludes that options should be prohibited since he considers options to be detached and 19
  20. 20. independent of the underlying asset and therefore unjustified for the seller to charge to premium.It should be noted here that yet other scholars have forbidden bai-ul-urbun transactions.Mufti Taqi Usmani (also of the Fiqh Academy, Jeddah)In answering a set of questions posed in a feature article, writes in response to a question about asale of stock with put options attached that while an option contract when viewed as a promise isacceptable, charging a fees and trading them are not. He also finds the sale of stock with a putoption to resell the stock to the issuer at a future date unacceptable since a precondition is placedon the original sale of stock.Mohd. Obaidullah ( 1997)Gharar has been another reason for objection to options. He writes, "permissibility toconventional options is generally denied by a majority of scholars on the ground that theseinvolve gharar and are primarily transacted for speculative gains". Acknowledging that gharardoes not have a consensus definition, gharar is said to be the result of jahJ, inadequateinformation and a lack transparency. Citing that some scholars have pointed out that in modernoptions markets standardized contract specification and other controls have rendered invalid thegharar argument, he goes on the state that this argument is rejected since there is no physicaldelivery but mere cash settlement; implying that cash settlement induces gharar and excessspeculation.He further adds that "while the gains, if they materialize are in the nature of maisir or unearnedgains the possibility of equally massive losses do indicate a possibility of default by the loser andhence gharar"; Both the maisir and gharar arguments here are invalid. That profits from optionsare "unearned", ignores the fact that both the buyer and seller take on risk and that the buyer alsohas at stake the premium he has paid. 20
  21. 21. Furthermore, the change in an options value arises from changes in underlying asset value andnot by chance. If such gains are unearned then it implies that all capital gains income could alsobe considered unearned. The second argument that options involve gharar since there is potentialfor default, totally ignores the fact that exchanges place margin requirements on seller of optionsprecisely to prevent default, Note that buyers of options would by definition not default sincetheir maximum possible losses is the premium, all of which is fully paid for at the time ofpurchase.Hashim Kamali (1995) examines the permissibility of modern day options and its trading in thelight of Islamic Commercial Law: analyzing the basic option contract, and the validity of itsparameters, such as, premiums, time to maturity and delivery, he concludes that "there is nothinginherently objectionable in granting an option, exercising it over a period of time or charging afee for it, and that options trading like other varieties of trade is permissible mubah and as such itis simply an extension of the basic liberty that the Quran has granted "3.3.6 Islamic alternative to conventional option.There are two Islamic alternative to conventional option. Which is khiyar al-shart and arbun.i) khiyar al-shart (option of stipulation)Among those who have drawn an analogy between the two concepts and concluded thatconventional option could be accommodated in Islamic law through khiyar al-shart are Kamali,Youssouf Sulaiman, Ali Abd al-Qadir, Shahhat al-Jundi and Obaidullah. However some scholarconcluded that conventional option could not be accommodated in Islamic law throught khiyaral-shart. 21
  22. 22. Thus, around thirty-three different types of options with varying degrees of importance havebeen identified in Islamic law. However, of these various kind of options, the one that ispotentially promising in desingning new financial instruments is khiyar al-shart and its variant orsubdivision, namely khiyar al-naqd or the option of paying the price as an indicator of theconfirmation of the contract.Concept of khiyar al-shart.Khiyar al-shart is an option in the nature of a condition stipulated in the contract whether toconfirm the contract or to cancel it in a specified period. Its provides a right to either of theparties, or both or even to a third party to confirm or to cancel the contract within a stipulatedperiod of time.It have been proved in hadith which is report that Hibban Ibn Munqidh complained to theProphet that he was the victim of frequent cheating in sale. The Prophet responded, “When youconcluded a sale, you may say there must be no fraud and you reserve for yourself an optionlasting for three days.” It is also asserted by the hadith of Abd Allah Ibn Umar to the effect that“the parties to a contract of sale have a right of a option as long as there are no separated exceptin a sale that is subject to option.” There was a little disagreement among scholars at thebeginning on khiyar al-shart but has been accepted by ijma‟.The terms of khiyar al-shartAbu Hanifah, Zuhar, and ShafieThey held that the option should not exceed three days as it is specified in the hadith, becausekhiyar al-shart is allowed contrary to the norms of qiyas as an exception. In other words, khiyaral-shart is initially against the objective of sale but, the syariah allowed it on the basis ofnecessity. 22
  23. 23. MalikiMore flexible stance toward the understanding of the hadith, saying that the hadith mentionsthree days in a figurative sense merely to convey the concept in an illustrated manner. The actualduration of an option may thus be determined by relating the option to the subject matter of sale.HanbaliThe option may be for any length of time and that is entirely a matter of agreement between thecontracting parties and there is no maximum permissible period.Ownership of commodity during the period of khiyar and libiality for damageHanafiBuyer and seller both parties hold the option , there would be no change in the ownership of thecountervalues and if the commodity is destroyed before taking possession, the seller would beheld liable. But, if it destroyed after the buyer taking possession, the contract would be cancelledand the buyer would be held liable and he required to pay the value of the destroyed. However, ifthe buyer holds the option and the commodity is destroyed before taking possession, he would beheld liable to pay the price and not the value.MalikiOwnership of the article of exchange does not shift during the option period irrespective of whoholds the option. The confirmation of the contract transfers the ownership to the buyer. When theseller holds the option , and the buyer takes possession of the article and subsequently claimsloss of the commodity, the issue will be resolve by legal process. In principle, seller should beliable for all damage to the commodity during the period of khiyar unless there is a case ofnegligence on the part of the buyer, because the buyer before taking possession is considered as atrustee. 23
  24. 24. HanbaliOwnership of the commodity transfer to the buyer during the option period irrespective ofwhether the option is with the buyer or the seller or both. If the buyer has taken possession, heshould be held liable in case of destruction. But if he did not take possession, then the sellerwould be liable. However, if the commodity does not possess the above characteristic, the buyerwould be held liable whether he has taken possession or not except in case he want to takepossession but has been prevent by the seller. In such case, the buyer would be held responsible.ShafieIf the seller initiates the option, his ownership of the commodity will continue. If the buyerretains the option, the ownership of the commodity transfers to him because the contract isbinding from the seller‟s side. And if both have stipulated the option, the ownership of thecommodity remains suspended during the time of the option. If the commodity destroyed beforebeing transferred by the seller to the buyer, the contract is considered annulled whether theoption is with the buyer, the seller or both.Managing price risk with khiyar al-shartSome scholars have discussed the possibility of charging a fee or premium for the option inkhiyar al-shart so as to match the conventional option.KamaliValid of charging a fee for options is a matter that falls under the general subject of contractualstipulation, a subject that invoked different responses from the schools of Islamic law nowwithstanding the affirmative nature of the source of evidence on it.Hanafi and shafieValid when they are in line with the essence of the contract. Thus a condition to provide aguarantor or a surety in the form of mortgage or pawn is legal provided that both parties agreeupon it. 24
  25. 25. Muslim jurist (Shahhat al-jundi, Yousuf Sulaiman and Ali Abd al-Qadir)They concluded: “the money taken by the seller as premium could not be return to the buyer (ifhe fails to ratify the contract within the agreed period) because Allah says, “Oh you who believefulfill your obligations.”So, it is clear that khiyar al-shart could serve as tool of risk management, and fulfill some of thebenefits associated with conventional option.ii) ArbunDefinitionSecond Islamic alternative to conventional option(included call option and put option) is arbun,its refers to a sale in which the buyer deposits earnest money with the seller as part payment ofthe price in advance, but agrees that if he fails to ratify the contract, he will forfeit the depositmoney, which the seller can keep. It is also defined as “a transaction whereby the buyer paysonly a small part of the price of a commodity (for instance two dirhams), on the understandingthat the seller will retain this amount if the sale is not finally concluded due to withdrawal of thebuyer.”Imam Malik give some example: it holds when a person buys or rents an animal and says to theseller or to the owner of the animal, “ I will give you one dinar or one dirham or more or less andif I ratify the sale or the rent contract, the amount I gave will be part of the total price. And if Icancel the deal, then what I gave will be for your without any exchange.” This not only in salecontract but also in a rent or leasing contract.As for the hadith, it is unreliable. But since the hadith upon which the proponents of bay al-arbunrely is also weak, al-Qaradawi observes that the issue should consequently be determined onrational grounds. 25
  26. 26. Arbun in commoditiesFrom imam Malik definition, arbun can be in bay(sale) and ijarah(rent). Therefore, it could besaid that arbun is legal with regard to commodities and services. Sale in Imam Malik‟s definitionis an example of the sale of commodities while ijarah is an example of service.Ex: Individual A want to buy a car, the current price are $20,00 but you have to purchase nowfor the price. However, A don‟t have cash in such amount, it takes about one week to manageloan. A offer the dealer $100 for him to keep the car for one week. This is as arbun. At the end ofthe week, if A buy the car , $100 is a part of car price. But if A not buy the car, then $100 wouldbelong to the seller.Arbun in present example while it is a call option contract in the earlier example.DIFFERENTS BETWEEN OPTION AND ARBUN1. An option requires payment for something that is a mere intangible “right”, not property (mal) in the usual sense of tangible good or a utility taken from a tangible good, as for this alone compensation can be demanded. Then, the option price is “unearned”.2. The right of option is given to the buyer as well the seller while arbun is given only to the buyer. The price of the option is separate from the price of the underlying commodity and one could sell it or give it as a gift, which is not the case in arbun.3. The objective of option trading is not the benefit of the contract, where the buyer receives the commodity and the seller receive the price, they, rather look, for price differentials. Moreover, in the exercise of the option, only one party can gain from the contract while the other must lose. Whether the party will gain or lose depends on unknown future market prices. 26
  27. 27. 4. In most actual option contracts, the parties have no intention of taking delivery, but only for liquidating their contracts against the price differentials. In every lawful Islamic sale, on the other hand, the parties fix their exchange fully and finally in the present. Thus, the entirety of at least one of the countervalues is at least presently owed, even if not immediately paid.5. The underlying asset in an option is not only a commodity as it is the case in arbun but it could also be currency or even stock indices, which are a kind of gambling.6. The price of an option is determined by the movement of interest rates, which is not Islamic.7. If the option is in currency, not even forward sales are allowed since currencies may be exchanged only on the spot.DOES OPTION TRADING INVOLVE THE COMBINATION OF TWO CONTRACTSIN ONE TRANSACTION?Ahadith reported from the Prophet (PBUH) prohibiting the sale of „bay ataini fi bay atinwahidah‟ or the combination of two contracts in one transaction. However, none of theinterpretations of Muslim jurists given to these hadith could be considered similar to the case ofthe options trading.Example of „bay ataini fi bay atin wahidah‟:„I will buy this item from you for 10 dinars cash and for 15 dinars if I have to pay one year later‟.The seller agrees without identified in which of the two terms of the deal the contract is included.This interpretation reported from Imam Malik. In additional Muslim jurist said it involve gharar. 27
  28. 28. 3.4 SWAPS It is an Islamic variant of the conventional transactions. The conventional swaps havebeen generally observed to be unIslamic as they clearly involve interest payments. Islamic swaps(al-murajaha al-Islamiyah) as highlighted in section 2 are in use by several Islamic banks. Aclose look at the nature of contracting reveals that the same essentially involves an exchange oftwo interest-free loans (qard) in different currencies which are repaid by both parties at the endof a stipulated time period. It is easy to see that such swaps partially enable the parties to hedgetheir currency risk. An Islamic swap between two banks may help both banks to partially reducetheir risk. The major difference of this type of swap from its conventional counterpart is that in caseof the latter, the interest payments along with the principal are swapped. In case of Islamic swap,only the principal is being swapped since the incomes to be generated on the investments are notpredetermined. Islamic swaps may perform many other useful functions besides serving as a tool of riskmanagement, such as, reducing cost of raising resources, identifying appropriate investmentopportunities, better asset-liability management and the like. These are also the benefits withconventional swaps. Islamic swaps are different in that they do not involve interest-related cashflows. However, Islamic swaps are not free from controversies and there is no consensusregarding their acceptability. An Islamic profit rate swap is basically an agreement to exchange profit rates between afixed rate party and a floating rate party or vice versa implemented through the execution of aseries of underlying contracts to trade certain assets under the Shariah contracts. Each party‟spayment obligation is computed using a different pricing formula. In Islamic rate profit rateswap, the notional principal is never exchanged as it netted off using the Islamic principle ofMuqasah. 28
  29. 29. An Islamic profit rate swap aims to match funding rates with return rates (frominvestment), achieve lower cost of funding, restructure existing debt profile without raising newfinance or altering the balance sheet and manage exposure to interest rate movement. It is alsoaimed to protect financial institutions from fluctuations in borrowing rates and to provide a riskcontrol mechanism. Like other Islamic contracts, contracts in Islamic swaps must also be free from anyelements of riba (usury), maysir (gambling), Gharar (unnecessary risk) and jahl (ignorance). Inaddition to these elements, Islamic swaps are different from conventional swaps in that they arelinked with asset-backed transactions such as Bai‟, Bai‟ Bithaman Ajil, Murabahah, Ijarah andother. 29
  30. 30. 4. ConclusionIn Islamic financial view in order to be halal, all financial instrument must be free from fiveelements namely, riba, rishwah, masyir, gharar and jahl. Most of the derivatives incorporategharar, gambling and interest and support speculative activities. Islamic legal rules, particularlythe ban on Gharar and on the sale of debt for debt, do not allow transactions devoid of real orproductive activities. Derivatives involving such financial contracts which themselves areprohibited in Shariah (Riba based bonds & forward foreign exchange where mutual exchange isnot simultaneous, for example) are clearly un-acceptable according to the Shari‟ah principles.Derivatives instruments have largely envolved in non-islamic environment, thus the are loadedwith values which may not bbe totally in compliance with Islamic principles. Therefore there isneed for systematic analysis of these tools of price dtermination as well as risk management andhedging devices from an Islamic perspective.Therefore Bai Salam contract and Istijrar has been engineered which is considered a basis forderivative contract within an Islamic framework. Bai salam contract has provisions andprecedence while istijra is a recent innovation practice in pakistant. There ara two other contract,the istina and joa‟la which are related to Bai Salam contract. 30
  31. 31. 5. RECOMMENDATIONIn the journal wrote by Obiyatullah Ismatch Bacha in title of „Derivative Instruments and IslamicFinance: Some thoughts For Reconsideration‟, he has highlight two derivative contracts withinan Islamic framework. These are (i) the Bai Salam Contract, and (ii) the Istijrar Contract.i) Bai salamDefinition of bai salamSalam is essentially a transaction where two parties agree to carry out a sale/purchase of anunderlying asset at a predetermined future date but at a price determined and fully paid for today.The seller agrees to deliver the asset in the agreed quantity and quality to the buyer at thepredetermined future date. This is similar to the conventional futures contract. However the bigdifference is that in a Salam sale the buyer pays the entire amount in full at the time the contractis initiated.Concept of bai salamThe payment must be in cash form. The idea behind such a prepayment requirement has to dowith the fact that the objective in a Bai Salam contract is to help needy farmers and smallbusinesses with working capital financing. The buyer in a contract therefore is often an Islamicfinancial institution. Since there is full prepayment, a Salam sale is clearly beneficial to theseller. As such the predetermined price is normally lower than the prevailing spot price. Thisprice behavior is certainly different from that of conventional futures contracts where the futuresprices is typically higher than the spot price by the amount of the carrying cost. The lower Salamprice compared to spot is the "compensation" by the seller to the buyer for the privilege given tohim. 31
  32. 32. Condition of bai salam(i) Full payment by buyer at the time of effecting sale.(ii) The underlying asset must be standardizable, easily quantifiable and of determinate quality.(iii) Salam contract cannot be based on a uniquely identified underlying asset. This means the underlying commodity cannot be based on commodity from a particular farm/field etc. By definition such an underlying asset would not be standardizable.(iv) Quantity, quality, maturity date and place of delivery must be clearly enumerated in the Salam agreement.(v) The underlying asset or commodity must be available and traded in the markets through the period of contract.ii) Istijrar contractDefitionThe istijrar contract is a recently introduced Islamic financing instrument. Introduced in Pakistan,the contract has embedded options that could be triggered if the underlying assets price exceedscertain bounds. The contract is complex in that it constituted a combination of options, averageprices and Muharabah or cost plus financing. The Istijrar involves two parties, buyer which couldbe a company seeking financing to purchase the underlying asset and a financial institution.Concept of istijrar contractA typical istijrar transaction could be as follows: a company seeking short term working capitalto finance the purchase of a commodity like a needed raw material approaches a bank. The bankpurchases the commodity at a current price, and resells it to the company for payment to be madeat a mutually agreed upon date in the future (for example in 3 months). The price at whichsettlement occurs on maturity is contingent on the underlying assets price movement from t 0 tot90 where t0 is the day the contract was initiated and t90 is the 90th day which would be thematurity day. 32
  33. 33. Unlike a Murabahah contract where the settlement price would simply be a predetermined price;P* where P* P0 (I + r), with r being the banks required return learning, the price at which theistijrar is settled on maturity date could either be P* or an average price (P) of the commoditybetween the period t0 to t90. As to which of the two prices will be used for settlement will dependon how prices have behaved and which party chooses to fix the settlement price. The embeddedoption is the right to chooses to fix the price at which settlement will Occur at anytime beforecontract maturity. At the initiation of the contract; t0 both parties agree on the following twoitems (i) in the predetermined Murabahah price; P* and (ii) an upper and lower bound around theP0. (banks purchase price at t0). 33
  34. 34. 6. BibliographyAl-amine, m. A.-b. (2008). Risk management in islamic finance: an analysis of derivativeinstruments in commodity markets. Netherlands: koninklijke brill nv,leiden.Ayub, m. (2007). Understanding islamic finance. England: john wiley and sons ltd.Bacha, a. I. (2001). Financial derivative: markets and application in malaysia. Kuala lumpur,malaysia: universiti putra malaysia.Ibrahim, a. M. (1999). Islamic financial services and products. Kuala lumpur, malaysia: ikimpublishing unit.Kharofa, p. D. (2000). Transactions in islamic law. Kuala lumpur, malaysia: pustaka hayati.Sheikh ghazali sheikh abod, s. O., & ghazali, a. H. (2005). An introduction to islamic economicsand finance. Kuala lumpur, malaysia: cert publications sdn.bhd. 34
  35. 35. ONLINE JOURNAL1. 35