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In today's world, the number of transactions within financial institutions is much greater than it was a decade ago. This increase leads to fluctuations in the prices of assets and shares, which, in turn, affects business decisions, especially when it comes to risk management.
Different types of transactions carry different types of risks, and various companies face these risks based on their portfolio management strategies.
For example, a company that relies heavily on equity may be more susceptible to interest rate risk. An individual who invests in Shariah-compliant investments may face rate-of-return risk. Companies involved in international activities must pay close attention to exchange rate risk.
To manage these risks effectively, it is essential to mitigate or avoid them, and the primary tools for doing so are derivatives. The most used derivatives include futures, forwards, swaps, and options.
Derivatives can be simply defined as financial instruments used for risk management. There are different types of derivative instruments, such as futures, forwards, options, and swaps.
These tools are used to spread risk among different parties. In addition to risk management, derivatives are also used for speculation.
Speculators use them for short-term gains, and while they may earn significant profits in a short period, they are also exposed to high risks. Derivatives can also be defined as financial assets that represent claims on other financial assets.
There are three broad categories of the players in the derivative market:
1- Hedgers: If the objective of a player is to mitigate uncertainty, they fall under the category of hedgers.
2- Arbitrageurs: who engage in arbitrage, which is the process of profiting from price differentials in the market. Arbitrageurs buy assets at a lower price in one market and sell them at a higher price in another market to earn a profit.
3- Speculators: The last category is speculators, whose activity is based on speculation. If they expect an asset’s price to decline in the future while the current price is high, they sell it at the higher price. If their expectations are correct, they buy back the asset at a lower price, profiting from the price differential.
Read more about: Beginner Guide to Hedging For Muslim Investors
A forward contract is a legally binding agreement between two parties, in which one party agrees to sell an asset or product in the future at a price mutually agreed upon by both parties.
The seller of the asset or product will deliver it on the future date, known as the settlement date, and the buyer will pay the agreed price on the same date.
The buyer will benefit if the price of the asset increases by the settlement date, as they will pay the lower forward price. Conversely, the seller will benefit if the price of the asset decreases by the settlement date, as they will receive the higher forward price.
A futures contract is similar to a forward contract, with a few key differences, such as the realization of profit and loss.
In the forward market, profit and loss are realized only on the settlement date. In contrast, with a futures contract, profit and loss are realized on a daily basis.
Due to this daily settlement, futures contracts are also known as "marked to market". The second difference is that the forward contract is over the countered (not standardised) and tailored made between the buyer and the seller while the future contract is standardised and regulated.
The swap contract is defined as the agreement between two parties to exchange or swap with a specified cash flow at the specific interval.
Unlike to the forward and future contract, this contract needs a swap dealer. The main function of the swap dealer is to make the arrangement on the swap. There are three main types of swaps, currency swap, interest rate swap and the commodity swap.
The three types of hedging require the parties involved to complete the transaction. One type of hedging, known as an option, grants the owner the right—but not the obligation—to buy or sell an asset on a specific future date at a predetermined price.
Essentially, an option contract provides the owner with rights, not obligations, to engage in the transaction.
There are two types of option call and put option, in call option the owner has the right to buy the underlying asset at a fixed price called strike price or an exercise price at the specific time in the future while the put option is the option that give the right to the owner to sell the underlying asset at a fixed price at the specific time in the future.
From a Shariah perspective, both forward and futures contracts are considered non-compliant with Shariah principles.
In these contracts, both the delivery of the asset and the payment of the price are deferred, which is classified as Bai-al-Khali-bil-Khali and is prohibited in Shariah. As stated in the hadith, the Prophet (P.B.U.H) forbade Bai-al-Khali-bil-Khali, where neither the buyer takes possession of the goods, nor the seller receives the price.
The most appropriate and perfect alternative to the forward and futures contracts is the Salam contract. In this sale, the payment for the subject matter is made on the spot, while the delivery of the subject matter is deferred.
These two conditions prevent the contract from being used for speculative purposes.
Unlike forward and futures contracts, where the money and goods change hands in the future, in Salam, the seller receives the money at the time of the Salam contract, while the buyer will receive the goods at a future date.
The benefit of the Salam contract is that the seller receives the money immediately, enabling him to utilize the amount for purchasing and manufacturing the goods.
Read more about: Salam vs. Future Contracts
Options are permissible from a Shariah perspective, provided their terms and conditions align with Shariah rules and principles. There are various types of options, with the most common being:
i-According to AAOIFI standard the cooling-off option is defined as: “Cooling-off options give one or both of the parties or a third party the right
either to continue with the contract or to revoke it within a stipulated period of time. It is effected by any phrase indicating that it is non-binding and revocable during the period of the option”. Terms and conditions for the colling-off options:
ii-The option must be stipulated in the contract unless it is implied by a pre-existing custom or party agrees to subsequently include it in the contract.
iii- The option must have a specific time limit, the option is not valid if the time limit is not stipulated or if it is unspecified.
iv-If the contract relates to several items, it must specify those items to which the option relates.
v-The subject matter must remain in the condition it was initially in when it was sold. For more detail, please refer to the AAOIFI standard
According to AAOIFI standard Arboun is defined as: “Earnest money is paid by the buyer to the seller at the time of contract on the basis that the buyer has the option to revoke the contract during an agreed period of time.
If he confirms the contract, the earnest money is credited towards the price. If he does not confirm the contract or fails to pay the remaining price during the stipulated time, the seller is entitled to forfeit ’Arboun (Earnest Money)”.
From a Shariah perspective, Arboun (earnest money) is permissible in commutative contract that do not require spot payment of one or both counter values whether the sale item is identified or is sold by description for future delivery (Ijarah Mawsufah Fi al-Dhimmah),
such as sales, Istisna’a contracts, leases of identified assets and of assets leased by description for a future date.
Payment of ’Arboun (Earnest Money) is not permissible in Salam and currency exchange contracts. For more detail, please refer to the AAOIFI standard,
Read more about: Your Basic Guide to Istisna
References:
-Omar,_Azmi;_Sukmana,_Raditya;_Abduh,_Muhamad-_Fun(z-lib.org).pdf
https://aaoifi.com/ss-53-arboun-earnest-money/?lang=en
https://aaoifi.com/ss-52-options-to-reconsider/?lang=en .
Disclamer:
This post is for educational purposes only, and the Firm does not directly or indirectly provide these services.
