Traditional VS Islamic Financial Derivatives

To: Prof. Naser Abu Mustafa By: Mwaffaq Al Jayousi & Mohammad Al Shdooh

Abstract This study focuses the light on defining financial derivatives and briefly describe their different types (Options, Forwards, Futures, Swaps, etc.). At the same time it tries to find if these financial derivatives exists in the Arab world, how they are implemented, and if we have an Islamic alternatives for them. Introduction There is a big debate in the Arab world regarding the usage of financial derivatives, Wither they are legal according to Islam or not, and If they are illegal in Islam; are there any Islamic alternatives to them. First we have to ask our self: Is there any need to use derivatives? And why they recently became so popular in the western countries? The need for financial derivatives emerges when people realize that there must be a way to reduce the risk associated with the trading of different kinds of goods. Risks such as price fluctuations and the uncertainty about the future market conditions. And since there are some people who are willing to bear this risk instead of us, this market took off and recently because of the communications revolution it flourished. Then why these financial derivatives did not reach the Arab world? The answer is simply because they hugely rely on speculations and anticipation; which are considered illegal according to Islam. But someone can ask: if it is illegal in Islam, then how come we couldn't Islamize them as we managed to Islamize the banking industry, which is a western invention as the financial derivatives. Through this study we will talk about financial derivatives and try to find if there are any Islamic alternatives.

Defining Derivatives

A derivative is a financial instrument whose value depends on is derived from the value of some other financial instrument, called the underlying asset. Common examples of underlying assets are: stocks, bonds, corn, wheat, rainfall, etc. Derivatives Definition by the IASB: 1 The international financial reporting standards (IFRS) by the London-based International Accounting Standards Board (IASB) defines derivative as a financial instrument whose value changes in response to a change in the price of an underlying, such as an interest rate, commodity, security price, or index. The definition also specifies that a derivative instrument typically requires no initial investment, or one that is smaller than would be needed for a classical contract with similar response to changes in market factors. Also part of the IASB definition is the fact that the derivatives contract is settled at a future date. History of Derivatives: 2 1600s - Holland. Tulip dealing is big business, and growers and dealers are trading in options to guarantee prices. Soon speculators are joining in and a thriving options market is born. But the market crashes, many speculators fail to honor their commitments, and the Dutch economy is brought to its knees. 1700s - London. Options are declared illegal! 1934 - USA. Investment act legitimizes options. Annual volume < 300,000 contracts by 1968. April 1973 - Chicago. The CBOT starts trading listed call options on 16 stocks, with a first-day volume of 911 contracts. 1974 - Chicago. The daily volume grows from 20,000 to over 200,000 contracts.

These financial instruments promise payoffs that are derived from the value of something else, which is called the underlying. The underlying is often

a financial asset or rate, but it does not have to be. For example, derivatives exist with payments linked to the S&P 500 stock index, the temperature at Kennedy Airport, and the number of bankruptcies among a group of selected companies. Some estimates of the size of the market for derivatives are in excess of $270 trillion more than 100 times larger than 30 years ago. When derivative contracts lead to large financial losses, they can make headlines. In recent years, derivatives have been associated with a few truly notable events, including the collapses of Barings Bank (the Queen of Englands primary bank) and Long-Term Capital Management (a hedge fund whose partners included an economist with a Nobel Prize awarded for breakthrough research in pricing derivatives). Derivatives even had a role in the fall of Enron. Indeed, just two years ago, Warren Buffett concluded that derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal. But there are two sides to this coin. Although some serious dangers are associated with derivatives, handled with care they have proved to be immensely valuable to modern economies, and will surely remain so. 3 When we know this deep-rooted history of derivatives, and it's huge impact on the economy and the circulation of cash generated by these financial instruments in the developed countries, we feel sorry that such powerful instruments are hardly if not used at all in the Arab countries.(in Kuwait the use only Put Options!). Someone might say that these financial instruments are prohibited according to the Islamic teachings, maybe this true if we use them without modifying them to suit us, but I think they can be tailored to suit our Islamic beliefs, as we in the past tailored banking industry.

The nuts and bolts 3

Derivatives come in flavors from plain vanilla to mint chocolate-chip. The plain vanilla include contracts to buy or sell something for future delivery (forward and futures contracts), contracts involving an option to buy or sell something at a fixed price in the future (options) and contracts to exchange one cash flow for another (swaps), along with simple combinations of forward, futures and options contracts. (Futures contracts are similar to forward contracts, but they are standardized contracts that trade on exchanges.) At the mint chocolate-chip end of the spectrum, however, the sky is the limit. I think saying that "the sky is the limit" when we are talking about sophisticated derivatives like the Mint Chocolate-Chip, I think is wrong. Such a wild derivative need to be tamed, otherwise they will be a destructive instruments instead of being constructive. Forward and Future Contracts 3 A forward and Future contracts obligate one party to buy the underlying at a fixed price at a certain future date (called the maturity) from a counterparty, who is obligated to sell the underlying at that fixed price. Consider a U.S. exporter who expects to receive a 100 million payment for goods in six months. Suppose that the price of the euro is $1.20 today. If the euro were to fall by 10 percent over the next six months, the exporter would lose $12 million. But by selling euros forward, the exporter locks in the current forward exchange rate. If the forward rate is $1.18 (less than $1.20 because the market apparently expects the euro to depreciate a bit), the exporter is guaranteed to receive $118 million at maturity. Hedging consists of taking a financial position to reduce exposure to a risk. In this example, the financial position is a forward contract, the risk is depreciation of the euro, and the exposure is 100 million in six months, which is perfectly hedged with the forward contract. Since no money changes hands when the exporter buys euros forward, the market value of the contract must be zero when it is initiated, since otherwise the exporter would get something for nothing.

Options 3 Although options can be written on any underlying, lets use options on common stock as an example. A call option on a stock gives its holder the right to buy a fixed number of shares at a given price by some future date, while a put option gives its holder the right to sell a fixed number of shares on the same terms. The specified price is called the exercise price. When the holder of an option takes advantage of her right, she is said to exercise the option. The purchase price of an option the money that changes hands on day one is called the option premium. Options enable their holders to lever their resources, while at the same time limiting their risk. Suppose Smith believes that the current price of $50 for Upside Inc. stock is too low. Lets assume that the premium on a call option that confers the right to buy shares at $50 each for six months is $10 per share. Smith can buy call options to purchase 100 shares for $1,000. She will gain from stock price increases as if she had invested in 100 shares, even though she invested an amount equal to the value of 20 shares. With only $1,000 to invest, Smith could have borrowed $4,000 to buy 100 shares. At maturity, she would then have to repay the loan. The gain made upon exercising the option is therefore similar to the gain from a levered position in the stock a position consisting of purchasing shares with ones own money plus money thats borrowed. However, if Smith borrowed $4,000, she could lose up to $5,000 plus interest if the stock price fell to zero. With the call option, the most she can lose is $1,000. But theres no free lunch here; shell lose the entire $1,000 if the stock price does not rise above $50. Swaps 3 A swap is a contract to exchange cash flows over a specific period. The principal used to compute the flows is the notional amount. Suppose you have an adjustable-rate mortgage with principal of $200,000 and current payments of $11,000 per year. If interest rates doubled, your payments would increase dramatically. You could eliminate this risk by refinancing with a

fixed-rate mortgage, but the transaction could be expensive. A swap contract, by contrast, would not entail renegotiating the mortgage. You would agree to make payments to a counterparty say a bank equal to a fixed interest rate applied to $200,000. In exchange, the bank would pay you a floating rate applied to $200,000. With this interest-rate swap, you would use the floating-rate payments received from the bank to make your mortgage payments. The only payments you would make out of your own pocket would be the fixed interest payments to the bank, as if you had a fixed-rate mortgage. Therefore, a doubling of interest rates would no longer affect your out-of pocket costs. Nor, for that matter, would a halving of interest rates. Exotics 3 An exotic derivative is one that cannot be created by mixing and matching option and forward contracts. Instead, the payoff is a complicated function of one or many underlyings. When P&G lost $160 million on derivatives in 1994, the main culprit was an exotic swap. The amount it had to pay on the swap depended on the five-year Treasury note yield and the price of the 30year Treasury bond. Another example of an exotic derivative is a binary option, which pays a fixed amount if some condition is met. For instance, a binary option might pay $10 million if, before a specified date, one of the three largest banks in Indonesia has defaulted on its debt. Pricing derivatives 3 Derivatives are priced on the assumption that financial markets are frictionless. One can then find an asset-buying-and-selling strategy that only requires an initial investment that ensures that the portfolio generates the same payoff as the derivative. This is called a replicating portfolio. The value of the derivative must be the same as that of the replicating portfolio; otherwise there would be a way to make a risk-free profit by buying the portfolio and selling the derivative. An example will help. Consider the euro forward contract described earlier. At maturity, the exporter has to pay 100 million and receives $118 million. A replicating

portfolio can be constructed as follows: borrow the present value of 100 million and invest the present value of $118 million in Treasury bills that come due the day the derivative contract matures. At maturity, you are guaranteed to have $118 million in hand and have to pay back the borrowed euros plus interest, which come to 100 million. The forward contract must thus be priced so that the exporter is indifferent to using the forward contract or the replicating portfolio to hedge. Otherwise, any investor could make easy, guaranteed money by buying dollars against euros using the cheaper approach and selling dollars against euros using the more expensive approach. Note that the value of a forward contract can change over its life. If the euro appreciates unexpectedly, the replicating portfolio makes a loss; the present value of the euro debt of the portfolio increases unexpectedly, but the value of the Treasury bills would not increase commensurately. Since the replicating portfolio has the same payoff as the forward contract, the loss means that the value of the forward contract has become negative. The replicating portfolio strategy is trickier to devise and implement for options. In their path breaking (and Nobel Prize-winning) work, Fischer Black and Myron Scholes provided a mathematical solution for calculating the option price at any time during the life of the option. The growth of derivatives markets 3 Some of the earliest derivatives were linked to tulip bulbs in Holland and to rice in Japan in the 17th century. But derivatives markets were small until the 1970s, when economic conditions, along with advances in the pricing of derivatives, led to spectacular growth. In that decade, the volatility of interest rates and currency exchange rates increased sharply, making it imperative to find efficient ways to hedge related risks. Meanwhile, deregulation in a variety of industries, along with soaring international trade and capital flows, added to the demand for financial products to manage risk. Development of the Black-Scholes formula in the early 1970s, along with the introduction of cheaper, faster computers to manage the computations,

changed the trading of derivatives forever. Thereafter, financial engineers could invent new derivatives and easily find their value. Until the 1970s, derivatives mostly took the form of option, forward and futures contracts. Except for futures contracts on commodities, the trading of derivatives had been done over the counter, meaning without intermediation by an organized exchange. But in 1972, the Chicago Mercantile Exchange started trading futures contracts on currencies. The Chicago Board Options Exchange, where stock options are traded, was founded in 1973. In the late 1970s and early 1980s, the swaps market took off. Exotic derivatives trading exploded a few years later. The OTC derivatives markets are decentralized and unregulated (except by contract law), and the parties are not required to report transactions. However, since an OTC derivative trade typically involves a bank or a regulated broker, the quasi-governmental Bank for International Settlements has been able to estimate the size of the OTC market for derivatives by surveying financial fi rms. In June 2004, the total notional amount of derivatives traded over the counter was $220 trillion. This figure is a proxy for the value of the underlyings against which claims are traded in the derivatives markets. The euro forward contract example discussed earlier had a notional value of $118 million, while the interest-rate swap had a notional amount of $200,000. Interest-rate swaps represent 56 percent of the derivatives market. In 1987, the notional amount of interest rate swaps outstanding was $865 billion; 17 years later, it was $127 trillion, implying growth at an average annual rate of 34 percent. The notional amount of exchange-traded derivatives (futures and options) grew from $616 billion in December 1986 to $50 trillion in mid-2003, for an average annual growth rate of 29 percent. Adding up the OTC market and the exchanges, the notional amount of derivatives was some $270 trillion at the end of June 2004. To put this number in perspective, the capitalization of all the markets for corporate debt and equity in the world was $31 trillion at the end of 2003. A second way to look at the size of the derivatives market is as follows:

Suppose that every party and counterparty had to write off all derivatives contracts. For each swap contract, one party would write off an asset, the positive value of the contract at that time, and the counterparty would write off a liability. Now, just add up the positive value of all contracts at that time. By this net measure, the aggregate value of OTC derivatives outstanding in June 2003 was $6.4 trillion a big number, but nothing compared to the notional amount of contracts outstanding. The benefits of derivatives 3 Derivatives are priced by constructing a hypothetical replicating portfolio. So who needs them? If derivatives can be replicated perfectly, limiting their use would change nothing. Well, not quite. First, individuals and nonfinancial firms face much higher trading costs than financial institutions. Thus, replicating a derivative like a call option would be prohibitively expensive. Second, for derivatives that include option features, the replicating portfolio strategy typically requires trades to be made whenever the price of the underlying changes. Third, identifying the correct replicating strategy is often a problem. The main gain from derivatives is therefore to permit individuals and firms to achieve payoffs that they would not be able to achieve without derivatives, or could only achieve at greater cost. Derivatives make it possible to hedge risks that otherwise would be not be possible to hedge. And when economic actors can manage risk better, risks are borne by those who are in the best position to bear them, and firms can take on riskier but more profitable projects by hedging. A second important benefit is that derivatives can make underlying markets more efficient. First, derivatives markets produce information. For example, in a number of countries, the only reliable information about longterm interest rates is obtained from swaps, because the swap market is more liquid and more active than the bond market. Second, derivatives enable investors to trade on information that otherwise might be prohibitively expensive to use. For instance, selling stock short (that is, selling stock

you dont own) is often difficult to do, because the shares must be borrowed from someone who does own them. This slows the speed at which adverse information is incorporated in stock prices, thereby making markets less efficient. With put options, a derivative that mimics the dynamics of selling short, investors can more easily take advantage of adverse information about stock prices. In theory, this cut's both ways; derivatives can also disrupt markets by making it easier to build speculative positions. But there isnt much evidence that derivatives trading have actually increased the volatility of the return of the underlying assets. Who uses derivatives and why 3 The most comprehensive study of the use of derivatives by nonfinancial firms was made by Sohnke Bartram, Gregory Brown and Frank Fehle (all University of North Carolina), who examined some 7,300 nonfinancial firms from 48 countries, using corporate reports from 2000 and 2001. They found that 60 percent of these firms used derivatives. The most frequently used were foreign-exchange derivatives (44 percent of firms), followed by interestrate derivatives (33 percent of firms) and commodity derivatives (10 percent). Swaps and forwards are used more than options. Wayne Guay (University of Pennsylvania) found that when firms started using derivatives, on average their stock return volatility fell by 5 percent, their interestrate exposure fell by 22 percent, and their foreign-exchange exposure fell by 11 percent. Clearly, firms do use derivatives for hedging, although if firms hedged systematically, the evidence suggests they would use derivatives much more than they actually do. Firms use derivatives for other reasons, too. Gordon Bodnar, Gregory Hayt, Richard Marston and Charles Smithson, writing in Financial Management in 1995, found 28 percent of the firms they surveyed used derivatives to minimize earnings volatility. There is also evidence that firms use derivatives to reduce tax liability. The way managers are paid affects the extent to which firms hedge. In general, firms for which options are a more important component of managerial compensation are less likely to

hedge. That makes sense: in many situations, managers who hold options benefit from increased volatility, since their options will be worth more if the stock price rises but the option will never be worth less than zero if the stock price falls. Finally, firms sometimes do use derivatives to speculate. Banks and investment banks make markets in derivatives, but they also take positions in derivatives to manage risk. In the third quarter of 2003, the banks with the 25 largest derivatives portfolios held 96.6 percent for trading purposes and 3.4 percent for risk-management needs. Little is known about derivatives use by individuals. What evidence there is, though, suggests that individuals fail to exploit them fully. For example, home mortgages in the United States typically contain an embedded option the borrower has the option to prepay the mortgage. Typically, though, mortgage holders exercise this option later than justified by models of option pricing. The risks of derivatives at the firm level 3 Derivatives that trade in liquid markets can always be bought or sold at the market price, so mathematical models are not required to value them. Valuation is much more problematic when trading is illiquid. In these cases, models have to be brought to bear to value derivatives a procedure called marking them to market. And, in the words of a skeptical Warren Buffett, In extreme cases, mark-to-market degenerates into what I would call mark-tomyth. The Black-Scholes formula for options valuation assumes, among other things, that markets are frictionless, interest rates are fixed, and trading is possible all the time. Yet, while the shortcomings of Black-Scholes are obvious, there is no general agreement on what would work better. Even relatively simple derivatives contracts can be badly misvalued. Chase Manhattan ended up with some very expensive egg on its face when it discovered in 1999 that one of its foreign-exchange traders had misvalued forward contracts to the tune of $60 million. In 2004, the National Australian Bank reported currency-option losses in excess of $280 million

U.S., due in part to incorrect valuations. Two interesting studies show substantial disagreement among experts on the value of derivatives. In one, the Bank of England asked dealers to value a number of different derivatives and found that while the dealers had similar numbers for the most actively traded derivatives, they were sometimes far apart for more complicated ones. In the other, Antonio Bernardo and Bradford Cornell of UCLA had access to data for an auction of 32 mortgage derivative securities. The average amount by which the highest bid price exceeded the lowest bid price was a remarkable 63 percent. But in spite of the practical difficulties in valuing derivatives, current U.S. accounting rules require firms to mark to market the derivatives positions on their balance sheets. Market Liquidity 3 If a firm buys a widely traded plain vanilla derivative say, a put option on the euro with a maturity and exercise price common in the marketplace it is generally easy to sell. However, it can be harder to get out of longmaturity contracts and complicated derivatives. First, it is much more likely that there is risk involved in the replicating strategy for such derivatives. Second, a complicated derivative only appeals to a small number of counterparties who both want that particular set of risk characteristics and are confident that they understand what they are getting. Transparency and Reliability of Accounting 3 Consider a 30-year swap contract in which Enron delivered gas at regular intervals and received fixed amounts of cash over time. The value of this contract had to be marked to market each quarter for accounting purposes. However, it can be tempting to tweak assumptions say, about the growth in the storage cost of gas decades down the road in a way that has a substantial impact on present profits. And, not surprisingly, Enron was not reluctant to make the best of the ambiguous. Though concerns about disclosures of derivatives positions have increased recently, the information disclosed typically focuses on the stand-alone risks of derivatives rather

than the context in which the derivatives are used. If a firm uses derivatives to hedge, it can take on a large amount of seemingly risky derivatives in the name of reducing risk. Although disclosure requirements for derivatives are not much help in seeing how they are used, some firms do report the impact of their hedging activities on various risks. Another problem is that it can be a major challenge for a firm to describe all the details of its derivatives risks. For example, Enron had complicated derivatives with credit-rating triggers that required it to make payments if its credit rating fell below a specified level. Once Enrons credit cratered and the triggers were activated, it could no longer survive because the required payments were too large. Derivatives and Incentives 3 The sale of a derivative generates revenue. A wise trading firm will typically hedge the derivative that it has sold. But placing a value on the derivative and the corresponding hedge can be difficult in an illiquid market. And executives do not always have strong incentives to side with risk managers who want to value derivatives conservatively. For example, when a conservative valuation would cause a firm to show a loss, top executives may find reasons to side with traders who prefer a more aggressive stance. Derivative trading does not require much cash. Swaps, for example, have no value at initiation, so a firm with a good credit rating can build a big portfolio of them without writing checks. As a result, derivative trading can look very profitable when its revenue is compared to the cash investment. Yet, derivative trading generates revenue by assuming additional risks. And proper evaluation of the profitability of derivatives requires taking into account the capital required to support those risks. The major banks have developed approaches that allow them to do just that. Other firms, though, are more likely to ignore the cost associated with the increase in risk, which leads them to overstate profitability. Understanding the Risks 3

In 1994, a firm in Cincinnati called Gibson Greetings loss of its profits for the year, thanks to its operations in derivatives. One of its derivative contracts worked like this: A swap specified that starting on April 5, 1993 and ending October 5, 1997, Gibson would pay Bankers Trust the six-month LIBOR (the London Interbank Offering Rate), a commonly used interest rate, squared, then divided by 6 percent times $30 million. In return, Bankers Trust paid Gibson 5.50 percent times $30 million. Such exotic transactions raise concerns that some parties involved dont fully understand the risks they are taking. In the past decade, regular users of derivatives have made considerable progress in measuring the risks of derivatives portfolios. One popular measure is called value-at-risk (or VaR). For instance, a 5 percent value-at risk of $100 million means that there is a 5 percent chance the derivative user will lose $100 million or more in a specified time period. With another measure, called a stress test, the firm computes the value of its derivatives portfolio using hypothetical scenarios. For example, it might compute the value of its portfolio if the Russian financial crisis of 1998 were repeated. Many firms with large portfolios of derivatives now report their value-at-risk and may also report the outcomes of various stress tests. But these measurement tools do not always work well. During the Russian crisis, banks exceeded their VaRs more than their risk models suggested they should have. Who gets hurt by derivatives losses? 3 With a derivative, somebodys loss is inevitably somebody elses gain. For instance, with a recent $550 million derivatives loss of China Aviation Oil, the counterparties to the derivatives contracts made some of that money (the rest has not been paid because of the companys bankruptcy). So, for a derivatives loss to create a loss to society as a whole, there must also be some deadweight costs incurred along the way. In many cases, these costs are small or nonexistent. But derivatives losses can lead to financial distress at the firm level and, in exceptional circumstances, can have

more pervasive effects on the economy. The Derivatives Risks of Financial Institutions 3 In the third quarter of 2003, insured commercial banks in the United States had derivatives positions with a total notional amount of $67.1 trillion, with 96 percent of the total held by seven banks. Banks generally report the market risk of their trading positions the risk associated with possible changes in financial prices and rates. For instance, J.P. Morgan Chase reported a value-at-risk of $281 million on the last day of 2003, which meant there was a 1 percent chance that it would make a one-day loss on its trading portfolio in excess of $281 million. Of course if the bank actually started losing sums of this magnitude, it would take steps to cut its risk. Note, moreover, that, at the time, stockholders equity in J.P. Morgan Chase was $43 billion. Thus, by any standard, the banks derivatives risks seemed manageable. A large bank might make significant losses if one or several of its large derivatives counterparties defaulted. However, participants in financial markets have strong incentives to control counterparty risk. Fully 65 percent of plain vanilla interest-rate swaps were collateralized in 2001. Parties also put triggers in derivatives contracts, forcing the counterparty to post more collateral if it becomes less creditworthy. One result: In the United States, charge-offs from derivatives losses by commercial banks have been small compared to charge-offs from commercial loans. Two issues are still worth considering here. First, even if large losses at the firm level would impose large costs on the financial system, firms have little incentive to take such externalities into account. Second, though existing measures capture most risks, they cant capture risks we do not know about. In 1998, liquidity risk the risk associated with the cost of selling a position quickly was crucially important, but it was not included in most models. The bottom line: while impossible to answer the question of whether unknown risks are large, the conventional measures suggest that no large bank is seriously at risk because of its derivatives holdings.

What Would Happen if a Major Dealer or User Collapsed? 3 Bankruptcy law contains an automatic-stay provision that prevents creditors from requiring immediate payment, making it possible for their claims to be resolved in an orderly fashion. Interest-rate swaps and some other derivatives are exempted from this automatic stay, however. Instead, the parties to a swap contract use a master agreement that specifies how termination payments are determined in the event of a default. Without this exemption from the automatic stay, defaults on derivatives contracts would present a considerable problem, since counterparties would in some cases have to wait (sometimes for years) for their claims to be adjudicated, leaving them with mostly unhedgeable risks. Consider a bank that experiences a default on a derivative contract. It chooses to ask for termination of the contract and is due a payment equal to the market value of its position at termination. If the position was hedged, the bank has only the hedge on its books after the default, without having the contract it was trying to hedge. The banks risk has increased, and it may not have received the cash payments that were promised. The bank may then lack the liquidity to make payments it owes, which leads to further problems. Under normal circumstances, markets are sufficiently liquid that the bank can quickly eliminate the risk created by default. But the situation may be direr if the default occurs in a period of economic turmoil. If all banks are trying to reduce risk, they may all get stuck, because there is only a limited market for the positions they are trying to sell. In such a situation, the Federal Reserve would have to step in to provide liquidity. Given the central role of Treasury securities in dynamic hedging, the Fed might also have to intervene to settle down the Treasury market. The LTCM Collapse 3 The collapse of the hedge fund Long-Term Capital Management (LTCM) is often cited as an example of a crisis linked to derivatives that could have led to a meltdown of the entire financial system. At the end of July 1998, LTCM held

assets worth $125 billion, which were financed with about $4.1 billion of its own capital along with loans. It also had derivatives with a total notional amount in excess of $1 trillion. Many strategies employed by LTCM involved taking long positions in bonds that LTCM perceived to have too high a yield in light of their risk, and then hedging these positions against interestrate risk with derivatives or short positions in U.S. Treasuries. When Russia defaulted on its sovereign debt in 1998, there was a general flight to safety by investors around the globe. Interest rates on Treasuries fell, but the yields on the bonds held by LTCM did not fall as much; so LTCM had losses on its hedges not matched by gains on the market value of its bonds. LTCMs losses then triggered a vicious circle. As the fund registered losses, it sold some assets, which put pressure on prices. More important, the market perceived that liquidation of its positions became more likely. Traders who knew about LTCMs portfolio could position themselves so that they would not be hurt by a liquidation and might even benefit from it. Their actions put pressure on prices, further reducing the value of LTCMs portfolio which made liquidation more likely and hence created incentives for a new round of trading. Whats more, as prices moved against LTCM and liquidity in the markets was drying up, counterparties were trying to maximize the collateral that they could obtain from the giant hedge fund on their marked to-market contracts. This generated further marked-to-market losses for LTCM. Finally, investors and banks that in normal times would have bid for assets in the event of an LTCM liquidation were facing losses of their own. Some were forced to sell assets that LTCM also held, putting yet more pressure on prices. By mid-September, LTCM could only avoid default by closing its positions or receiving an infusion of capital. Closing LTCMs positions would have been exceptionally difficult, since it was a party to more than 50,000 derivatives contracts and securities positions in markets where liquidity was now low. For creditors, the most efficient solution was to take over the fund, inject some cash, and liquidate the portfolio slowly or find a buyer

for it. A potential buyer did appear: Warren Buffetts Berkshire Hathaway and Goldman Sachs bid $4 billion for the portfolio. Instead, creditors chose to inject $3.6 billion into the fund and took control, with the LTCM partners retaining some ownership. There was no default and no public bailout; the creditors eventually took more money out than they put in. We will never know what would have happened if LTCM had defaulted. But one lesson is clear: When a market participant that is large relative to the markets gets in trouble, its difficulties may affect prices adversely. That makes its situation worse a fact that does not figure in models treating economic agents as passive price-takers. If LTCM had been denied easy access to derivatives, it could have manufactured its own. This would have decreased its profits a bit, and might have been too expensive for some strategies. But LTCM would still have been very highly levered, would still have registered extremely large losses in September 1998, and might still have ended in bankruptcy. It is difficult to say, then, whether the risk to the economy would have been greater or smaller had LTCM been subject to restrictions on its use of derivatives. Its leverage would have been lower. But in replicating derivatives on its own, it might have needed to trade more in illiquid markets. What to make of it all 3 Derivatives allow firms and individuals to hedge risks or to bear risk at minimum cost. They can also create risk at the firm level, especially if a firm is inexperienced in their use. For the economy as a whole, the collapse of a large derivatives user or dealer may create systemic risks. On balance, derivatives plainly make the economy more efficient. However, neither users of derivatives nor their regulators can afford to be complacent. Firms have to make sure that derivatives are used properly. This means that the risks of derivatives positions must be measured and understood, and these firms must have well defined policies for derivative use. Whats more, a firms board must know how risk is managed within the firm and what role derivatives play. For their part, regulators need to monitor financial firms with large

derivatives positions very carefully. Though regulators seem to be doing a good job in monitoring banks and brokerage houses, the risks taken by insurance companies, hedge funds and government-sponsored enterprises like Fannie Mae and Freddie Mac are not equally well understood and monitored. Should we fear derivatives? Most of us choose to fly on airplanes even though they sometimes crash. But we also insist that planes are made as safe as it makes economic sense for them to be. The same logic should apply to derivatives.

Islamic derivatives Given that the Islamic banking industry is working in the same environment and circumstances in which conventional banking is operating, and subject to the same risks in terms of the volatility of interest rates and exchange rates, the lack of an alternative Islamic derivatives to the traditional derivatives would expose Islamic financial institutions to these risks, forcing them to avoid engaging in financial transactions, which include those risks, thereby reducing the role of Islamic financial institutions, and it will reduce the efficiency of the management of assets and liabilities and raises the cost of finance, so we must consider possible Islamic alternatives for these tools. Some of the Islamic derivatives are similar to traditional derivatives ( is like futures contracts and deposit is like call option), and some are different. Here some examples of them. Sale and buy-back agreement (Bai' al 'inah) Is a financing facility with the underlying buy and sell transactions between the financier and the customer. The financier buys an asset from the customer on spot basis. The price paid by the financier constitutes the disbursement under the facility. Subsequently the asset is sold to the customer on a deferred-payment basis and the price is payable in installments. The second sale serves to create the obligation on the part of the customer under the facility. There are differences of opinion amongst the scholars on the

permissibility of Bai' al 'inah, however this is practiced in Malaysia (A set of strict conditions must be complied) and the like jurisdictions. Deferred payment sale (Bai' bithaman ajil) This concept refers to the sale of goods on a deferred payment basis at a price, which includes a profit margin agreed to by both parties. Like Bai' al 'inah, this concept is also used under an Islamic financing facility. Interest payment can be avoided as the customer is paying the sale price which is not the same as interest charged on a loan. The problem here is that this includes linking two transactions in one which is forbidden in Islam. The common perception is that this is simply straightforward charging of interest disguised as a sale. Credit sale (Bai' muajjal) Literally means a credit sale. Technically, it is a financing technique adopted by Islamic banks that takes the form of murabahah muajjal. It is a contract in which the bank earns a profit margin on the purchase price and allows the buyer to pay the price of the commodity at a future date in a lump sum or in installments. It has to expressly mention cost of the commodity and the margin of profit is mutually agreed. The price fixed for the commodity in such a transaction can be the same as the spot price or higher or lower than the spot price. Bai' muajjal is also called a deferred-payment sale. However, one of the essential descriptions of riba is an unjustified delay in payment or either increasing or decreasing the price if the payment is immediate or delayed. Joint venture (Musharakah) Is an agreement between two or more partners, whereby each partner provides funds to be used in a venture. Profits made are shared between the partners according to the invested capital. In case of loss, no partner loses capital in the same ratio. If the Bank provides capital, the same conditions apply. It is this financial risk, according to the Shariah, that justifies the bank's claim to part of the profit. Each partner may or may not participate

in carrying out the business. A working partner gets a greater profit share compared to a sleeping (non-working) partner. The difference between Musharaka and Madharaba is that, in Musharaka, each partner contributes some capital, whereas in Madharaba, one partner, e.g. A financial institution, provides all the capital and the other partner, the entrepreneur, provides no capital. Note that Musharaka and Madharaba commonly overlap. Mudarabah "Mudarabah" is a special kind of partnership where one partner gives money to another for investing it in a commercial enterprise. The investment comes from the first partner who is called "rabb-ul-mal", while the management and work is an exclusive responsibility of the other, who is called "mudarib". The Mudarabah (Profit Sharing) is a contract, with one party providing 100 percent of the capital and the other party providing its specialist knowledge to invest the capital and manage the investment project. Profits generated are shared between the parties according to a pre-agreed ratio. Compared to Musharaka, in a Mudaraba only the lender of the money has to take losses in this only "rabb-ul mal"suffered from loss mudarib do not suffered with loss.Profit distributed between both rabb-ul-mal and mudarib. Murabahah This concept refers to the sale of goods at a price, which includes a profit margin agreed to by both parties. The purchase and selling price, other costs, and the profit margin must be clearly stated at the time of the sale agreement. The bank is compensated for the time value of its money in the form of the profit margin. This is a fixed-income loan for the purchase of a real asset (such as real estate or a vehicle), with a fixed rate of profit determined by the profit margin. The bank is not compensated for the time value of money outside of the contracted term (i.e., the bank cannot charge additional profit on late payments); however, the asset remains as a mortgage with the bank until the default is settled.This type of transaction is

similar to rent-to-own arrangements for furniture or appliances that are common in North American stores. Musawamah Is the negotiation of a selling price between two parties without reference by the seller to either costs or asking price. While the seller may or may not have full knowledge of the cost of the item being negotiated, they are under no obligation to reveal these costs as part of the negotiation process. This difference in obligation by the seller is the key distinction between Murabahah and Musawamah with all other rules as described in Murabahah remaining the same. Musawamah is the most common type of trading negotiation seen in Islamic commerce. Bai Salam Means a contract in which advance payment is made for goods to be delivered later on. The seller undertakes to supply some specific goods to the buyer at a future date in exchange of an advance price fully paid at the time of contract. It is necessary that the quality of the commodity intended to be purchased is fully specified leaving no ambiguity leading to dispute. The objects of this sale are goods and cannot be gold, silver, or currencies based on these metals. Barring this, Bai Salam covers almost everything that is capable of being definitely described as to quantity, quality, and workmanship. Basic features and conditions of Salam 1. The transaction is considered Salam if the buyer has paid the purchase price to the seller in full at the time of sale. This is necessary so that the buyer can show that they are not entering into debt with a second party in order to eliminate the debt with the first party, an act prohibited under Sharia. The idea of Salam is normally different from the other either in its quality or in its size or weight and their exact specification is not generally possible.

2. Salam cannot be effected on a particular commodity or on a product of a particular field or farm. For example, if the seller undertakes to supply the wheat of a particular field, or the fruit of a particular tree, the salam will not be valid, because there is a possibility that the crop of that particular field or the fruit of that tree is destroyed before delivery, and, given such possibility, the delivery remains uncertain. The same rule is applicable to every commodity the supply of which is not certain. 3. It is necessary that the quality of the commodity (intended to be purchased through salam) is fully specified leaving no ambiguity which may lead to a dispute. All the possible details in this respect must be expressly mentioned. 4. It is also necessary that the quantity of the commodity is agreed upon in unequivocal terms. If the commodity is quantified in weights according to the usage of its traders, its weight must be determined, and if it is quantified through measures, its exact measure should be known. What is normally weighed cannot be quantified in measures and vice versa. 5. The exact date and place of delivery must be specified in the contract. 6. Salam cannot be effected in respect of things which must be delivered at spot. For example, if gold is purchased in exchange of silver, it is necessary, according to Shari'ah, that the delivery of both be simultaneous. Here, salam cannot work. Similarly, if wheat is bartered for barley, the simultaneous delivery of both is necessary for the validity of sale. Therefore the contract of salam in this case is not allowed. 7. This is the most preferred financing structure and carries higher order Shariah compliance. Hibah (gift)

This is a token given voluntarily by a debtor to a debitor in return for a loan. Hibah usually arises in practice when Islamic banks voluntarily pay their customers a 'gift' on savings account balances, representing a portion of the profit made by using those savings account balances in other activities. It is important to note that while it appears similar to interest, and may, in effect, have the same outcome, Hibah is a voluntary payment made (or not made) at the bank's discretion, and cannot be 'guaranteed.'{akin to Dividends earned by Shares, however it is not time bound but is at the bank's discretion) However, the opportunity of receiving high Hibah will draw in customers' savings, providing the bank with capital necessary to create its profits; if the ventures are profitable, then some of those profits may be gifted back to its customers as Hibah. Ijarah Means lease, rent or wage. Generally, Ijarah concept means selling the benefit of use or service for a fixed price or wage. Under this concept, the Bank makes available to the customer the use of service of assets / equipments such as plant, office automation, motor vehicle for a fixed period and price. Ijarah thumma al bai' (hire purchase) Parties enter into contracts that come into effect serially, to form a complete lease/ buyback transaction. The first contract is an Ijarah that outlines the terms for leasing or renting over a fixed period, and the second contract is a Bai that triggers a sale or purchase once the term of the Ijarah is complete. For example, in a car financing facility, a customer enters into the first contract and leases the car from the owner (bank) at an agreed amount over a specific period. When the lease period expires, the second contract comes into effect, which enables the customer to purchase the car at an agreed to price. The bank generates a profit by determining in advance the cost of the item, its residual value at the end of the term and the time value or profit margin for the money being invested in purchasing

the product to be leased for the intended term. The combining of these three figures becomes the basis for the contract between the Bank and the client for the initial lease contract. This type of transaction is similar to the contractum trinius, a legal maneuver used by European bankers and merchants during the Middle Ages to sidestep the Church's prohibition on interest bearing loans. In a contractum, two parties would enter into three concurrent and interrelated legal contracts, the net effect being the paying of a fee for the use of money for the term of the loan. The use of concurrent interrelated contracts is also prohibited under Shariah Law. Ijarah-wal-iqtina A contract under which an Islamic bank provides equipment, building, or other assets to the client against an agreed rental together with a unilateral undertaking by the bank or the client that at the end of the lease period, the ownership in the asset would be transferred to the lessee. The undertaking or the promise does not become an integral part of the lease contract to make it conditional. The rentals as well as the purchase price are fixed in such manner that the bank gets back its principal sum along with profit over the period of lease. Qard hassan (good loan/benevolent loan) This is a loan extended on a goodwill basis, and the debtor is only required to repay the amount borrowed. However, the debtor may, at his or her discretion, pay an extra amount beyond the principal amount of the loan (without promising it) as a token of appreciation to the creditor. In the case that the debtor does not pay an extra amount to the creditor, this transaction is a true interest-free loan. Some Muslims consider this to be the only type of loan that does not violate the prohibition on riba, since it is the one type of loan that truly does not compensate the creditor for the time value of money Islamic bonds ( Sukuk)

Is the Arabic name for financial certificates that are the Islamic equivalent of bonds. However, fixed-income, interest-bearing bonds are not permissible in Islam. Hence, Sukuk are securities that comply with the Islamic law (Shariah) and its investment principles, which prohibit the charging or paying of interest. Financial assets that comply with the Islamic law can be classified in accordance with their tradability and non-tradability in the secondary markets. Islamic insurance (Takaful) Is an alternative form of cover that a Muslim can avail himself against the risk of loss due to misfortunes. Takaful is based on the idea that what is uncertain with respect to an individual may cease to be uncertain with respect to a very large number of similar individuals. Insurance by combining the risks of many people enables each individual to enjoy the advantage provided by the law of large numbers. See Takaful for details. Wadiah (safekeeping) In Wadiah, a bank is deemed as a keeper and trustee of funds. A person deposits funds in the bank and the bank guarantees refund of the entire amount of the deposit, or any part of the outstanding amount, when the depositor demands it. The depositor, at the bank's discretion, may be rewarded with Hibah (see above) as a form of appreciation for the use of funds by the bank. Conclusion As we seen financial derivatives are very important tools of reducing risks associated with various financial transactions in the modern world. And a necessary instruments to circulate cash in the economy. The American Economy Stood back on his feet within less than two years after the 2008's financial crisis, and the credit goes to the efficient financial derivative's market in the USA. But at the same time they are a very dangerous weapons if they are misused, having the potential to destroy whole economies. This not only my opinion, it's also the opinion of some western financial figures like Warren

Buffet. On the other hand, there are some restrictions imposed by Islamic Shareea' on those financial derivatives, and considering the fact that the majority of Muslims will avoid using them since they are prohibited by Islam, so we have to find alternatives to them or we can modify them to suit us. As we shown there are some Islamic alternatives that can be used instead of them, but those Islamic alternatives need to be systemized by creating a market for them similar to the markets used to deal with the traditional financial derivatives, or we can modify those western derivatives to be acceptable by Muslims. Some Muslim countries like Malaysia and turkey have done a good job in this regard, but still not enough. Other countries like Kuwait did less effort. So obviously there is a great deal of deficit from our side. So I think a great deal of the blame lies on the shoulders of our financial specialists, who should do more effort and more research to get solutions to this dilemma. They cannot keep saying we have to use the western financial derivatives as they are, since there is as we mentioned a majority of Muslims who refuse to use them in their current shape. Also our governments have a share of the blame, since they have the capabilities to create the necessary infrastructure and to finance and support our financial specialists to establish the long-waited Islamic financial derivatives market.

References 1: Introduction to Derivative Financial Instruments: Options, Futures,Forwards, Swaps, and Hedging. By: DIMITRIS N. CHORAFAS: McGRAW-HILL. Tony Ware, MITACS 6th Annual Conference, May 11 2005 Demystifying Financial Derivatives, By: Ren M. Stulz

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