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Derivatives under Shariah

BY : KUMAIL RIZVI NABEEL HUSSAIN MURTAZA ABIDI FURQAN SYED KASHAF JAMAL

Introduction of derivatives
A type of a contract between two parties in which one party will deliver a pay off (in money, commodity or a good) to another, sometime in the future It depends on

-- the promisors ability to perform


-- value of the underlying asset or variable

Brief History of Derivatives


First initiated in Mesopatoamia and the Roman World Derivative products initially emerged as hedging devices against fluctuations in commodity price Derivatives came into spotlight in the post -1970 period due to growing instability in the markets.

By 1990 they accounted for 2/3rd of the transactions

Types of derivatives
Futures Forwards Options Swaps

Brief History of Islamic Finance


In the late 1960s, the Islamic scholars developed an Islamic economic philosophy to address modern economic issues

The first Islamic bank explicitly based on shariah principles was established by the Organization of Islamic countries (OIC) in 1974
The Shariah compliant institutions avoid riba(interest), risk/uncertainty (gharar) and speculation(maysir)

Futures/Forwards under Shariah


The Futures transaction in stock and commodities markets today are not permissible for two reasons:

1. According to Shariah that sale or purchase cannot be affected for a future date.
2. In most of the Futures transactions, delivery of the commodities or their possession is not intended. In most cases, the transactions end up with the settlements of difference of prices only, which is not allowed in the Shariah.

Options under Shariah


An option is a promise to sell or purchase a thing on a specific price within a specified period. Such a promise in itself is permissible and is normally binding on the promisor. However this promise cannot be the subject matter of a sale or purchase. Therefore, the promisor cannot charge the promisee a fee for making such a promise.

Since the options (both put and call) transactions are based on charging fees on these promises, they are not valid according to the Shariah.

Islamic Derivatives
Bai 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.
Bai Salam is subject to several conditions:
Full payment by buyer The underlying asset must be standardized

Quantity, Quality, Maturity date and Place of delivery

must be clearly enumerated.

Istisna : under this contract the underlying asset is yet to be manufactured. The buyer contracts a manufacturer for the product with the specifications. The price is agreed upon and fixed but not paid The contract can be cancelled before production starts.

Bail bil-wafa : under this contract, one party sells an asset to a buyer who pledges to sell back the asset to the original owner at a predetermined future date. However, the resale price must be the same as the original purchase price

Ishtijrar : a newly introduced instrument, some what like an option. A typical Istijrar transaction could be as follows; a company seeking short term working capital to finance the purchase of a commodity like a needed raw material approaches a bank. The bank purchases the commodity at the current price (Po ), and resells it to the company for payment to be made at a mutually agreed upon date in the future for example in 3 months. The price at which settlement occurs on maturity is contingent on the underlying assets price movement from t0 to t90. Where t0 is the day the contract was initiated and t90 is the 90th day which would be the maturity day.

The embedded option is the right to choose to fix the price. At the initiation the two parties agree on

1) pre-determined murhaba price which could be p* = Po (1+r), or an average of the price of 90 days. 2) the upper and lower bounds of Po

Jurists view points on conventional derivatives

Futures
Shariah advisory council of securities commission Futures trading of commodities is approved as long as underlying asset is halal Crude Palm Oil Futures Contracts are approved for trading

Fatwa of Omam Al-Haramaini Al-Jauwaini

Futures Trading is Halal if the practice is based on Darurah and the Needs or Hajaat of the Ummah

Ustaz Ahmad Allam; Islamic Fiqh Academy (14/5/1992) Until and unless the underlying asset or basket of securities in the SIF is all Halal; SIF trading is not approved. Mufti Taqi Usmani Sale and purchase cannot be affected at a future date In most futures transactions delivery or possession is not intended. Futures contracts are prohibited whether they are used for speculation or hedging.

Options
Ahmad Muhayyuddin Hassan Maturity beyond three days is unacceptable on grounds of khair al- shart (object to stipulation)

Buyer gets more benefits than the seller


Abu Sulayman (Fiqh Academy Jeddah) Considers options to be detached from the underlying asset and hence unacceptable

Mohd. Obaidullah Dismisses the arguments of gharar and maisir aruguments.

Both buyer and seller take on a risk

Conclusion
Conventional derivative instruments are not acceptable under Shariah due to presence of speculation and unnecessary risk present.

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