Futures, Options, and Risk Management

FIN 4870

Section 1

Group Assignment: Group 5

Derivatives Contracts & Markets in Islamic

Financial and Economics System
Name Matric No
Ahmad Sirajuddin Helmi Bin Abd Rajes 1429041
Mohamad Wafiy Bin Mohd Wary 1422033
Umar Ukasah Bin Abdul Halim 1424289
Syahrul Aman Bin Ismail 1427215
Muhammad Zaki Bin Norman 1428291
Abdul Azim Nadzri Bin Abdul Hafiz 1429997

Instructor:

Dr. Nazrol Kamil Bin Mustaffa Kamil

Date of Submission:
November 20th, 2017
 Derivatives Contracts & Markets in Islamic
Financial & Economics System
1.0 Introduction
In simple words, financial market is place where the trading of financial instruments or
securities such as stocks, currencies, bonds and derivatives takes place. Some of the famous
financial markets in the worlds are like the New York Stock Exchange (NYSE), London Stock
Exchange (LSE) and Tokyo Stock Exchange. Among the financial securities currently being
traded, derivatives can be considered as the youngest as compared to other financial assets
where even the world’s oldest exchange traded financial derivatives, the interest rate futures
came to existence only in the last three decades (Bacha, 2017). According to Hull (2012), a
derivative can be defined as a financial instrument that derives its value from the value of its
underlying assets and the value of the underlying variables will be the prices of the underlying
assets that are being traded. Therefore, this financial instrument does not have or possess a very
small value in it (Bacha, 2017). To illustrate, suppose there is an individual say Mr. A who
buys and owns a cocoa futures contract. The worth of this contract relies on the value of its
underlying asset which is the cocoa itself and its spot price. In the event the value of the cocoa
increases, the value of the cocoa futures contract will increase as well i.e. futures contract
values are dependent on the value of the underlying assets being traded.
Currently, there are three common types of derivative instruments namely; forward
contract, futures contract, and option contract. However, a fourth derivative instrument and is
becoming more popular is known as swap contract. Forward contract according to Bacha (2017)
is a contract involving two contracting parties where both of them agree to perform a
transaction at a later date but at the price fixed today. According to Hourani and Zarai (2014)
futures contracts are contracts that will be exercised at a later date. Hourani and Zarai further
defined futures contract as a contract where the exchange of financial instruments will take
place by means of purchasing and selling with specific rules and conditions together with its
delivery as well as the predetermined price at a later date (as cited in Hanafi, 2003). An option
contract was defined by Imran Iqbal and et al (2012) as an agreement which grants the
purchaser the right. However, he is not obliged to sell or purchase the underlying assets at a
specified price and at a predetermined date in the future. Bacha (2017) defines swap contract
as “a transaction in which two parties simultaneously exchange cash-flows based on a notional
amount of the underlying asset” (p.3).

1
 The issue of the permissibility of derivatives has been debated for many years
particularly pertinent to its permissibility according to shariah ruling. According to Bacha (as
cited in Hashim Kamali, 1995) where Hashim concludes that “there is nothing inherently
objectionable in granting an option, exercising it over a period of time or charging a fee for it,
and that options trading like other varieties of trade is permissible mubah and as such, it is
simply an extension of the basic liberty that the Quran has granted…” (p.16). However, such
argument has attracted numerous opposite arguments i.e. derivatives are considered as haram
according to shariah ruling. It is worth to note that, majority of the opponents of derivatives
have three reasons to disallow derivatives in Islamic financial and economic system. Their
common ground is on the basis that derivatives involve the three prohibited elements in shariah
namely; maysir (gambling), gharar (uncertainty) and riba (usury) (Injadat, 2014).
To further understand this issue, we need to analyze views from both perspectives i.e.
from the derivatives’ proponents as well as the opposition. This paper is meant to provide the
reader with the rationale of the prohibition of derivatives. However, we would also include the
view from the derivatives proponent where it should be allowed as a means for risk hedging
which is permissible according to the shariah since islam does not permit taking excessive risk.
The proponents’ view also serves as a means for a better understanding and also for the purpose
of comparison. Our view regarding this matter is we believe that derivatives contracts and
markets should not be part of an Islamic financial and economic system due to the presence of
the prohibited elements by the shariah such as gharar and maysir.

2
2.0 Arguments prohibiting derivatives.
2.1 Element of Gharar

Derivatives contracts involve many aspects that contradict with the shariah principles.
One of the Shariah principles that derivatives contracts have violated is the presence of the
element of gharar which literally means uncertainty. According to Islamic Research and
Training Institute (2000), gharar can be defined as “a state of uncertainty that exists when the
process of concluding a transaction involves an unknown aspect” (p.264) (as cited in Kasri and
Ansary 2013). In any transaction, when the element of uncertainty exists, the result may or may
not materialize. For instance, when we entered into a derivative contract, we are not certain
whether at the end of the contract the commodity will be delivered or not. That level of
uncertainty is prohibited in Islam. It can be seen clearly in this contract the element of gharar
as delayed in the delivery of its counter-values (as cited in Kasri and Ansary, 2013).
However, there are some arguments from Shariah Advisory Council (SAC), arguing
that it is allowed to sell something that does not exist at the time of sale take place. Shariah
Advisory Council stated that this argument is based on bay’ ma’dum transaction that allows
the sale to be done even though commodity will only be delivered in the future (as cited in
Kasri and Ansary, 2013). However, according to in Majelle Ottoman Civil Code (n.d) “the
thing sold must be in existence” and “the sale of a thing which is not in existence is void” (as
cited in Uddin, 2015).
As we can see in the contract of futures, where it involves sales of something that is not
owned by the seller therefore it leads to gharar. Ibn Qudamah (1491H) and Al-Sanani (1335H)
further mentioned that sales of something that is not owned by the seller is haram (as cited in
Uddin,2015). Ibn Abdeen (n.d) and Al-Sywasi (n.d) also argued that sales that lack of
ownership contain the element of uncertainty or gharar (as cited in Uddin,2015).
On top of that, the element of gharar also exists in Eligible Delivery Agreement.
Eligible Delivery Agreement is a kind of agreement that standardizes the effect of which the
person who is under the obligation to make or accept delivery at a future time with a quantity
that agree in the agreement (Kasri, 2013). The buyer and seller are allowed to surrender their
position to other party before the agreement matures by selling his position and enter into the
new Eligible Delivery Agreement. By the time agreement matures, the buyer and the seller
might not be the original buyer and original seller who entered the agreement in the first place
but they could be anyone that hold buying and selling position when the delivery is finally
materialized. An element of gharar exists when the buyer or seller sells their futures position

3
to the new buyer in which they sell something that they do not own or possess at the time of
sale (Kasri, 2013).

Everything regarding the quantity, quality, delivery process and the price trading limit
will be included in the contract specification. However, the absence of fixed delivery date in
contract causes uncertainty, especially to the buyer (Kasri, 2013). There is no actual date for
the delivery mentioned in the contract. This actually contradicts with the salam transaction in
which the buyer should know about the volume and delivery date of the goods (Bukhari, as
cited in Kasri 2013). The International Fiqh Academy also mentioned that futures contract and
salam contracts are not identical in the sense that the price in the future contracts will be
deferred until the date of maturity meanwhile in the contract of salam the price to be paid for
the contract can be deferred up to three days (as cited in Uddin,2015).
There are also disputes in between the Shariah jurists regarding the issue of legality of
the sale with the deferment of both counter-values. This counter-values refers to crude palm
oil and its payment. The issue arises due to the agreement of sale is identical to the sale of one
debt to another debt (ISRA, as cited in Kasri,2013). According to the hadith of al-kali’bi-al-
kali’, it is prohibited to have any exchange or sale contract that involves delay terms. This
includes the transfer of title and also for actual payment or delivery of both counter-values.
This rule restricts the deferral of the trading both counter-values, paying little mind whether
one or both of the products are dayn or ‘ayn in which according Uddin (2015), bay’ al-kali bil
kali is considered as usury or riba by both Ibn Taymiyyah and Ibn Al-Qayyim and therefore it
is an invalid legal benefit and leads to excessive risk and uncertainty.
Undoubtedly, the presence of the element of gharar is prevalent in futures contracts.
Such uncertainty that exists in the transactions may cause delivery failure, seller may delay or
revoke the deal and risky to poses high risk to buyer due to the possibility of not receiving the
goods in the future.

4
2.2 Element of Maysir

Another reason why derivative contracts and markets are opposed is due to the presence
of elements of Maysir in the derivative contract itself. Maysir can be defined as any activity
which is purely dependent on chance and luck whereby the winner will take all and the loser
will lose all which means that one will gain at the expense of the other and it is also known as
a zero-sum game (International Shari’ah Research Academy for Islamic Finance, as cited in
Kasri, 2013). Assad (1984) also defined maysir as “a game of chance” (as cited in Smorlaski,
Schapek and Iqbal,2006). In Islam, maysir is strictly prohibited because it causes people to be
totally be dependent on luck and chance instead of earning something with their efforts, as it
may lead to hatred, enmity and greed as well as it brings harm to the society (Yusuf, as cited
in Kasri, 2013). The discussions on the topic of maysir in derivatives will be narrowed down
specifically on the future margin system and offsetting transaction revolves around the element
of betting and chance and the unlawful gain of one party at the expense of the other which leads
to hatred and enmity between the two parties.
There are views that agreed that the margin payment is considered as a betting
mechanism since the margin payment is to account for the movement of the daily prices. In
gambling, the losers will have to pay for their losses to the winner. Same goes to the margin
payment, the payment is made compulsory to ensure that the loser has the money to pay to the
gainer (Syed, as cited in Kasri, 2013). After all, the futures contract can be seen as a betting
contract whereby the two parties “bet” on the price movement of the commodity by locking in
the price now. If the price moves in the favor of one party, that person wins and the other party
loses. In other words, futures contracts constitute game of chance. This is due to the fact one
party can only gain when the other party loses and this is similar to the concept of zero-sum
game (Bacha, 2017).
With regards to the unlawful gain at the expense of another, it is done through mark-
to-market system. In futures contract, the two parties have to pay the initial margin first and
any subsequent movement of prices will be reflected on their account on daily basis whereby
if one party gains on that particular date, his account will increase by that amount and another
party’s account will decrease by that amount (Suwailem, as cited in Kasri, 2013). The money
that came into the gainer’s account is the loser’s money and this constitutes gain at the expense
of the other which is one of the elements of gambling or maysir. This type of activity is akin to
speculation since it is used as a means to exploit the fluctuation in prices for the sake of earning
capital gains (Uddin,2015). To further understand the mechanism, let us look at this simple

5
example whereby two parties paid initial margin amounting to RM 10 when the spot price is
RM 100. If on the next day the spot price changes to RM 99, the one who shorts the contract
will gain RM 1 and the one who longs the contract will lose RM 1 and the loser’s money will
be transferred to the gainer’s account. At the end of the day, the one who shorts the contract
will have RM 11 in his/her account while the one who longs the contract will have RM 9 in
his/her account. This clearly shows that the gainer can only gain at the expense of the other and
this is one of the elements of gambling or maysir which is strictly prohibited in Islam.
Gambling practices can also lead to hatred and enmity between the parties involved
which is one of the reasons why gambling or maysir is prohibited in Islam. As the points stated
above implies that futures contract constitutes gambling therefore it has the potential to produce
this vice. Yusuf (as cited in Kasri, 2013) said that in gambling there will always be a winner
and a loser, the one who lose will feel frustrated due to anger and disappointment at the loss of
money. While some may say it is normal to feel angry and disappointed due to losing, we
should not take this for granted. There was a case in 1999 when Mark Barton, an Atlanta day
trader who had suffered a huge loss from his speculative trading went on a killing spree (Kasri,
2013). This shows that we shouldn’t take these emotions lightly though they might seem
insignificant. A continuous stream of anger and frustration might lead to a bigger and worse
emotion as what happened in the above case.
In conclusion, based on the evidences above, futures contract can be said to have the
elements of maysir which are the element of betting and chance, unlawful gain of a party at the
expense of the other which results in hatred and enmity between the two parties. While the
former’s arguments aren’t as strong as the latter, it is undeniable that the essence of the
elements of maysir is still there hence derivatives should not be a part of the Islamic economic
and financial system.

6
3.0 Arguments Supporting Derivatives

The proponents of derivatives believe that derivatives are not prohibited in Islam if they
are used as a means to hedge risk. The discussion on the permissibility of the usage of
derivatives in hedging risk will be focusing on the options contract. Options contract as defined
in the earlier part of this paper as an agreement which grants the purchaser the right. However,
he is not obliged to sell or purchase the underlying assets at a specified price and at a
predetermined date in the future (Imran Iqbal et al, 2012). Smorlaski et al (2006) defines risk
as “actual results varying from the expected outcomes” (p.427). We will look at the mechanics
of options’ trading, the settlement process and also the reasons for trading options. According
to Smorlaski et el (2006), risk-reduction by ways of hedging the underlying position is
considered as permissible by the shariah ruling. This is due the presence of a third party whose
job is to handle the trading process, the settlement together with the process of clearing which
will reduce gharar. To further understand this matter, how hedging is used to manage the risk
needs to be understood first.
Before continuing with the illustration, it is imperative to understand the type of options
contracts available. According to Galitz (1995), there are two types of options namely; call
option which gives the buyer the right to purchase a certain underlying asset at a fixed price in
the future date, whereas a put option is type of option that gives the seller a right to sell a certain
quantity of underlying asset at a certain fixed price in the future date. In both transactions, the
selling or purchasing rights can be exercised on or before the date of maturity (as cited in
Smorlaski et al, 2006).
Suppose individual W wishes to purchase 1000 shares of KLM on December 31, 2005
at RM 120 per share. It is given that the current price of KLM’s shares is RM 120 per share.
Suppose the market price of a KLM share call option is RM 10 per option right. Individual W
will buy the call options at the price of RM 10 per share which in return will provide him with
the right to purchase KLM shares at RM 120 per share. In the event that on the December
31,2005 the price of KLM shares rises to RM 140 per share, individual W would exercise the
option and purchase the share at RM 120 instead of RM 140 since he has paid the premium of
RM 10 per share to grant him the right. What will happen is, individual A will get a gain of
RM 10 per share [ RM 140-RM 120-RM 10]. This results from the individual A’s motive which
is to hedge the price of KLM share due to risk price i.e. fluctuation of prices of KLM share.

7
 One may argue about the premium paid as injustice and burdensome. However,
according to Kamali (1997), the premium charged is essentially a compensation received by
the seller for providing the options right to the purchaser (as cited in Smorlaski et al, 2006).
The next discussion will be on the basis to rebut the arguments by the opposition of
derivatives. With regards to the issue of selling what is not owned by the seller as it seems to
be the most popular critics about derivatives. The issue of the presence of gharar in derivatives
transaction is argued by Smorlaski et al (2006) with regards to the hadith by Prophet
Muhammad S.A.W where the sales mentioned by the prophet does not apply to fungible goods.
Ibn Al-Qayyim (n.d) also agreed that the hadith was referring to a specific item (as cited in
Smorlaski et al,2006). Next, with regards to the issue of bai al-kali bil kali, Hamoud (n.d)
argued that the deferring both in exchange is allowable on the basis of principle of muawadhah
(as cited in Smarloski et al, 2006). Further, Al-Abani (n.d, as cited in Smorlaski, 2006) and
Kamali (1999) and Al-amine (2001) (as cited in Kasri,2013) regarded the hadith regarding bai
al-kali bil kali as weak and therefore should not be used as basis for the prohibition.
One of the prominent arguments behind the rationale of permitting derivatives is it is
accepted under dharurat i.e. dire need. Bacha (1999) regards trading of derivatives as
acceptable in Islam due to the principle of necessity or dharurah (as cited in Uddin, 2015). In
fact, according to the Shariah Advisory Council of Securities Commission Malaysia futures
trading of commodities is permitted as long the underlying assets do not fall under the
categories of impermissible items (as cited in Uddin, 2015).

8
4.0 Conclusion

The differing in opinions with regards to the permissibility of derivatives indeed

provides detailed explanations on the ‘hows’ and the ‘whys’ derivatives should be considered
as permissible or vice versa. The proponents of derivatives provided arguments on the basis of
istihsan, maslahah as well as dharurah or dire need (Uddin,2015). They further argued that the
business world is very complex thus it calls for the needs to allow derivatives. However, the
rationales provided by the scholars pertinent to the prohibition of derivatives seems to be more
prevalent especially with the fact that the permissibility of derivatives happens only in
Malaysia whereas, the OIC Fiqh Academy and Islamic Fiqh Academy had come to conclusion
that derivatives are considered as prohibited under the shariah ruling (Uddin,2015).
We have to admit that arguments provided by the proponents are very persuasive in the
sense that it would help to make Islamic financial market and economics systems to be more
competitive. However, the confutation arguments by the opposition seems to outrank the
arguments by the former. In conclusion, after special consideration given the scrutiny of the
rationales and arguments given, we believe that indeed derivatives should not be included as
part of the Islamic financial and economic system.

9
 5.0 References

Bacha, O. I. (2013). Risk management, derivatives and shariah compliance.

doi:10.1063/1.4801099

Bacha, O. I. (2017). Financial Derivatives: Markets and Applications in Malaysia. Shah Alam:

McGraw-Hill (Malaysia).

Hourani, Y. A., & Zarai, M. A. (2014). Investment in Financial Derivatives Contracts from an

Islamic Perspective. International Finance and Banking,1(1). doi:10.5296/ifb.v1i1.5442

Hull, J. (2012). Options, futures, and other derivatives(8th ed.). New York, NY: Pearson.

Injadat, E. M. (2014). Futures and Forwards Contracts from Perspective of Islamic Law. Journal

of Economics and Political Economy,1(2). Retrieved from www.kspjournals.org.

Iqbal, I., Kunhibava, S., & Dusuki, A. W. (2012). Application of Options in Islamic

Finance. ISRA Research Paper,(46).

Kamali, M. H. (1999). Prospects for an islamic derivatives market in Malaysia. Thunderbird

International Business Review,41(4-5), 523-540. doi:10.1002/tie.4270410413

Kasri, N. S. (2013). Maysir in the Crude Palm Oil Futures Contract: A Critical Analysis of the

Resolution of the Malaysian Securities Commission Shariah Advisory Council - Part 2. ISRA

Research Paper,(63).

Kasri, N. S., & Abd Rahman, Z. (2016). Issues in Islamic Hedging Practices: A Critical

Analysis. ISRA Research Paper,(88).

Khasri, N. S., & Ansary, R. (2013). Gharar in the Crude Palm Oil Futures Contract: A Critical

Analysis of the Resolution of the Malaysian Securities Commission Shariah Advisory

Council - Part 1. ISRA Research Paper,(62).

10
Rizvi, S. A., Arshad, S., & Lahsasna, A. (2014). Derivatives in Islamic finance: the need and

mechanisms available. International Journal of Financial Services Management,7(3/4).

doi:10.1504/ijfsm.2014.065572

Smolarski, J., Schapek, M., & Tahir, M. I. (2006). Permissibility and use of options for hedging

purposes in Islamic Finance. Thunderbird International Business Review,48(3), 425-443.

doi:10.1002/tie.20103

Uddin, M. A. (2015). Conventional Futures: Derivatives from Islamic Law of Contract

Perspective. Munic Personal RePEc Archive. Retrieved from https://mpra.ub.uni-

muenchen.de/70147/.

11