Islamic derivative asgmnt

ISLAMIC VIEW OF CURRENT DAY DERIVATIVE INSTRUMENTS

PREPARED BY:

ROSWAHIDA BINTI AHMAD SHUBELI 07BB03001

NUR HAYATI BINTI MAISAM 07BB03015

SYAFIQAH MARHAINI BINTI SA’ADAN 08BB03012

PREPARED FOR:

EN MOHD RIZAL AB KARIM

BBFO 6003

FUTURES AND OPTION

22nd July 2010

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CONTENT

1. ACKNOWLEDGEMENT 1

2. INTRODUCTION 2

a. AN ASSESSMENT OF THE ARGUMENTS 3

AGAINST DERIVATIVES

3. BODY

3.1 FORWARD 4

3.2 FUTURES 8

3.3 OPTION 14

3.4 SWAP 26

4. CONCLUSION 28

5. RECOMMENDATION 29

6. BIBLIOGRAFY 32

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ACKNOWLEDGEMENTS

All praise to Allah (swt) the most Gracious and most Merciful, by whose grace and blessing to

Encik Mohd Rizal Ab. Karim, our lecture of subject Futures and Options, due to the

opportunities to us in discussing about Islamic view of current day derivative instruments.

We also thankfully to our college (Selangor International Islamic University College) for

allowed us to learn and have the knowledge in this subject matter. And to all the Librarians of

our university college in their co-operations helping us regarding some journal and books Islamic

Derivative.

We also take this opportunity, while relying on the instruction of the Prophet to the effect that:

“whoever does not thank people does not thank Allah”

We are indebted to our discussion from online journal, articles and books as supporting to the

idea and get all the information from it while writing the assignment.

We have given all our effort to this paper work and we hope that this paper work will provide

lessons and information which will complete the need of this assignment and also answering all

the question of Islamic derivative.

May Allah (Almighty) reward them all for their contribution and consider our efforts for his sake

only.

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2. INTRODUCTION

The conventional options, swaps and futures stem from debts and involve sale and

purchase of debts or liabilities. As a group, products such as interest-rate swaps, stock options

and futures, currency futures etc are called derivatives which are instruments derived from the

expected future performance of the respective underlying assets. These are very complex and

risky contracts having present market value of trillions of dollars over the world. According to an

article published in the Economist, some $ 128 trillion of over the counter derivatives were

outstanding in June 2002, a 28% increase over a year earlier1. It has been observed, however,

that global financial market is becoming increasingly fragile as more and more derivatives and

‘hedging’ instruments emerge.

The development of derivative markets in emerging markets plays a special role in this

context as more institutional money is dedicated to emerging markets, which requires the

availability of financial instruments to manage market, credit and interest rate risks in largely

underdeveloped local capital markets. Derivatives in general are financial contracts whose

inherent values derive from, and exist by reference to, a pre-determined payoff structure of

securities, interest rates, commodities, credit risk, and foreign exchange or any other tradable

assets, indices thereof and/or baskets of any combination of the above with varied maturities.

Derivatives assume economic gains from both risk shifting and efficient price discovery by

providing hedging and low-cost arbitrage opportunities.

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2.1 AN ASSESSMENT OF THE ARGUMENTS AGAINST DERIVATIVES

This final section is intended to evaluate some of the arguments and reservations put forth

by Islamic scholars, from a conventional finance viewpoint. The objective is to clarify why the

trading mechanism and other processes in derivative markets are the way they are. Before

proceeding, it must be kept in mind that contemporary derivative markets have in place

processes and trading systems that have been fine tuned over years of practice, There have been

many past failures and exchanges and markets have had painful lessons. They have responded by

tightening regulation, redesigning instruments and trading methods and added new control

features. It would be absurd to brush aside all of these experiential learning.

i. Trading Volume

The first issue that will be address here is the argument often put forth that the huge

trading volume of derivative markets is indicative of extensive speculation, that the market

attract and accentuates speculative behavior. While it cannot be denied that there is plenty of

speculative activity, there are logical reasons for why the total trading volume is often much

larger than underlying asset volume. Often 10 or 15 times higher, this huge divergence between

underlying assets and trading volume has to do with risk dissipation.

ii. The Issue of Non Delivery

Issue that causes uneasiness among ulama’s is the fact that a large portion of those

trading in derivative markets have no intention of either making or taking delivery of the \

underlying asset. The implication is that since there is no intention of delivery, these people must

all be speculators. There are however many situations in which even genuine hedgers world not

want to take or make delivery.

iii. Cash Settlement

The issue of cash settlement is yet another contentious point. Some have alleged that cash

settlement was designed in order 10 enhance speculative activity. Far from being intended to

help speculators, cash settlement is used for the many advantages it has. Cash settlement is

normally though not exclusively used with financial futures and options as for example such as

stock index futures and index options.

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3.1. FORWARD

A derivative instrument is simply a financial instrument or asset that derives its value

from the value of some other underlying asset. The first derivative instrument was probably the

forward contract. Not surprisingly, forwards was also the simplest type of derivatives. In a

forward contract two parties undertake to complete a transaction at a future date but at a price

determined today.

Forward in the terms of its benefits based on Fiqh Academy resolution are mainly

contracts that provide the opportunity for industrial and commercial institutions to finance their

projects through the issuance and sale of stocks and financial instruments. Besides that, it also

provides a permanent venue for traders in commercial instruments and commodities. However,

there are some objections to forward contract which are:

1) Its contracts are by and large paper transactions and not genuine purchases and sales

as they do not involve the delivery or taking of possession of their underlying

commodities.

2) Entail oppressive practices on the part of those who engage in them through a kind of

monopoly by making large sales and purchases of contracts in commodities to force

smaller traders to take a loss and suffer hardship as a result.

3) Bring price distortion. Price is not entirely the function of market forces of supply and

demand or genuine purchases and sales by parties who need to conclude a certain

transaction.

Although spot trading is basically a contract for the physical delivery, sometimes the

contract may involve some elements of forwarding.

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SALAM AND THE FORWARD CONTRACT.

It is the closet among the contracts in Islamic law to the conventional forward contracts.

Some scholars have considered it as the Islamic alternative to the forward contracts. Sudin Haron

said:

Forward markets exist in Islamic financial system but only on a limited scale. In case of

forward markets for money there is a divergence of opinion pertaining to the legality of such

transaction from the point of view of shariah. Forward markets for commodities are aloowed by

shariah under the principle of bay’ al-salam (advance purchase) and istisna (contract to

manufacture).

Here, the outstanding issue is that in bay’ al-salam full payment at the time of agreement

is a requirement according to the majority of Muslim jurists which is not the case in the forward

contract. Other issue concern related to bay’ al-salam and the forward contract is the claim made

by many scholars that bay’ al-salam accepted in Islamic law but not in accordance to the norms,

rather its acceptance is considered to be an exception. It is not possible to make an analogy

between salam and any new contract. It is also need to be addressed in connection with the

legality of the forward contract. Zamir Iqbal had stated that bay’ al-salam to be the closet

substitute for the forward contract. He acknowledged that bay’ al-salam is not practiced in the

financial market for two reasons that are first compared to the western forward contract, bay’ al-

salam requires full payment at the time of agreement. Second, since interest is incorporated in

the determination of the forward contract price it is synonym with paying or receiving interest.

He then concluded that a forward contract may not incorporate the element of interest as it is

prohibited.

It may submitted that the issues related to salam in connection to the forward contract

which need to be discussed are the issue if full payment at the time of agreement in salam and

other is possibility of drawing an analogy and not against it. Lastly, based on other argument and

the fact that salam is in line with qiyas and not against it, it can be understand that the modern

forward contract is a valid contract by way of analogy to salam.

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ISTISNA AND THE FORWARD CONTRACT

It is a contract for selling a manufacturable thing with an undertaking by the seller to

present it manufactuered from the person own material with a specified descriptions and at a

determined price. Several conditions should be fulfilled that are:

a) The object of the contract must be precisely determined both in its essence and quality.

b) The time of delivery must be specified (short and long) to avoid confusion of date of

delivery, which may otherwise lead to conflict between the parties.

c) The manufacturer should supply the material. If the material is supplied by the buyer, the

contract is ijara and not istisna.

d) The place of delivery should be specified if the commodity needs loading or

transportation expenses. In istisna, not a condition to advance the payment though it is

permissible to do so. Otherwise it could be deferred or made in instalments. Moreover, it

is not a condition that the seller be an expert in manufacturing.

However, istisna is more in line with the conventional forward contract where the price is

not paid in advance as well. Majority of Muslim jurists, istisna cannot be applied to commodities

that are normally available in the market. Thus, a seller agreeing to provide a product in the

future under istisna will have to be a producer or have to establish a parallel contract with a

producer. It is clear from the contractual specifications of istisna that is almost the same as the

modern forward contract. The deferment of price in istisna according to the classical scholars is

allowed on the basis of istihsan and need rather than norms. The difference between istisna as a

production contract and the modern forward contract as a trading contract should not be used as

an excuse to reject the forward contract.

Under bay’ al-istisna the two parties can agree on the sale of a nonexistent product as it is

elaborated. A certain percentage of the sale price as an advance is permissible. Istisna achieved

some of the benefits of the conventional forward contract. There is a need for the adoption f the

forward contract in Islamic finance.

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IBTIDA’ AL-DAYN AND THE FORWARD CONTRACT

The sale of debt for debt called by the Malikis ibtida’ al-dayn bi al-dayn (deferment of

both countervalues) is at the core of forward trading. The different schools of law have

prohibited this form of sale of debt. Some of the sales involves riba’ while for others it is gharar.

The Malikis consider this as one of the lesser evils. Rafiq al-Masri argued that no extra gharar is

involved in deferring both countervalues compared to the deferment of one of them only. In

other words, if one of the countervalues has been delivered while the other is deferred for a

future date or both of them are deferred, the level of risk is the same and there is no possibility of

extra gharar. However the objective of the forward contract or uqud al-tawrid is to satisfy the

need of some public institutions, factories and construction companies which are in need of

certain materials on a specific date and may not be need of the money at the time of contract.

BAY’ AL-SIFAH AND THE FORWARD CONTRACT’

Is the sale of something that is not present at the time of contract but will be delivered in

the future. The Hanafis validate the sale by description or bay’ al-sifah and the guarantee the

buyer the option of inspection whether the subject matter of the contract is presented according

to the agreed upon condition or not. The Malikis and Hanbalis guarantee the buyer the right of

the option of inspection only when the commodity is presented without fulfilling the conditions

required.

On the possibility of accommodating the conventional forward contract as a kind of bay’

al-sifah, Abd al-Wahhab Abu Sulaiman maintained that first it is bay al-sifah and then forward

contract based on a detailed description of the subject matter, relying on previous observation.

Second, in both contracts the subject matter is absent and the parties have a real intention to fulfil

the contract and want it to be executed according to the time and place specified. Lastly are both

contracts countervalues are deferred although the price could be paid by instalments as well.

The close similarities between the two contracts and the fact that the conventional

forward contract is immune from riba and gharar, which are the most commonly advanced

arguments to invalidate it, it could stated the forward contract is a valid contract in Islamic law.

Similarly there is no risk regarding the subject matter of the contract since it is well defined.

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3.2 FUTURES CONTRACT

3.2.1 DEFINITION OF FUTURES CONTRACT

In finance, a futures contract is a standardized contract between two parties to buy or sell a

specified asset of standardized quantity and quality at a specified future date at a price agreed

today). The contracts are traded on a futures exchange. Futures contracts are not "direct"

securities like stocks, bonds, rights or warrants. The party agreeing to buy the underlying asset in

the future assumes a long position, and the party agreeing to sell the asset in the future assumes

a short position.

The price is determined by the instantaneous equilibrium between the forces of supply and

demand among competing buy and sell orders on the exchange at the time of the purchase or sale

of the contract.

Futures contract is the evolutions of forward contract for aims as multiple coincidences,

restriction to restrict often lies in the way the forward price is arrived and as counterparty risk. It

quite similar to forward, except that they are standardize. Quantity, quality, deliveries, location,

are all standardize. Price is the only variable which is decides through the forces of supply and

demand. Unlike forward contract, futures are traded in organized markets.

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3.2.2 THE IMPORTANT OF FUTURES CONTRACT IN MODERN FINANCIAL

Futures trading markets deals in almost all the basic commodities worldwide such as corn,

wheat, cotton, crude oil, heating oil, gasoline, cocoa, palm oil, timber, rubber, aluminum copper,

zinc, nickel, tin, coffee, sugar etc, and other of goods. Oil is one of the examples of the most

important commodities goods which it is impossible to conduct world commerce because its

price is generally determined by the use of oil derivatives transactions.

Therefore futures contract are important to modern financial because its make the market more

liquid, bridging the gap between present and future as well as providing information about the

impact of current events on the future prices and also provide the hedgers financial protection

against price volatility for commercial firms. Besides that future can be used to control rise and

to adjust risk expositor of a portfolio to new economic information with the existence of future

contract, the market can be absorb greater volume of transaction without adverse effect on

current or future commodity prices.

However according to Resolution of the Securities Commission Shariah Advisory Council,

Second Edition, page 79 a composite index futures contract is one of the instruments categorized

as a financial commodity futures contract. There are two types of financial futures contracts in

the futures industry in Malaysia. These are the Kuala Lumpur Composite Index (KLCI) futures

contracts and KLIBOR futures contracts which are traded on Bursa Malaysia Derivate Bhd and

the Shariah Advisory Council has decided that both of these contracts are not permissible by

Shariah. Stock index trading is allowed as long as it is Shariah compliant and this is done by

ensuring that the index component is made up of Shariah Compliant securities so this is the main

issue that will be discus in this chapter.

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3.2.3 SHARIAH OBJECTION ON CONVENTIONAL FUTURES CONTRACT

There are two objections by Shariah which implied the prohibition of futures contract that

practices in present modern finance and the objection is in term of payment of commodities and

also bought and sold time of commodities.

3.2.3.1 PAYMENT

An essential part of the futures program as practiced in organized markets, is that sellers and

buyers only pay a small percentage of the total price. Even then such percentage is paid only paid

to the cleaning house and not to the counterpart. Therefore, a futures contract will not be

accepted by Shariah. As require by Shariah, full price must be paid immediately at the time of

the contracting. It is a well-recognized principle of Sharia that a sale or a purchase cannot be

effective in a future date. There is a hadith (saying quoted) from Prophet Mohammad (PBUH)

that such transactions are not permissible. As mention that there are four types of business

transactions and three of which are permissible under Islamic law as follows:

1. Spot

2. Deferred

3. Salam

4. Future

In spot or cash trading both commodity and money changed simultaneously and immediately. In

the deferred transaction the commodity is delivered but money payment is deferred. Salam is a

form of business dealing in which money is paid but commodity will be delivered later in a

future date. These three types are islamically accepted. The forth type is futures transaction in

which delivery of money and commodity as well are to be done in a future date are as it appears

not an accepted type dealing.

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3.2.3.2 BOUGHT AND SOLD COMODITIES TIMES

According to the majority of jurists a commodity bought on Salam basis can’t be disposed of by

sales before actual delivery. Where future matter contract is affected, buyer must wait until

delivery in order to be able to sell it. However, this is not what happens in the future market.

Commodities, in the organized futures market, are bought and sold in several time before actual

delivery, otherwise the market will fail to provide liquidity, which is essential part of the

mechanism. But from Shari’ah perspective even in standard sales contract it is not permitted that

the buyer sale before actual receipt of the purchased items.

In most of the futures transactions delivery of commodity or their possession is not intended. In

most cases, these transactions are closed with settlement of difference in prices, more precisely it

is used for speculation purpose, and speculation being some sort of gambling as it is perceived,

and therefore, forbidden in Islam. Hence based on these reasoning a futures transaction is not

allowed under Islamic Shari’ah.

3.2.4 FUTURES CONTRACT IN ISLAMIC SCHOLAR PERSPECTIVE

According to the Shafi'i and Hanbali schools, the 'usufruct' of an asset (in other words, the

benefit arising from the use of that asset) can be considered as property and thus can be subjected

to an exchange transaction, whereas the Hanafi and Maliki schools do not share this view.

However most scholars of later periods side with the Shafi'i and Hanbali schools on this matter.

A sale by public auction (bay`a muzayadah) in which an item is sold to the highest bidder, is

disallowed by many jurists apparently on the basis that auctions may be rigged by a small group

of well informed 'insiders'.Whatever the truth of this particular matter, such a view does not seem

to prohibit the making of a public offer to sell at a given price.

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The Shari`ah permits making public offer with fixed deadlines for acceptance, binding the

offeror to abide by the deadline he has fixed. According to many jurists, a contract of sale must

relate to only one transaction. Hence, rather than signing a single contract to cover more than one

separately identifiable transaction, individuals should instead enter into each transaction under a

separate contract. There is important condition which if followed strictly, it helps to prevent

usurious agreements being constructed from a set of underlying contracts that may, in

themselves, be quite acceptable. The condition is in term of price agreed and also prohibited of

debt.

3.2.4.1 PRICE AGREED AT IGNITION TIME

The price agreed must be fixed at the time of contracting the exchange transaction, and

ownership remains with the seller until delivery is made. In this respect, there should be a formal

event that signifies the point at which a contract is concluded, for example a handshake or a

signature.Though a sale cannot be made conditional upon a future event, conditions may be

imposed upon the sale, for example the implementation of a service contract on a manufactured

item sold to a buyer, or the availability of a warranty against defective goods (daman).

3.2.4.2 PROHIBITED SALE OF DEBT

It is important to note that Muslim scholars have traditionally prohibited the sale of a debt (bay`a

al-dayn) at anything other than face value. Thus, if person B lends person A £100, B cannot then

sell this debt to person C for anything other than £100. (If B sold the debt to C for, say £90, then

C would effectively be earning interest of £10 on a loan of £90 made to A).

Among the achievements of the Islamic Fiqh Academy (affiliated to the OIC) was the issuing of

a detailed decision ... for deeds based on debts, which shall be non-negotiable except where

transfer is made with the exchange of the face value of that debt. If they are purchased for less

than their face value this would be the same principle as is applied to discounting of bills of

exchange which is prohibited.

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3.2.5 FUTURES CONTRACT IN SHARIAH PERSPECTIVE

Bai Salam is the Shari’ah injunctions on futures trading or the synthetic futures contract package

that is financially engineered by combining futures contract on islamically permissible

commodities and Islamic cost-plus sale contract (Bai’ Murabahah). This financially engineered

package meets all the requirements of Islamic jurisprudence and dominates Islamic forward

contract on efficiency and welfare issues.

As futures contract Bai salam is 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. However it is necessary

that the quality of the commodity intended to be purchased is fully specified leaving no

ambiguity leading to dispute and 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. Therefore there

are difference between modern futures contract and islamically futures contract (Bai Salam) in

term basis feature and condition which is show as below.

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3.3: OPTION

3.3.1 Concept of option

Option is an alternative way. Through futures contract it have handle forward overcome

problem. Futures enabled easy hedging by locking in the price at which one could buy or sell,

being locked-in also means that one could not benefit from subsequent favorable price

movement. “Wouldn’t it be wonderful to have an instrument that protects you from unfavorable

price movements while at the same time enables you to take advantage of favorable price

movements?” This is precisely what option do.

Option has three advantage over forward and option. First, option may provide downside

protection (bearish) and upside potential (bullish). Second, option is extremely flexible and can

be combined in various ways to achieve different objective or cash flows. And the last but not

least option can handle business risk that cannot be handle by forward and futures contract.

3.3.2 Definition of option

“An option is a contract between two parties in which one party (the buyer) has the right, but not

obligation, to buy or sell a specified asset at a specified price, at or before a specified date, from

the other party (the seller). The seller of the option, therefore, has a contingent liability or an

obligation, which is activated if the buyer exercise that right.” Thus, “An option contract conveys

the right to buy or sell an underlying commodity at a specified price within a specified period of

time.”

Means that buyer of the option is not obliged to complete the deal, and will do so only if changes

in price make it profit for him. The buyer of the option is protected from unfavorable market

movements, yet he is able to profit from movement in the buyer’s favor. The risk of loss is

carried by the seller, who charges the buyer fee for taking this risk. This fee is called the

premium.

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Now the question is: if options are permitted under Islamic law?

3.3.3 Economic benefits of option

In particular, options have the following benefits state by Muslims economist:

1. They bring about an increase in the liquidity of the market. It is noted that one of the

main advantages of the stock market is its ability to provide investment opportunity while

financing long-term projects. It can short-term to the investor, which will increase the

overall investment. The negotiable nature of options contracts leads to further

accomplishment of this objective.

2. Option contracts lead to a reduction in the effect of fluctuations in the price of securities.

3. Investing in the stock market involve a high level of commercial risk due to price

fluctuations and the influence of the moods of investors on the market. The current

political and economic development also affects stock market investment.

4. Stock market are totally depends on futures forecasts, any event influence the economic

situation will necessary affect the market trends. Option can play a role as nature

insurance and investors may minimize its adverse effects.

5. Option give the investor the opportunity to rearrange his investment portfolio by

choosing the most appropriate position for his preferences related to the risk return trade

off.

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Some Muslims economist opinion regarding to the benefit of options:

1. El-Gari

He stressed that: “There are many legitimate and Islamically desirable uses of options in

stock markets. In particularly, the hedging aspect of options is quite in line with the

recognized need of individuals, which is not contradictory to the shariah. The fact

remains however, that an option contract should not have an existence independent of

sale or lease contract.”

2. Fuad al-Omar and Muhammed ‘Abdel Haq

They suggested that “with the basic considerations in view, it is proposed that certain

types of derivatives, mainly modified forms of options in stocks and Islamic financial

certificates, will continue to render useful functions under Islamic financing. The

modifications are needed to ensure that the price paid for any option is, in fact, the price

of the underlying asset paid in advance, rather than the price of the option itself. This is

necessitated by the fact that in Islamic financing, an option by itself, is not recognized as

a marketable asset. Derivatives may also play other useful role within the framework of

Islamic financing. To work out fully such benefits, and make use of them, substantial

practical and conceptual effort would be required.”

3. Obiyathullah

He held the view that “the option is an important tool of financial engineering. Financial

engineers often use options in the design of new financial contracts or in developing

innovative strategies for financial problems, such as, management of risk.”

Some Muslim jurists, in Islamic Fiqh Academy concluded that there is no need for option in

Islamic economics because they do not serve any benefit. In such a situation the opinion of

Muslim economist is the one which should be considered because they have knowledge about

this particularly field.

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3.3.4 Option in Islam

First view of option has examined their validity under the fiqh doctrine of al-khiyarat or

contractual stipulations.

Second, while others have drawn parallels between options and bai-al-urbun; urbun being a

transaction in which a buyer places a initial good faith deposit with the seller.

Should the buyer decide to go ahead with the transaction, the payment is adjusted for the initial

deposit, but is nonrefundable if the buyers decided not to proceed with the transaction.

A third view has been to examine options in the light of gharar or uncertainty.

In at least one other situation (Abu Sulayman 1992) options have been viewed as totally

detached from the underlying asset.

When viewed solely as a promise to buy or sell an asset at a predetermined price within a

stipulated period, Shariah scholars find nothing objectionable with options. However, it is in the

trading of this promise and the charging of premiums that objections are raised.

3.3.5 Shcolar view of option

A number of scholars, notably Ahmad Muhayyuddin Hasan (1986), Abu Sulayman (1992) and

Taqi Usmani ( 1996) have all found options objectionable. Each of these scholars have objected

for a different reason.

Ahmad Myhayyuddjn Hasan

He objects on two grounds, firstly, that maturity beyond three days as per khiyar-al:.shart (option

of stipulation) is unacceptable. And second, that the buyer of an option is granted much more

benefits than the seller and that "this is oppression and injustice". Abu Sulayman (1992) of the

Fiqh Academy of Jeddah, finds options acceptable when viewed in the light of bai- al-urbun but

concludes that options should be prohibited since he considers options to be detached and

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independent of the underlying asset and therefore unjustified for the seller to charge to premium.

It should be noted here that yet other scholars have forbidden bai-ul-urbun transactions.

Mufti Taqi Usmani (also of the Fiqh Academy, Jeddah)

In answering a set of questions posed in a feature article, writes in response to a question about a

sale of stock with put options attached that while an option contract when viewed as a promise is

acceptable, charging a fees and trading them are not. He also finds the sale of stock with a put

option to resell the stock to the issuer at a future date unacceptable since a precondition is placed

on the original sale of stock.

Mohd. Obaidullah ( 1997)

Gharar has been another reason for objection to options. He writes, "permissibility to

conventional options is generally denied by a majority of scholars on the ground that these

involve gharar and are primarily transacted for speculative gains". Acknowledging that gharar

does not have a consensus definition, gharar is said to be the result of jahJ, inadequate

information and a lack transparency. Citing that some scholars have pointed out that in modern

options markets standardized contract specification and other controls have rendered invalid the

gharar argument, he goes on the state that this argument is rejected since there is no physical

delivery but mere cash settlement; implying that cash settlement induces gharar and excess

speculation.

He further adds that "while the gains, if they materialize are in the nature of maisir or unearned

gains the possibility of equally massive losses do indicate a possibility of default by the loser and

hence gharar"; Both the maisir and gharar arguments here are invalid. That profits from options

are "unearned", ignores the fact that both the buyer and seller take on risk and that the buyer also

has at stake the premium he has paid.

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Furthermore, the change in an option's value arises from changes in underlying asset value and

not by chance. If such gains are 'unearned' then it implies that all capital gains income could also

be considered unearned. The second argument that options involve gharar since there is potential

for default, totally ignores the fact that exchanges place margin requirements on seller of options

precisely to prevent default, Note that buyers of options would by definition not default since

their maximum possible losses is the premium, all of which is fully paid for at the time of

purchase.

Hashim Kamali (1995) examines the permissibility of modern day options and its trading in the

light of Islamic Commercial Law: analyzing the basic option contract, and the validity of its

parameters, such as, premiums, time to maturity and delivery, he 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 "

3.3.6 Islamic alternative to conventional option.

There are two Islamic alternative to conventional option. Which is khiyar al-shart and arbun.

i) khiyar al-shart (option of stipulation)

Among those who have drawn an analogy between the two concepts and concluded that

conventional option could be accommodated in Islamic law through khiyar al-shart are Kamali,

Youssouf Sulaiman, Ali Abd al-Qadir, Shahhat al-Jundi and Obaidullah. However some scholar

concluded that conventional option could not be accommodated in Islamic law throught khiyar

al-shart.

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Thus, around thirty-three different types of options with varying degrees of importance have

been identified in Islamic law. However, of these various kind of options, the one that is

potentially promising in desingning new financial instruments is khiyar al-shart and its variant or

subdivision, namely khiyar al-naqd or the option of paying the price as an indicator of the

confirmation of the contract.

Concept of khiyar al-shart.

Khiyar al-shart is an option in the nature of a condition stipulated in the contract whether to

confirm the contract or to cancel it in a specified period. Its provides a right to either of the

parties, or both or even to a third party to confirm or to cancel the contract within a stipulated

period of time.

It have been proved in hadith which is report that Hibban Ibn Munqidh complained to the

Prophet that he was the victim of frequent cheating in sale. The Prophet responded, “When you

concluded a sale, you may say there must be no fraud and you reserve for yourself an option

lasting for three days.” It is also asserted by the hadith of Abd Allah Ibn Umar to the effect that

“the parties to a contract of sale have a right of a option as long as there are no separated except

in a sale that is subject to option.” There was a little disagreement among scholars at the

beginning on khiyar al-shart but has been accepted by ijma’.

The terms of khiyar al-shart

Abu Hanifah, Zuhar, and Shafie

They held that the option should not exceed three days as it is specified in the hadith, because

khiyar al-shart is allowed contrary to the norms of qiyas as an exception. In other words, khiyar

al-shart is initially against the objective of sale but, the syariah allowed it on the basis of

necessity.

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Maliki

More flexible stance toward the understanding of the hadith, saying that the hadith mentions

three days in a figurative sense merely to convey the concept in an illustrated manner. The actual

duration of an option may thus be determined by relating the option to the subject matter of sale.

Hanbali

The option may be for any length of time and that is entirely a matter of agreement between the

contracting parties and there is no maximum permissible period.

Ownership of commodity during the period of khiyar and libiality for damage

Hanafi

Buyer and seller both parties hold the option , there would be no change in the ownership of the

countervalues and if the commodity is destroyed before taking possession, the seller would be

held liable. But, if it destroyed after the buyer taking possession, the contract would be cancelled

and the buyer would be held liable and he required to pay the value of the destroyed. However, if

the buyer holds the option and the commodity is destroyed before taking possession, he would be

held liable to pay the price and not the value.

Maliki

Ownership of the article of exchange does not shift during the option period irrespective of who

holds the option. The confirmation of the contract transfers the ownership to the buyer. When the

seller holds the option , and the buyer takes possession of the article and subsequently claims

loss of the commodity, the issue will be resolve by legal process. In principle, seller should be

liable for all damage to the commodity during the period of khiyar unless there is a case of

negligence on the part of the buyer, because the buyer before taking possession is considered as a

trustee.

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Hanbali

Ownership of the commodity transfer to the buyer during the option period irrespective of

whether the option is with the buyer or the seller or both. If the buyer has taken possession, he

should be held liable in case of destruction. But if he did not take possession, then the seller

would be liable. However, if the commodity does not possess the above characteristic, the buyer

would be held liable whether he has taken possession or not except in case he want to take

possession but has been prevent by the seller. In such case, the buyer would be held responsible.

Shafie

If the seller initiates the option, his ownership of the commodity will continue. If the buyer

retains the option, the ownership of the commodity transfers to him because the contract is

binding from the seller’s side. And if both have stipulated the option, the ownership of the

commodity remains suspended during the time of the option. If the commodity destroyed before

being transferred by the seller to the buyer, the contract is considered annulled whether the

option is with the buyer, the seller or both.

Managing price risk with khiyar al-shart

Some scholars have discussed the possibility of charging a fee or premium for the option in

khiyar al-shart so as to match the conventional option.

Kamali

Valid of charging a fee for options is a matter that falls under the general subject of contractual

stipulation, a subject that invoked different responses from the schools of Islamic law now

withstanding the affirmative nature of the source of evidence on it.

Hanafi and shafie

Valid when they are in line with the essence of the contract. Thus a condition to provide a

guarantor or a surety in the form of mortgage or pawn is legal provided that both parties agree

upon it.

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Muslim jurist (Shahhat al-jundi, Yousuf Sulaiman and Ali Abd al-Qadir)

They concluded: “the money taken by the seller as premium could not be return to the buyer (if

he fails to ratify the contract within the agreed period) because Allah says, “Oh you who believe

fulfill your obligations.”

So, it is clear that khiyar al-shart could serve as tool of risk management, and fulfill some of the

benefits associated with conventional option.

ii) Arbun

Definition

Second Islamic alternative to conventional option(included call option and put option) is arbun,

its refers to a sale in which the buyer deposits earnest money with the seller as part payment of

the price in advance, but agrees that if he fails to ratify the contract, he will forfeit the deposit

money, which the seller can keep. It is also defined as “a transaction whereby the buyer pays

only a small part of the price of a commodity (for instance two dirhams), on the understanding

that the seller will retain this amount if the sale is not finally concluded due to withdrawal of the

buyer.”

Imam Malik give some example: it holds when a person buys or rents an animal and says to the

seller or to the owner of the animal, “ I will give you one dinar or one dirham or more or less and

if I ratify the sale or the rent contract, the amount I gave will be part of the total price. And if I

cancel the deal, then what I gave will be for your without any exchange.” This not only in sale

contract but also in a rent or leasing contract.

As for the hadith, it is unreliable. But since the hadith upon which the proponents of bay al-arbun

rely is also weak, al-Qaradawi observes that the issue should consequently be determined on

rational grounds.

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Arbun in commodities

From imam Malik definition, arbun can be in bay(sale) and ijarah(rent). Therefore, it could be

said that arbun is legal with regard to commodities and services. Sale in Imam Malik’s definition

is an example of the sale of commodities while ijarah is an example of service.

Ex: Individual A want to buy a car, the current price are $20,00 but you have to purchase now

for the price. However, A don’t have cash in such amount, it takes about one week to manage

loan. A offer the dealer $100 for him to keep the car for one week. This is as arbun. At the end of

the week, if A buy the car , $100 is a part of car price. But if A not buy the car, then $100 would

belong to the seller.

Arbun in present example while it is a call option contract in the earlier example.

DIFFERENTS BETWEEN OPTION AND ARBUN

1. An option requires payment for something that is a mere intangible “right”, not property

(mal) in the usual sense of tangible good or a utility taken from a tangible good, as for

this alone compensation can be demanded. Then, the option price is “unearned”.

2. The right of option is given to the buyer as well the seller while arbun is given only to the

buyer. The price of the option is separate from the price of the underlying commodity and

one could sell it or give it as a gift, which is not the case in arbun.

3. The objective of option trading is not the benefit of the contract, where the buyer receives

the commodity and the seller receive the price, they, rather look, for price differentials.

Moreover, in the exercise of the option, only one party can gain from the contract while

the other must lose. Whether the party will gain or lose depends on unknown future

market prices.

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4. In most actual option contracts, the parties have no intention of taking delivery, but only

for liquidating their contracts against the price differentials. In every lawful Islamic sale,

on the other hand, the parties fix their exchange fully and finally in the present. Thus, the

entirety of at least one of the countervalues is at least presently owed, even if not

immediately paid.

5. The underlying asset in an option is not only a commodity as it is the case in arbun but it

could also be currency or even stock indices, which are a kind of gambling.

6. The price of an option is determined by the movement of interest rates, which is not

Islamic.

7. If the option is in currency, not even forward sales are allowed since currencies may be

exchanged only on the spot.

DOES OPTION TRADING INVOLVE THE COMBINATION OF TWO CONTRACTS

IN ONE TRANSACTION?

Ahadith reported from the Prophet (PBUH) prohibiting the sale of ‘bay ataini fi bay atin

wahidah’ or the combination of two contracts in one transaction. However, none of the

interpretations of Muslim jurists given to these hadith could be considered similar to the case of

the options trading.

Example of ‘bay ataini fi bay atin wahidah’:

‘I will buy this item from you for 10 dinars cash and for 15 dinars if I have to pay one year later’.

The seller agrees without identified in which of the two terms of the deal the contract is included.

This interpretation reported from Imam Malik. In additional Muslim jurist said it involve gharar.

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3.4 SWAPS

It is an Islamic variant of the conventional transactions. The conventional swaps have

been generally observed to be unIslamic as they clearly involve interest payments. Islamic swaps

(al-murajaha al-Islamiyah) as highlighted in section 2 are in use by several Islamic banks. A

close look at the nature of contracting reveals that the same essentially involves an exchange of

two interest-free loans (qard) in different currencies which are repaid by both parties at the end

of a stipulated time period. It is easy to see that such swaps partially enable the parties to hedge

their currency risk. An Islamic swap between two banks may help both banks to partially reduce

their risk.

The major difference of this type of swap from its conventional counterpart is that in case

of the latter, the interest payments along with the principal are swapped. In case of Islamic swap,

only the principal is being swapped since the incomes to be generated on the investments are not

predetermined.

Islamic swaps may perform many other useful functions besides serving as a tool of risk

management, such as, reducing cost of raising resources, identifying appropriate investment

opportunities, better asset-liability management and the like. These are also the benefits with

conventional swaps. Islamic swaps are different in that they do not involve interest-related cash

flows. However, Islamic swaps are not free from controversies and there is no consensus

regarding their acceptability.

An Islamic profit rate swap is basically an agreement to exchange profit rates between a

fixed rate party and a floating rate party or vice versa implemented through the execution of a

series of underlying contracts to trade certain assets under the Shariah contracts. Each party’s

payment obligation is computed using a different pricing formula. In Islamic rate profit rate

swap, the notional principal is never exchanged as it netted off using the Islamic principle of

Muqasah.

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An Islamic profit rate swap aims to match funding rates with return rates (from

investment), achieve lower cost of funding, restructure existing debt profile without raising new

finance or altering the balance sheet and manage exposure to interest rate movement. It is also

aimed to protect financial institutions from fluctuations in borrowing rates and to provide a risk

control mechanism.

Like other Islamic contracts, contracts in Islamic swaps must also be free from any

elements of riba (usury), maysir (gambling), Gharar (unnecessary risk) and jahl (ignorance). In

addition to these elements, Islamic swaps are different from conventional swaps in that they are

linked with asset-backed transactions such as Bai’, Bai’ Bithaman Ajil, Murabahah, Ijarah and

other.

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4. Conclusion

In Islamic financial view in order to be halal, all financial instrument must be free from five

elements namely, riba, rishwah, masyir, gharar and jahl. Most of the derivatives incorporate

gharar, gambling and interest and support speculative activities. Islamic legal rules, particularly

the ban on Gharar and on the sale of debt for debt, do not allow transactions devoid of real or

productive activities. Derivatives involving such financial contracts which themselves are

prohibited in Shariah (Riba based bonds & forward foreign exchange where mutual exchange is

not simultaneous, for example) are clearly un-acceptable according to the Shari’ah principles.

Derivatives instruments have largely envolved in non-islamic environment, thus the are loaded

with values which may not bbe totally in compliance with Islamic principles. Therefore there is

need for systematic analysis of these tools of price dtermination as well as risk management and

hedging devices from an Islamic perspective.

Therefore Bai Salam contract and Istijrar has been engineered which is considered a basis for

derivative contract within an Islamic framework. Bai salam contract has provisions and

precedence while istijra is a recent innovation practice in pakistant. There ara two other contract,

the istina and joa’la which are related to Bai Salam contract.

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5. RECOMMENDATION

In the journal wrote by Obiyatullah Ismatch Bacha in title of ‘Derivative Instruments and Islamic

Finance: Some thoughts For Reconsideration’, he has highlight two derivative contracts within

an Islamic framework. These are (i) the Bai Salam Contract, and (ii) the Istijrar Contract.

i) Bai salam

Definition of 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.

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 the conventional futures 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.

Concept of bai salam

The payment must be in cash form. The idea behind such a 'prepayment' requirement has to do

with the fact that the objective in a Bai Salam contract is to help needy farmers and small

businesses with working capital financing. The buyer in a contract therefore is often an Islamic

financial institution. 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

prices is typically higher than the spot price by the amount of the carrying cost. The lower Salam

price compared to spot is the "compensation" by the seller to the buyer for the privilege given to

him.

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Condition of bai salam

(i) Full payment by buyer at the time of effecting sale.

(ii) The underlying asset must be standardizable, easily quantifiable and of determinate quality.

(iii) Salam contract cannot be based on a uniquely identified underlying asset. This means the

underlying commodity cannot be based on commodity from a particular farm/field etc. By

definition such an underlying asset would not be standardizable.

(iv) Quantity, quality, maturity date and place of delivery must be clearly enumerated in the

Salam agreement.

(v) The underlying asset or commodity must be available and traded in the markets through the

period of contract.

ii) Istijrar contract

Defition

The istijrar contract is a recently introduced Islamic financing instrument. Introduced in Pakistan,

the contract has embedded options that could be triggered if the underlying asset's price exceeds

certain bounds. The contract is complex in that it constituted a combination of options, average

prices and Muharabah or cost plus financing. The Istijrar involves two parties, buyer which could

be a company seeking financing to purchase the underlying asset and a financial institution.

Concept of istijrar contract

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 a current price, 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 t 0 to

t90 where t0 is the day the contract was initiated and t90 is the 90th day which would be the

maturity day.

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Unlike a Murabahah contract where the settlement price would simply be a predetermined price;

P* where P* P0 (I + r), with 'r' being the bank's required return learning, 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 to t90. 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 chooses to fix the price at which settlement will Occur at anytime before

contract maturity. At the initiation of the contract; t0 both parties agree on the following two

items (i) in the predetermined Murabahah price; P* and (ii) an upper and lower bound around the

P0. (bank's purchase price at t0).

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6. Bibliography

Al-amine, m. A.-b. (2008). Risk management in islamic finance: an analysis of derivative

instruments in commodity markets. Netherlands: koninklijke brill nv,leiden.

Ayub, m. (2007). Understanding islamic finance. England: john wiley and sons ltd.

Bacha, a. I. (2001). Financial derivative: markets and application in malaysia. Kuala lumpur,

malaysia: universiti putra malaysia.

Ibrahim, a. M. (1999). Islamic financial services and products. Kuala lumpur, malaysia: ikim

publishing unit.

Kharofa, p. D. (2000). Transactions in islamic law. Kuala lumpur, malaysia: pustaka hayati.

Sheikh ghazali sheikh abod, s. O., & ghazali, a. H. (2005). An introduction to islamic economics

and finance. Kuala lumpur, malaysia: cert publications sdn.bhd.

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ONLINE JOURNAL

1.http://www.isu.ac.ir/Farsi/Academics/economics/edu/dlc/3rd%20DLC%20%20Monetary%20E

conomics/04%20Financial%20Derivatives%20An%20Islamic%20Perspective/Financial

%20Derivatives%20-%20Some%20Thoughts%20for%20Reconsideration.pdf

2.http://www.imamu.edu.sa/Data/abstract/management/acc/ISLAMIC%20JUSTIFICATION

%20OF%20DERIVATIVE%20INSTRUMENTS.pdf

3.http://www.iefpedia.com/english/wp-content/uploads/2009/08/Derivatives-in-Islamic-

Finance.pdf

4. http://sbp.org.pk/departments/ibd/derivatives_islamic.pdf

5.http://www.azmilaw.com.my/archives/Article_outside_publications_asian_counsel/

Development_of_Islamic_Swaps_in_Msia_Dec2006(00125808).PDF

6.http://www.kau.edu.sa/centers/spc/jkau/Doc/Isl/11/Financial%20Options%20in%20Islamic

%20Contracts.pdf

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