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Home > Financial Risk Management Best Practice > Introduction to Islamic Financial Risk Management Products

Financial Risk Management Best Practice

Introduction to Islamic Financial Risk Management Products

by Qudeer Latif and Susi Crawford

Executive Summary

  • The main features of Islamic finance and shariah scholars are introduced.

  • Conventional financial risk management products are viewed as non-shariah-compliant, which means that such products are not available to Islamic investors.

  • The popularity of Islamic finance has given rise to a demand for shariah-compliant financial risk management products for underlying Islamic investments.

  • A number of structures of shariah-compliant financial risk management products are available in the marketplace, all based around a murabaha sale structure.

  • The rising popularity of the wa’ad structure is discussed.

  • The article concludes with a brief summary of the future of shariah-compliant financial risk management products.

Introduction: The Main Features of Islamic Finance

To consider the basics of Islamic financial risk management products it is helpful to summarize the Islamic principles and jurisprudence on which Islamic finance is based.

  • Speculation: contracts which involve speculation (maysir) are not permissible (haram) and are considered void. Islamic law does not prohibit general commercial speculation, but it does prohibit speculation which is akin to gambling, i.e. gaining something by chance rather than productive effort.

  • Unjust enrichment: contracts where one party gains unjustly at the expense of another are considered void.

  • Interest: the payment and receipt of interest (riba) are prohibited, and any obligation to pay interest is considered void. Islamic principles require that any return on funds provided by the lender be earned by way of profit derived from a commercial risk taken by that lender.

  • Uncertainty: contracts which contain uncertainty (gharar)—particularly when there is uncertainty as to the fundamental terms of the contract, such as the subject matter, price, and time for delivery—are considered void.

To ensure adherence to these underlying principles, most banks that sell Islamic products have a board of shariah scholars (or will appoint a shariah scholar on a product-by-product basis) to ensure the bank’s (or product’s) compliance with the Islamic precepts.

On the whole, shariah scholars in the financial field hold the view that financial risk management products (commonly referred to as hedging arrangements) in the conventional finance space fall into the category of speculation (maysir) and uncertainty (gharar), both of which are prohibited under the shariah and cannot therefore be marketed as shariah-compliant products or used in conjunction with Islamic financing.

With the rise in sophistication of Islamic finance in recent years, however, a school of thought has emerged among pre-eminent shariah scholars that Islamic investors should be able to enter into hedging arrangements, provided that the financial risk management product is itself structured in a shariah-compliant manner and that there is genuine underlying risk arising from an Islamic investment.

The conventional financial risk management products have become an intrinsic part of the mechanics of banking finance and are, to a large part, documented by standard documentation and negotiated without recourse to lawyers. Any shariah-compliant financial risk products have to strike the balance of being faithful to the principles of shariah while maintaining the user-friendly structure of their conventional counterparts.

The Conventional Products

Financial risk management products in the conventional world are, in their basic form, a derivative, and each product is based on the principles that a derivative is a financial instrument whose value derives from that of an underlying asset, and the underlying asset must be capable of being ascribed a market value.

The number of “assets” that can be ascribed a market value and from which, therefore, a derivative can be derived has resulted in a variety of financial risk management products. The commonly known structures are those based on interest and currency rates: i.e. interest rate swaps, cross-currency swaps, and foreign exchange forwards. There are also commodity derivatives based on gold, steel, and other metals. More recently, products known as “exotics” based on the weather and carbon emissions have appeared in the market in response to the requirements of a changing environmental as well as financial climate.

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Further reading

Websites:

  • International Islamic Financial Market (IIFM): www.iifm.net
  • International Swaps and Derivatives Association (ISDA): www.isda.org

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