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Financial Risk Management Best Practice

Risk Management of Islamic Finance Instruments

by Andreas Jobst

Executive Summary

  • Derivatives are few and far between in Islamic countries. This is due to the fact that the compatibility of capital market transactions with Islamic law requires the development of Shariah-compliant structures that guarantee certainty of payment obligations from contingent claims on assets with immutable object characteristics. Notwithstanding these religious constraints, Islamic finance can synthesize close equivalents to conventional derivatives.

  • Based on the current use of accepted risk transfer mechanisms, this article explores the validity of risk management in accordance with fundamental legal principles of Shariah and summarizes the key objections of Shariah scholars that challenge the permissibility of derivatives under Islamic law.

  • In conclusion, the article also offers suggestions for the Shariah compliance of derivatives.

Types of Islamic Finance

Since only interest-free forms of finance are considered permissible in Islamic finance, financial relationships between financiers and borrowers are not governed by capital-based investment gains but by shared business risk (and returns) in lawful activities (halal). Any financial transaction under Islamic law implies direct participation in performance of the asset, which constitutes entrepreneurial investment that conveys clearly identifiable rights and obligations for which investors are entitled to receive a commensurate return in the form of state-contingent payments relative to asset performance. Shariah does not object to payment for the use of an asset as long as both lender and borrower share the investment risk together and profits are not guaranteed ex ante but accrue only if the investment itself yields income—subject to the intent to create an equitable system of distributive justice and promote permitted activities in the public interest (maslahah).

The permissibility of risky capital investment without explicit earning of interest has spawned three basic forms of Islamic financing for both investment and trade: (1) synthetic loans (debt-based) through a sale–repurchase agreement or back-to-back sale of borrower- or third party-held assets; (2) lease contracts (asset-based) through a sale–leaseback agreement (operating lease) or the lease of third party-acquired assets with purchase obligation components (financing lease); and (3) profit-sharing contracts (equity-based) of future assets. As opposed to equity-based contracts, both debt- and asset-based contracts are initiated by a temporary (permanent) transfer of existing (future) assets from the borrower to the lender or the acquisition of third-party assets by the lender on behalf of the borrower.

“Implicit Derivatives” in Islamic Finance

From an economic point of view, the “creditor-in-possession”-based lending arrangements of Islamic finance replicate the interest income of conventional lending transactions in a religiously acceptable manner. The concept of put–call parity1 illustrates that the three main types of Islamic finance outlined above represent different ways of recharacterizing conventional interest through the attribution of economic benefits from the ownership of an existing or future (contractible) asset by means of an “implicit derivatives” arrangement.

In asset-based Islamic finance, the borrower leases from the lender one or more assets A valued at S, which have previously been acquired from either the borrower or a third party. The lender allows the borrower to (re-)gain ownership of A at time T by writing a call option −C(E) with time-invariant strike price E subject to the promise of full repayment of E (via a put option +P(E)) plus an agreed premium in the form of rental payments over the investment period. This arrangement amounts to a secured loan with fully collateralized principal (i.e. full recourse). The present value of the lender’s ex ante position at maturity is L = S − C(E) + P(E) = PV(E),2 which equals the present value of the principal amount and interest of a conventional loan. In a more realistic depiction, this put–call combination represents a series of cash-neutral, maturity-matched, risk-free (and periodically extendible) synthetic forward contracts

t = 1T [Pt(E) − Ct(E)]

over a sequence of rental payment dates t. By holding equal and opposite option positions on the same strike price at inception, there are no objectionable zero-sum gains or uncertainty of object characteristics and/or delivery results.

Overall, the put–call arrangement of asset-based Islamic lending implies a sequence of cash-neutral, risk-free (forward) hedges of credit exposure. Since poor transparency of S in long-dated contracts could make the time value of +P(E) appear greater than its intrinsic value, long-term Islamic lending with limited information disclosure would require a high repayment frequency to ensure efficient investor recourse. In debt-based Islamic finance, borrower indebtedness from a sale–repurchase agreement (“cost-plus sale”) of an asset with current value PV(E) implies a premium payment to the lender for the use of funds over the investment period T and the same investor payoff L.3 In Islamic profit-sharing (equity-based) agreements, the lender receives a payout in accordance with a pre-agreed disbursement ratio only if the investment project generates enough profits to repay the initial investment amount and the premium payment at maturity T. Since the lender bears all losses, this equity-based arrangement precludes any recourse in the amount +P(E) in the absence of enforceable collateral.

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Further reading

Books:

  • Jobst, Andreas A. “Derivatives in Islamic finance.” In Syed Salman Ali (ed), Islamic Capital Markets—Products, Regulation and Development. Jeddah, Saudi Arabia: Islamic Research and Training Institute, 2008a, 97–124.
  • Kamali, Mohammad Hashim. Islamic Commercial Law—An Analysis of Futures and Options. Cambridge, UK: Islamic Texts Society, 2001, ch. 10.
  • Khan, Muhammad Akram. “Commodity exchange and stock exchange in an Islamic economy.” In A. H. M. Sadeq et al. (eds), Development and Finance in Islam, Kuala Lumpur: International Islamic University Press, 1991, 191–212.

Articles:

  • Bacha, Obiyathullah Ismath. “Derivative instruments and Islamic finance: Some thoughts for a reconsideration.” International Journal of Islamic Financial Services 1:1 (April–June 1999): 12–28. Online at: www.iiibf.org/journals/journal1/art2.pdf
  • Jobst, Andreas A. “The economics of Islamic finance and securitization.” Journal of Structured Finance 13:1 (Spring 2007): 6–27. Online at: dx.doi.org/10.3905/jsf.2007.684860
  • Jobst, Andreas A. “Double-edged sword: Derivatives and Shariah compliance.” Islamica (July–August 2008b): 22–25.
  • Kamali, Mohammad Hashim. “Commodity futures: An Islamic legal analysis.” Thunderbird International Business Review 49:3 (May/June 2007): 309–339. Online at: dx.doi.org/10.1002/tie.20146
  • Usmani, Maulana Taqi. “Futures, options, swaps and equity investments.” NewHorizon no. 59 (June 1996): 10. (NewHorizon is the magazine of the London-based Institute of Islamic Banking and Insurance.)
  • Usmani, Maulana Taqi. “What Shariah experts say: Futures, options and swaps.” International Journal of Islamic Financial Services 1:1 (April–June 1999): 36–38.

Reports:

  • DeLorenzo, Yusuf Talal. “The total returns swap and the ‘Shariah conversion technology’ stratagem.” December 2007. Online at: www.dinarstandard.com/finance/DeLorenzo.pdf
  • Khan, M. Fahim. “Islamic futures and their markets.” Research paper no. 32, Islamic Research and Training Institute, Islamic Development Bank, Jeddah, Saudi Arabia, 1995, p. 12.
  • Mohamad, Saadiah, and Ali Tabatabaei. “Islamic hedging: Gambling or risk management?” Islamic Law and Law of the Muslim World Paper no. 08-47, New York Law School, August 27, 2008. Online at: ssrn.com/abstract=1260110

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