Financial Derivatives

Submitted to:

tives: Its uses and Implications in the Real World.

761

4296

Nimra Hashmi-13005
Myra Razi-15052
Hassan Khan-12790
Aatif Iqbal-15912

Acknowledgement
First of all we would like to thank All Mighty Allah, great entity that helped us
to get through this report safely, the one who was always there when no one
was!
We would like to pay tribute to our loving parents and teachers whose
invaluable prays salutary admire and embodying attitude kept our spirit alive
to strive for knowledge and integrity which enable us to reach milestone, we
would also like to express enormous gratitude to my respectable teacher
Sir Fahid Fahim
Who was always there to help and guide us whenever we needed help, his
perceptive criticism kept me working to make this project better. We are
thankful to him for his encouraging and valuable support. Working under him
was an extremely knowledgeable and enriching experience for us. We are
very thankful to him for all the value addition and enhancement done to us.
We also acknowledge the help and pleasant gathering of all my class fellows.
We are also thankful to all of those people who helped us in accomplishing
this report.

EXECUTIVE SUMMARY

If one were to single out an area of derivative trading which can find support
in the relevant evidence of Shari'ah, it would unquestionably be the
commodity futures. This is because futures and options that derive from
commodities, especially agricultural commodities and food grains, can be
used for a variety of beneficial purposes. Commodity futures can be used as
hedging devices that protect farmers and the food production industry
against the price risk over a period of time.
Futures and options can also be used in the interest of effective planning by
the market players in agricultural and industrial sectors that may wish to
have the security of selling in advance instead of facing the uncertainties of
marketing at short notice, especially for commodities that can only be stored
over a period of months rather than years. The greatest benefit of trading in
futures and options is that they facilitate risk management and risk
reduction.
All of these would fall, from the Shari'ah point of view, within the broad scope
of public interest or maslahah, which is a recognized proof and basis of
judgment in Shari'ah. However, the validity of maslahah in areas and issues
which have given rise to controversy need to be established through valid
Shari'ah evidence. This is the nature of the challenge that we face
concerning trading in derivatives.

Table of Content:
1- Conventional Derivatives:
iIntroduction
4
iiTypes of
derivatives
..4
iii- Uses of
derivatives
.6

2. Islamic Derivatives:
iIntroduction
.6
iiTypes of
Derivatives
7

3. Islamic Vs Conventional:
iQuran
Verses
..9
iiAhadiths
10
iii- Opinions of
Scholars
.11

4- Derivative market of
Malaysia12

5Conclusion
14
6- References
.15

Conventional Derivatives:
Introduction:
Derivatives are financial contracts whose value is derived from some
underlying asset. These assets can include equities, bonds, exchange rates,
and commodities, residential and commercial mortgages. The more common
forms of these contracts include options, forwards/futures and swaps. Most
derivatives are traded over-the-counter (off-exchange) or on an exchange
such as the Chicago Mercantile Exchange. Derivatives can be used for a
number of purposes, including insuring against price movements (hedging),
increasing exposure to price movements for speculation.
(i) Hedging and risk management,
(ii) Price discovery, and
(iii) Enhancement of liquidity.

Types of Conventional Derivatives:

1. A forward contract is a private agreement between two parties
giving the buyer an obligation to purchase an asset (and the seller an
obligation to sell an asset) at a set price at a future point in time.

2. A futures contract is a contract between two parties to buy or sell an

asset for a price agreed upon today (the futures price) with delivery
and payment occurring at a future point, the delivery date.

3. The swap agreement defines the dates when the cash flows are to be
paid and the way they are accrued and calculated. Specifically, two
counterparties agree to exchange one stream of cash flows against
another stream. These streams are called the legs of the swap.
4. An options contract is an agreement between a buyer and seller that
gives the purchaser of the option the right to buy or sell a particular
asset at a later date at an agreed upon price. Options contracts are
often used in securities, commodities, and real estate transactions.

Uses of Derivatives:
1. Corporations use financial derivatives to reduce the volatility of their earnings
stream by hedging exposures to interest rate, exchange rate and commodity
price risks.
2. In world, about one-third of publicly listed firms use financial derivatives. The
use of derivatives is widespread across all sectors of the economy and
increases during periods of greater uncertainty.

3. Non-financial firms that use derivatives are typically larger and more
profitable and have lower volatility of earnings than those that do not use
derivatives. Overall, the firm characteristics of hedgers seem to be consistent
with those found in other jurisdictions.

Islamic derivatives:
Introduction:
A number of instruments/contracts exist in Islamic finance that could be
considered a basis for forward/futures contracts within an Islamic framework.
We will examine three such contracts. These are (i) the Salam Contract,
(ii) the Istisna Contract and (iii) Joala Contract. Each of these

contracts concern deferred transactions, and would be applicable for

different situations. The first and probably the most relevant of these to
modern day forward/futures contracts would be the Salam Contract or Bai
Salam.

Types of Islamic Derivatives:

1. Bai Salam
Salam is essentially a transaction where two parties agree to carry out a
sale/purchase of an underlying asset at a predetermined future date but at a
price determined and fully paid for today. This is similar to a conventional
forward contract; however, the big difference is that in a Salam sale, the
buyer pays the entire amount in full at the time the contract is initiated.
The contract also stipulates that the payment must be in cash form.
Since there is full prepayment, a Salam sale is clearly beneficial to the seller.
As such, the predetermined price is normally lower than the prevailing spot
price. This price behavior is certainly different from that of conventional
futures contracts where the futures price is typically higher than the spot
price by the amount of the carrying cost.

Thus, Bai Salam is subject to several conditions:

i)
ii)
iii)
iv)

Full payment by buyer at the time of effecting sale.

The underlying asset must be standardizable, easily quantifiable
and of determinate quality.
Cannot be based on a uniquely identified underlying.
Quantity, Quality, Maturity date and Place of delivery must be
clearly enumerated.

2. Istisna and Joala Contracts

There are two other contracts where a transaction is made on a yet to
exist underlying assets. These are the Istisna and Joala contracts.

The Istisna Contract has as its underlying, a product to be manufactured.

Essentially, in an Istisna, a buyer contracts with a manufacturer to
manufacture a needed product to his specifications. The price for the product
is agreed upon and fixed. While the agreement may be cancelled by either
party before production begins, it cannot be cancelled unilaterally once the
manufacturer begins production. Unlike the Salam Contract, the payment
here is not made in advance. The time of delivery too is not fixed. Like Bai
Salam, a parallel contract is often allowed for in Istisna.
The Joala Contract is essentially aIstisna but applicable for services as
opposed to a manufactured product.

Options in Islamic Finance

Recall our earlier argument that to be acceptable an instrument/investment

must be free of gharar and not have zero risk in order to provide some
positive return.
The Istijrar Contract is a recently introduced Islamic financing instrument.
The contract has embedded options that could be triggered if an underlying
assets price exceeds certain bounds. The contract is complex in that it
constitutes a combination of options, average prices and Murabaha or cost
plus financing. The Istijrar involves two parties, a buyer which could be a
company seeking financing to purchase the underlying asset and a financial
institution.

At the initiation of the contract; to, both parties agree on the following
two items (i) in the predetermined Murabaha price; P* and (ii) an upper
and lower bound around the Po. (Banks purchase price at to).

where Po
=The price
underlying commodity.

that

bank

pays

P*

=Murabaha price; P* = Po (1+r).

PLB

=The lower bound price

to

purchase

Why Conventional Derivatives are haram in Islam?

The concept of business, trade and finance is very different in Islam than the
one we know which is not Islamic and is ribbah (interest) based. ALLAH swt
has prohibited the dealing in ribbah this is a well known fact. But there are
certain other business related activities which we do not know and so indulge
ourselves in the illegal business activities which are not illegal in the eyes of
the modern system of financing but are surely against Quran and Sunnah.
There is a wide use of financial derivative in the current finance markets. The
derivatives are those financial instruments that derive their value from an
underlying actual asset and these are actually the contracts made between
parties based on some future delivery dates.
Those derivatives that involve any kind of ribbah (interest) based
transactions are already out of the Islamic financial system because dealing
in interest is haram (prohibited) act in Islam. Before going into the
discussion, first take a look at a hadith (saying of MUHAMMAD S.A.W.W)
regarding trading In advance, and then the discussion on the derivatives use
will be furthered.

Some Ahahadiths regarding to Ribah:

Sahihbukhari: Volume 3, Book 35, Number 451:
Narrated Abu Al-Bakhtari:
I asked Ibn Umar about Salam (the fruits of) date-palms. He replied, "The
Prophet forbade the sale of dates till their benefit becomes evident and fit for
eating and also the sale of silver (for gold) on credit." I asked Ibn 'Abbas
about Salam for dates and he replied, "The Prophet forbade the sale of dates
till they were fit for eating and could be estimated."
Summary:
The hadith mentioned above talks about one very basic and important
aspect of trading. We cannot sell what we do not have. How can we sell
dates when they are not ripened yet, or when they are still on trees?
Similarly, we cannot sell or buy an asset which we do not possess or about
which we are uncertain. This hadith tells us that do the trade of that tangible
asset that you have in hand and that you measure or at least try.
Sahihbukhari: Volume 3, Book 35, Number 443:
Narrated Ibn 'Abbas:
The Prophet came to Medina and the people used to pay in advance the
price of dates to be delivered within two or three years. He said (to them),
"Whoever pays in advance the price of a thing to be delivered later should
pay it for a specified measure at specified weight for a specified period."

Holy Quran

also speaks about the contracts made based on future

transactions. It is mentioned in:

surah Al-bakrah: 2:282:

The verse speaks about two aspects, number one is to write down a written
and tangible contract whenever one undergoes into any business deal or
debt; second is the thing described is that there is no need of writing down of
daily transactions that are made as a daily matter.

Opinion of Scholars
We know that all the future transactions based on financial derivatives
involve at least one risk. The most common risk in such trades is the risk of
default. Second thing is that these deals are even made when one party does
not have in hand, the asset for which it is dealing which increases the risk to
a great extent. The risk factor whenever involved in the business or in any
deal makes it uncertain. This uncertainty has been addressed by different
schools of thought as below.
The Holy Quran prohibits gambling (games of chance involving money), and
bayu al-gharar (trading in risk, where the word gharar is taken to mean
risk). Different schools have differing interpretations, of which the three
major interpretations are:

The Hanafimadhab (legal school) in Islam defines gharar as that whose

consequences are hidden;The Sjafi legal school defined gharar as that
whose nature and consequences are hidden or that which admits two
possibilities, with the less desirable one being more likely; and The Hanbali
school defined it as that whose consequences are unknown or that which
is undeliverable, whether it exists or not.
The modern scholar of Islam, Professor Mustafa Al-Zarqa wrote that,
gharar is the sale of probable items whose existence or characteristics are
not certain, due to the risky nature which makes the trade similar to
gambling. There are a number of hadith (traditional sayings, many of the
Prophet) that forbid trading in gharar.
Conversely, Fahim Khan (Islamic Futures and their Markets, Research Paper
No.32, Islamic Research and Training Institute, Islamic Development Bank,
Jeddah, Saudi Arabia, 1996, p.12) states that:
"we should realize that even in the modern degenerated form of futures trading,
some of the underlying basics concepts as well as some of the conditions for such
trading are exactly the same as were laid down by the Prophet (PBUH) for forward
trading. For example, there are clear sayings of the Prophet (PBUH) that he who
makes a Salaf (forward trade) should do that for a specific quantity, specific weight
and for a specified period of time. This is something that contemporary futures
trading pay particular attention to." (Fahim Khan does go on, however, to criticize
the modern futures contract for its exploitation of small farmers.)

Research Paper:
Prospects of An Islamic Derivatives Market In Malaysia
By Dr. Muhammed Hashim Kamali

Derivative market in Malaysia:

Futures trading in Malaysia began in the mid-1980s, apparently not in an
Islamic framework but along American lines. In the early year of its operation
American experts were frequently invited to Malaysia to advice over the
development of the derivatives market here. I personally do not envisage a
major departure from the existing market structures. Islamic derivatives are
likely to develop much in the same way as Islamic banking. The broad outline
of the expected pattern will be a dual market, one of it more familiar and
modeled on the American prototype and the other a newcomer and

somewhat of an unknown quantity perhaps. Nevertheless, the derivatives

market may not be faced with the same kind of duality. Whereas the essence
of the distinction between the conventional and Islamic banks boils down to
an internal disagreement over principles, namely that of interest/riba, no
single factor as such is likely to play a focal role in the derivatives. We may
therefore expect that in some areas of derivatives trading, especially in the
commodities futures and options, the lines of division between the Islamic
and conventional financial instruments will hardly be noticeable, as both will
probably operate over the same underlying assets. We also expect that the
Islamic banking experience will encourage public support for derivatives.
While the derivatives market is an arena mainly for institutional players, the
Islamic banking sector and institutions in Malaysia are likely to support it. A
successful Islamic derivatives market in Malaysia is also likely to attract
participants from other Muslim countries where this facility is generally
absent. But the challenges ahead are likely to be shared by the Islamic and
conventional components of the derivatives market: both will be preoccupied
with issues of viability and diversification not only in the Malaysian context
but also in the highly sophisticated and competitive international market.
And in Malaysia itself, as I said earlier, success in one of the two components
of the derivatives market is likely to encourage the other. The inherent
diversity of the derivatives market makes it potentially more versatile than
the banking sector.
Diversifying the commodity futures and options and providing an adequate
mix of products is a challenging prospect, not only in the Islamic components
of derivatives market, but for derivatives generally. As we are aware, new
contracts are often introduced but fail to take off the ground and are
eventually abandoned for lack of liquidity and volume. Islamic derivatives
will require sustained effort and careful engineering. A selective process is
likely to be involved so as to identify and publicize derivative instruments
whose underlying assets are clear of riba, gambling and trading in prohibited
substances.

The range and number of derivative instruments and products are on the
whole not expected to be large, for reasons obviously of standardization and
volume. The range here is not nearly as wide or diverse as that of the stock
market where standardization and bulk trade is not among the market
imperatives. I may refer here to a recent development in the Malaysian
capital market which relates to our discussion over the potential of Islamic
derivatives. This is the identification in the stock market of the so-called

halal counters. A large number of such counters have been recently verified
and known as such either directly or through the process of cleansing. This
development can be seen as a step forward in the general prospects for
Islamic derivatives. Since trading in the designated halal counters is deemed
permissible, the derivatives instruments that are based upon them would
also be deemed permissible.
To the extent that the current economic downturn in Malaysia has affected
trading volumes in securities, this is obviously expected to have a
dampening effect on the prospects of trading volume and liquidity in the
relevant sectors of derivatives trading, such as the stock index futures in the
halal counters - if one were to introduce futures and options over them.
Trading in commodity futures such as in palm oil contracts in the KLCE, and
other possible candidates of a similar type, may not be necessarily affected
in the same way. The current economic downturn is very much a financial
one, and not a production or commodity-related crisis. We have seen, for
instance, trading in palm oil futures to have enjoyed unprecedented
buoyancy in both volume and price.

Conclusion:

Derivatives instruments require an unusually high level of trading volume

and wide-ranging participation, and Islamic derivative instruments would be
no exception to this. To encourage Muslim participation and involvement in
the future development of such instruments, it is necessary that we come to
grips with the Shari'ah-related concerns about them, especially as
derivatives trading is a relatively new phenomenon in Malaysia and the rest
of the Muslim world outside Malaysia.
I hope that this brief analysis of the issues will further encourage an ijtihad
-oriented discourse that merits credibility and recognition by our Shariah
scholars and all those who are concerned with the economic success and
prosperity of the ummah.

References:
1. Ali Salehabadi & Mohammad Aram. Islamic Justification of Derivatives
Instruments. International Journal of Financial Services. Vol 4, No. 3, Oct- Dec
2002.
2. Dar, H. (2005). Innovation in Islamic finance: marriage of conventional and
Islamic contracts. Islamic Finance News 2, no. 7
3. Dubofsky, D, Options and Financial Futures, McGraw-Hill, 1992

4. Dusuki, A. W. (2009). Shariah parameters on Islamic foreign exchange

swap as a hedging mechanism in Islamic finance. ISRA International Journal of
Islamic Finance 1, no. 1: 77.
5. Hans, R. Stoll and Robert E. Whaley (1993), Futures and Options Theory
and Applications, Ohio: South-Western Publishing Co.
6. Kahf, (2006), Innovation and risk Management in Islamic Finance: Shariah
Consideration. Seventh Harvard International Forum on Islamic Finance, April
22-23, 2006
7. Kamali, (1999), The Permissibility and Potential of Developing Islamic
Derivatives as Financial Instruments, IIUM Journal of Economics
&Management, 7(2), 73-86
8. Khan, M. Akram (1988), "Commodity Exchange and Exchange in Islamic
Economy", the American Journal of Islamic Social Science, Vol. 5, No. 1