Chapter 13

DERIVATIVE INSTRUMENTS AND
ISLAMIC FINANCE
CHAPTER 13
Chapter Objectives
• This Chapter provides an overview of Islamic financial contracts that have the features
of modern day derivatives.
• On completion of this chapter you should have a good appreciation of the necessary
features for an Islamic financial instrument.
• You should also have a good understanding of several Shariah compliant structured
products and their mechanisms for use in risk management.
CHAPTER 13: Derivative Instruments and Islamic Finance Copyright © 2017 by McGraw-Hill Education (Malaysia) Sdn. Bhd.
3
Necessary Features for Islamic Financial Instruments
• All Islamic financial instruments and transactions in general must meet a number of
criteria in order to be considered halal (acceptable).
• At a primary level, all financial instruments and transactions must be free of at least
the following five items:
• Riba (usury)
• Riba which literally translates to usury is more commonly referred to as the charging of interest.
• Riba can be in different forms and is prohibited in all its forms.
• Rishwah (corruption)
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• Maysir (gambling)
• Maysir from a financial instrument viewpoint would be one where the outcome is purely
dependent on chance alone – as in gambling
• Gharar (unnecessary risk)

• It has been taken to mean, unnecessary risk, deception or intentionally induced uncertainty.
• In the context of financial transactions, gharar could be thought of as looseness of the underlying
contract such that one or both parties are uncertain about possible outcomes.
• Jahl (ignorance)
• Jahl refers to ignorance. From a financial transaction viewpoint, it would be unacceptable if one
party to the transaction gains because of the other party’s ignorance.
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• The Shariah has some basic conditions with regards to the sale of an asset (in this case
a real asset as opposed to financial assets).
• Since a derivative instrument is a financial asset dependent on the value of its

underlying asset (real asset in most cases), the Shariah conditions for the validity of a
sale would also be relevant.
• The underlying asset must be halal
• The underlying asset or commodity must currently exist in its physical, sellable form
• The seller should have legal ownership of the asset in its final form.
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Islamic Finance Instruments with Features of Derivative
Instruments
• Ba’i Salam
• Ba’i 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.
• The seller agrees to deliver the asset in the agreed quantity and quality to the buyer at the
predetermined future date.
• This is similar to a conventional forward contract with the big difference being 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.
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Instruments
• Ba’i Salam
• The Ba’i Salam contract is subject to several conditions, of these the important ones are as follows:
• Full payment by buyer at the time of effecting the sale.
• The underlying asset must be standardizable, easily quantifiable and of determinate quality.
• A Salam contract cannot be based on an uniquely identified underlying asset. This means the underlying
commodity cannot be based on a commodity from a particular farm/field etc.
• Quantity, quality, maturity date and place of delivery must be clearly enumerated in the Salam agreement.
• The underlying asset or commodity must be available and traded in the markets throughout the period of
contract.
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Instruments
• Ba’i Salam
• The current exchange traded futures would conform to the conditions of Ba’s Salam with the
exception of the first, which requires full advance payment by the buyer.
• Given the customized nature of Ba’i Salam, it would more closely resemble forwards rather than
futures.
• Some of the problems of forwards, namely ‘multiple-coincidence’, potential for price squeeze and
counterparty risk can exist in the Salam sale.
• Counterparty risk, however, would be one-sided, in that, since the buyer has fully paid.
• In order to overcome the potential for default on the part of the seller, the Shariah allows for the
buyer to require security which may be in the form of a guarantee or mortgage.
9
Instruments
• Ba’i Salam
• This contract could also form the basis for the provision of working capital financing by Islamic financial
institutions.
• Since financial institutions would not want possession of the underlying commodity, parallel contracts
may be used.
• Not all jurists are in agreement about its permissibility, the literature cites two venues for parallel Salam.
• The first is a parallel Salam with the original seller while the other is an offsetting transaction by the financial
institution with a third party.
• In the first alternative, the financial institution after entering into the original contract, gets into a parallel Salam to
sell the underlying commodity after a time lapse for the same maturity date to the original seller.
• The resale price would be higher and considered justifiable since there has been a time lapse. The difference
between the two prices would constitute the bank’s profit.
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Instruments
• Ba’i Salam
• This contract could also form the basis for the provision of working capital financing by Islamic
financial institutions.
• Since financial institutions would not want possession of the underlying commodity, parallel
contracts may be used.
• Not all jurists are in agreement about its permissibility, the literature cites two venues for parallel
Salam.
• The first is a parallel Salam with the original seller while the other is an offsetting transaction by the financial
institution with a third party.
• The second is when the bank which had gone into an original contract enters into a contract promising to sell
the commodity to a third party on the maturity date of the contract.
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Instruments
• Istisna and Joa’la
• The Istisna & Joa’la contracts can be thought of as variants of the Ba’i Salam.
• 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.

• Unlike the Salam contract, the payment here is not made in advance.
• A parallel contract is allowed for in Istisna. Thus, the Istisna contract may be used by Islamic banks for
product financing.
• The Joa’la contract is essentially a Istisna but applicable for services as opposed to a manufactured
product.
• The conditions described for the Istisna contract apply in the case of Joa’la.
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Instruments
• The Istijrar Contract
• The Istijrar is a financing contract with embedded options.
• If the spot price of the underlying asset exceeds predetermined bounds than the parties have the
right to exercise the option to fix the settlement price at the predetermined Murabaha price.
• The Istijrar involves two parties, a buyer which could be a company seeking financing to purchase
the underlying asset and a financial institution.
• Istijrar contract is a recently introduced Islamic financing instrument in Pakistan
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Instruments
• Istijrar Contract
• Illustration:
• 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 asset’s 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.
• Unlike a Murabaha contract where the settlement price would simply be a predetermined price, P* where P*
= Po (1 + r), the price at which the Istijrar is settled on maturity date could either be P* or an average price (
P) of the commodity between the period t0 an t90.
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Instruments
• Illustration:
• As to which of the two prices will be used for settlement will depend on how prices have behaved and which
party chooses to ‘fix’ the settlement price.
• The embedded option is the right to choose to fix the price at which settlement will occur at anytime before
contract maturity.
• 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 (bank’s purchase price at to).
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Instruments
• Illustration:
• For either party to exercise its option and thereby fix the settlement price at P*, the spot price during the
term of the contract must have exceeded the bounds at any time.
• As to which party would exercise would of course depend on the direction of the spot price movement.
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Instruments
• Illustration:
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Instruments
• Illustration:
• Analyzing the Istijrar contract in its entirety from an option’s viewpoint is complicated since it has two
different exercise styles rolled into one.
• The embedded options in the Istijrar can simply be thought of as follows: The fact that the buyer gets to fix
the buying price at P* when the price goes higher implies that he has a call option at an exercise price of P*
while the bank a put option at the same exercise price.
• The maximum potential gain or loss is limited.
• Such a contract fulfills the need to avoid a fixed return on a riskless asset which would be considered riba
and also avoids gharar in that both parties know up front P* and the range of other possible prices.
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Instruments
• Bai-Al-Urbun
• In an urbun contract, the buyer of a product may place with the seller a small deposit in exchange for
which, the seller might grant a period of time, at the end of which the buyer forfeits his deposit.
• If the buyer goes ahead with the transaction within the stipulated time, then the buyer pays the
agreed price less the urbun payment made earlier.
• The typical period of time granted in an urbun is 3 days, similar to a 3 day call option.
• In the case of options, regardless of whether it is exercised or not, the premium paid is never
recovered while in the case of the urbun, the deposit placed is deducted from the agreed price to
take delivery from the seller.
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Instruments
• Bai-Al-Urbun
• Bai-al-urbun has two variants:
• A non-refundable urbun.
• The non-refundable urbun is one where the deposit placed is lost to the seller if the buyer decides not to go
ahead with the transactions.
• This is also the variant which is more controversial, in that with the exception of the Hanbali madzhab, which
permits it. The Maliki, Shafii’ and Hanafi madzhabs find it objectionable.
• A refundable urbun
• The refundable urbun on the other hand is acceptable to all four madzhabs.
• The refundable urbun is one where the deposit placed by the buyer is returned to the buyer if he chooses
not to proceed.
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Instruments
• Bai bil-wafa and Bai bil-Istighlal Contracts
• Bai bil-wafa is financial contract that would resemble the convential REPO or repurchase agreement.
REPOs are commonly used with shortterm/money market money instruments.
• Bai bil-wafa works in a the following way.

• One party sells an asset to another, promising to buy it back at a future period. The buyer can only resell the
asset to the original party and not to a third party.
• Bai bil-wafa is really a composite contract that has two elements – Bai (sale) and rahnu or rihn (pledge).
• The rihn element prevents the buyer from selling the asset to any other party.
• Unlike conventional REPO, initial selling price and the repurchase prices are equal. Secondly, while a
REPO is always of fixed maturity, the bil-wafa can be terminated by either party at anytime.
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Instruments
• Bai bil-wafa and Bai bil-Istighlal Contracts
• Bai bil-Istighlal can be thought of as an extension of the bil-wafa contract that includes an ijarah
(lease).
• In a bil-Istighlal contract, one party sells an asset to a buyer who immediately pays the sale price in
full.
• In the Bai bil-Istighlal contract ownership changes allowing the buyer to lease-back (ijara) the asset
to the seller for fixed lease payments.
• The lease/ijara will be in effect until the original seller repurchases the asset.
• The Bai bil-Istighlal therefore would be a contract much more amenable for use in modern financial
markets.
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Instruments
• Islamic Structured Products
• Structured products are essentially investment products custom designed by banks.
• Given the lack of harmony in Shariah viewpoints, but the reality of risk management needs, many
players appear to have taken the route of structured products.
• Based on a willing buyer-willing seller premise, the Shariah compliance needs no broad public
consensus, merely the approval of each party’s Shariah committee.
• An interesting innovation is the Islamic Profit Rate Swap (IPRS) structured by CIMB and validated by
the National Shariah Advisory Council (NSAC) of Bank Negara.
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Instruments
• Mechanics of the Islamic Profit Rate Swap
• Stage 1:
• In the first stage, the Islamic bank would sell an asset to a counterparty for a notional amount. The
counterparty then resells the asset to the Islamic bank at notional principal plus a fixed mark-up profit rate.
• The net result of this stage is that the notional amounts cancel out, leaving the Islamic bank as the fixed
profit payer. This fixed rate is payable according to the reset period.
• Stage 2:
• In the second stage of the transaction, the Islamic bank sells an asset to the counterparty for a notional
amount plus a floating rate (based on an agreed upon reference rate).
• In exchange, the counterparty resells the asset to the Islamic bank for the notional amount. The net result of
this second stage is that the counterparty becomes the floating profit rate payer.
• On completion of both stages, the Islamic bank is the fixed profit rate payer and floating rate
receiver while the counterparty is in the opposite position.
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Instruments
25
Instruments
• The IPRS can be used by Islamic financial institutions to manage rate risk and asset-liability mismatches.
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Shariah Views on the Trading of Currency and Shariah
Compliant Tools for Managing Currency Risk
• The Shariah viewpoint on the trading of currencies is based on the legal definition of
the currency exchange (sarf) contract, which is:
• The exchange of one monetary form for another in the same or different genera, i.e. gold for gold
coins, silver for silver, gold for silver, silver for gold etc. whether it is in the form of jewelry or minted
coins.
• Such trading is permitted since the Prophet (pbuh) permitted such exchange.
However, in addition to the 5 basic conditions currency exchange contracts require the
fulfillment of the following four additional conditions.
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Shariah Views on the Trading of Currency and Shariah
Compliant Tools for Managing Currency Risk
• Mutual receipt prior to the contracting parties’ parting
• Equality of quantities if monies of the same genus are traded
• Inapplicability of additional conditions (syart)
• Non-deferment.
• The need for these conditions arise from the saying of the Prophet (pbuh):
‘Gold for gold, in equal amounts, hand-to-hand; and silver for silver, in equal amounts, hand-to-hand’,
as well as his (pbuh) saying: ‘Do not trade one of them absent (thus, deferred) for the other
immediately delivered’.
• These were authenticated by major narrators as

‘Gold for gold, silver to silver, wheat for wheat, barley for barley, dates for dates, and salt for salt, in
equal amounts, hand-to-hand; and if the genera differ (in an exchange), then trade as you wish
provided it is hand-to-hand’.
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Shariah Views on the Trading of Currency and Shariah Compliant Tools for
Managing Currency Risk
• Based on the these viewpoint, fuqaha had for long withheld permissibility of currency
trading.
• In view of the genuine need for hedging for companies in cross border business, there
had been much ‘pressure’ on the fuqaha to review the prohibition.
• There have been a number of developments that have made Shariah compliant tools
possible.
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• The convention of Fiqh scholars at its Muktamar in Kuwait (1409H) recommended that
forward and futures contracts be transacted based on Islamic nominate contracts such
as Salam Sarf and wa’ad.
• The OIC’s Islamic Fiqh Academy pronounced that the wa’ad is obligatory and can stand
in a court of law if it is made as a unilateral promise in a commercial transaction and if
violation of the promise can cause one to incur liabilities or losses.
• BNM’s Shariah council in its resolution of April 2005 pronounced that IFI’s are allowed
to enter forward currency transactions based on a unilateral binding promise (wa’ad).
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• Islamic FX Forward
• Under this arrangement, an IFI provides a unilateral promise (wa’ad) to a customer in return for a
fee.
• Depending on the customer’s needs, the wa’ad by the IFI could be either buy or sell a currency in
exchange for another at a predetermined price and future date.
• Depending on the IFI’s product structure, there may be another unilateral wa’ad by the customer to
the IFI.
• The customers’ wa’ad would obviously be in the opposite direction that is promising to deliver or
take delivery of the currency from the IFI at a predetermined price/exchange rate.
• By way of these wa’ad arrangements, a customer effectively ‘locks-in’ the exchange rate at which he
will buy or sell a currency to the IFI.
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Islamic FX Forward - Illustration
• A Malaysian importer has a Korean Won, KRW 60 million payable to Samsung Corporation of Korea
for a shipment of electrical appliances.
• Payment is due in 60 days. The Malaysian company is afraid of any appreciation of the KRW against
the ringgit.
• To hedge this risk, the Malaysian company enters into an Islamic FX Forward wa’ad contract as
follows with a Malaysia IFI.
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Islamic FX Forward - Illustration
33
Islamic FX Waád Option
• Islamic FX wa’ad (FX Option)
• This structured product effectively replicates a conventional currency option.
• A customer intending to use this product will ‘buy’ a promise from the IFI to either buy or sell one
currency for another for a fee.
• In essence, the customer is buying the right to buy or sell a currency at a predetermined rate for a
fee. At a future maturity date, the customer can ‘exercise’ this right.
• Illustration: Suppose the Malaysian company in the earlier example wants to use a wa’ad based
option rather than the wa’ad forward, then, the structure and cash flows would be as follows
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Islamic FX Waád Option - Illustration
35
Islamic FX Waád Option - Illustration
• Islamic FX wa’ad (FX Option) – Illustration
• Malaysian company is effectively long a 60 day call option on 60 million KRW.
• Suppose the IFI charges a fee of RM20,000 for the wa’ad option then the Malaysian company is
assured that its maximum cost on the shipment from Samsung is:
Payment on exercise = RM 3,157,800.00
Fee (Premium) paid to IFI = RM 20,000.00
Maximum cost = RM 3,177,800.00
• With the wa’ad option, the Malaysian company is buying itself insurance against an appreciation of
the KRW.
• While the forward protects against a KRW appreciation, it does not allow the company to take
advantage of a potential depreciation. The FX wa’ad option contract does.
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Islamic Banks and Derivative/Structured Products.
Bank Wa’ad Based Hedging Products
Wiqa’ Profit Rate Swap (WPRS)
Bank Islam Wiqa’ Forward Rate Agreement (WPRA)
Islamic FX Forward
Bank Muamalat Forward Foreign Exchange
Islamic Foreign Exchange Spot
Islamic Foreign Exchange Forward
CIMB Islamic Foreign Exchange Swap
Islamic Profit Rate Swap (PRS-i)
Cross Currency Profit Rate Swap (CCPRS-i)
Islamic Profit Rate Swap
RHB Islamic Cross Currency Swap
Dual Currency Investment-I (DCI-i)
Islamic Profit Rate Swap
Islamic Cross Currency Swap
Maybank
Islamic Foreign Exchange Undertaking (Options)
Structured Product - Islamic Range Accrual
KFH KFH Promissory FX Contract-i
Islamic Profit Rate Swap (IPRS)
Islamic Cross Currency Swap (ICCS)
Standard Chartered Saadiq
Islamic Forward Rate Agreement (IFRA)
FX Forward-i
Dual Currency Investment-i
HSBC Amanah
Structured Investment-i
Islamic Profit Rate Swap (IPRS)
Hong Leong Islamic
Islamic Cross Currency Swap (iCCS).
Al-Rajhi Forward Forex- i
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Islamic View of Current Day Derivative Instruments
• The validity and permissibility of derivatives appears to vary by scholar/ jurists.
• Even where Islamic scholars have found them objectionable, their reasons for
objection differs. There does not appear to be a consensus.
• Much of the work by Islamic scholars has been of a highly juridical nature. They
examine derivatives within narrow confines of contractual arrangements and thereby
miss the broader picture of why they are needed in modern business environments.
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• Opinions on Futures Contracts
• Fatwa of Imam Al-Haramaini Al-Jauwaini
• The trading of futures is halal if the practice is based on Darurah and the needs or Hajaat of the ummah
• Syariah Advisory Council (SAC) of Securities Commission, Malaysia
• (a) Futures trading of commodities is approved as long as underlying asset is halal.

• (b) Crude Palm Oil futures contracts are approved for trading.
• (c) For Stock Index Futures (SIF) contract, the concept is approved.
• However, since the current FBM KLCI based SIF has non-halal stocks, it is not approved.
• Thus, it implies that an SIF contract of a halal index would be acceptable.
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• Opinions on Futures Contracts
• Ustaz Ahmad Allam (Islamic Fiqh Academy – Jeddah, 1992)
• Stock Index Futures (SIF) trading is haram, since some of the underlying stocks are not halal.
• Until and unless the underlying asset or basket of securities in the SIF is all halal, SIF trading is not approved.
• Mufti Taqi Usmani (Fiqh Academy – Jeddah)
• Futures transactions not permissible for two reasons:
• (a) According to the Shariah, sale or purchase cannot be affected for a future date.
• (b) In most futures transactions, delivery or possession is not intended.
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• Opinions on Option Contracts
• Ahmad Muhayyuddin Hassan (1986)
• Objects to option trading for 2 reasons:

• (a) Maturity beyond three days as in al-khiyarat is not acceptable.
• (b) The buyer gets more benefits than the seller – injustice.
• Abu Sulayman (Fiqh Academy – Jeddah, 1992)

• Acceptable when viewed in the light of bai-al-urbun but considers options to have been detached and
independent of the underlying asset – therefore, unacceptable.
• Mufti Taqi Usmani (Fiqh Academy – Jeddah)

• Promises as part of a contract is acceptable in Shariah, however the trading and charging of a premium for
the promise is not acceptable.
• Yet others have argued against options by invoking ‘maisir’ or unearned gains; that is, the profits from
options may be unearned.
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• El Gari (1993) & Yusuf Qaradawi
• El Gari argues in favour of call options based on the framework of bai-al-urbun.

• Yusuf Qaradawi argues that the ruling by Ibn Hanbal on urbun should be adapted to modern
times. Implying that the use of options could be justified on the basis of urbun.
• Hashim Kamali (International Islamic University Malaysia, 1998)
• Finds options acceptable.

• Invokes the Hanbali tradition, cites Hadiths of Barira (RA) and Habban Ibn Munqidh (RA).
• Also draws parallels with the bai-al-urbun in arguing that premiums are acceptable.
• Cites that contemporary scholars such as Yusuf al-Qaradawi and Mustafa al-Zarqa have
authenticated bai-al-urbun.
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• Shariah Advisory Council (SAC) Securities Commission, Malaysia
• No formal opinion on options. The fact that there are no equity options, only index options available
currently has meant that there is no urgency. Index options are disallowed based on the argument that some
of the stocks in the FBM KLCI are non-halal.
• However, the SAC has approved as halal the trading of warrants/ TSRs as long as the underlying stock is
designated as a halal stock.
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Thank You

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DERIVATIVE INSTRUMENTS AND

• Gharar (unnecessary risk)

• Since a derivative instrument is a financial asset dependent on the value of its

• The price for the product is agreed upon and fixed.

• Istijrar contract is a recently introduced Islamic financing instrument in Pakistan

• The maximum potential gain or loss is limited.

• Bai bil-wafa works in a the following way.

• These were authenticated by major narrators as

• Syariah Advisory Council (SAC) of Securities Commission, Malaysia

• (a) Futures trading of commodities is approved as long as underlying asset is halal.

• Thus, it implies that an SIF contract of a halal index would be acceptable.

• Mufti Taqi Usmani (Fiqh Academy – Jeddah)

• Futures transactions not permissible for two reasons:

• (b) In most futures transactions, delivery or possession is not intended.

• Objects to option trading for 2 reasons:

• Abu Sulayman (Fiqh Academy – Jeddah, 1992)

• Mufti Taqi Usmani (Fiqh Academy – Jeddah)

• El Gari argues in favour of call options based on the framework of bai-al-urbun.

• Hashim Kamali (International Islamic University Malaysia, 1998)

• Finds options acceptable.

• Shariah Advisory Council (SAC) Securities Commission, Malaysia

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