Thread by @SafdarAlam

THREAD

Derivatives in Islamic banking

One area of great interest and discussion in Islamic banking is the use of derivatives.

Here I will cover briefly the position on derivatives and give an overview of how an “Islamic” FX option would work.

Derivatives are any financial instrument that “derive” their value with reference to something else. They are paper securities, with a value that is the expected value of the potential cash flow to the owner. So, if I own a derivative and I have a 50% chance of receiving $100,

then it’s value to me is $50.

So, in theory, if I paid $40 for it, I should make a profit of $10, right?
Not really, because, as each day matures, the value of the option will change. Tomorrow it could be worth $30, and then I have made a paper loss of $10.

In any case, if the option matures, it will either pay me $100, or zero. I will never earn the theoretical value of $50. But, if I buy millions of them, on average I could expect to earn $50 on each one.

Back to Islamic banking – derivatives are generally impermissible. Imagine I want to buy option that enables me to earn $100 if it rains tomorrow, and zero if it does not rain. This option certainly has a value.

But I will not be buying anything tangible at all. It is just a piece of paper.

I will have to pay a premium to buy this option – in Shariah terms, I have to justify what I am buying with this money.

It is effectively speculation.

There are many reasons why this is not permissible – the speculation angle, the lack of a tangible asset, the presence of Gharar (ambiguity), the lack of contribution to the real economy and so on.

But some Islamic derivatives are permitted. Often this is when the option (in this case) is used to hedge risk, not to speculate in risk.

For example, let’s say I have bought a ticket to see a cricket match, and I paid £50 for it. In England, it often rains, so there is some chance it can rain and the match is cancelled. Assuming I cannot claim a refund, then I want to hedge my risk.

I can buy a rain option, whereby if it rains and the match is cancelled, I receive the cost of the ticket, £50. I have to pay to buy this option, say, £5. In this case, this is not speculation, this is hedging my risk.

If it does not rain, I watch the match and I have paid £55 in total (ticket cost plus option premium I paid), and if it rains, I make a net loss of £5 (I paid 55 as before but I receive 50 back), instead of just losing £50 for the ticket.

The idea of hedging risk is good, however this is still impermissible, as the contract involves no tangible asset or transaction.

In FX, we can not use options to speculate. However, we can use them to hedge real risk. If I am a firm that has to make payments in a foreign currency in the future, then I face currency risk. If my home ccy is GBP and I have to pay out USD in the future,

then I have some choices:

1) just wait and pay out the USD in future, at the prevailing GBPUSD spot rate at that time – this leaves me fully exposed to fx rate movements – good and bad

2) Convert some GBP to USD now, , and place it on deposit with a bank, so it matures to the

correct USD amount in the future – I have certainty now, but I have to commit some GBP immediately – this might not be ideal for me.

3) hedge my risk via an option or forward – so I can hedge my risk in case the market turns against me,

but if it does not, I can then still use the advantageous rate in the future.

Ok, so how do we execute a halal FX option?

A simple way is to deliver an undertaking, called a Waad in Arabic. We have to find a seller of this option (or risk taker), and ask it to make a Waad for our benefit (we are the recipient).

Let us use some numbers now:

we have to pay $100 in one month’s time. Our base currency is GBP. The spot rate now is 1.24, and the forward rate is 1.30 (an assumption).

Let us consider 3 scenarios for the prevailing spot rate in one month’s time – let's fast forward one month

If the FX rate is 1.30, I have to use $100/1.30 = £76.92 to convert into $100.

If the rate is 1.25, I have to use £80, and if the rate is 1.35, I have to use £74.07.

So my risk here is that the FX rate can fall (dollar strengthens), then I have to pay more GBP

to convert to $100 (as GBP is now weaker).

So, I ask the seller to make an undertaking to me that, if the prevailing spot rate falls below 1.30 (the forward rate), then he will sell $100 to me in exchange for £76.92 at a rate of 1.30 (the exercise rate).

So now let us consider the three scenarios.

1) FX rate is 1.30 – I execute at the market rate and have to pay £76.92 to buy $100

2) FX rate is 1.25, the option kicks in (I am “in the money”), and I ask the seller to fulfil his promise, so I now only pay £76.92

3) FX rate is 1.35, I am out of the money (which is what I wanted) and I now have to convert at market rate and pay £74.07

Compare my obligations with the halal option, and without the halal option

So, we can see that we save money with the option – either we pay the same, or less, as we would without the option.

We have a chance of saving £3.08.

So, how much should we pay for the option? There is complex modelling to derive option pricing, but the economics is clear:

We should be willing to pay a premium to buy an option that is less than the savings we expect to make. So, should we pay £3.07 for the option, which is less than the £3.08 we could save?

The answer is no, because the £3.08 represents the MAXIMUM saving we can make. We have a fair chance of making zero saving, too. So, we need to apply some probabilities to the outcomes we are considering.

But that is a different topic!

Back to our halal option – a conventional option is impermissible, but this one is halal. Why?
1) The Waad is a Shariah compliant contractual form, it is a unilateral promise or undertaking
2) There is a real transaction that will occur in the future (if we are in the money) –

- we are converting one currency into another. A spot FX transaction is permissible.

Compare this to the rain option where we were paid cash if it rained – there is no tangible sale transaction there.

The wording of the Islamic option would look like this:

I (the seller of this halal FX option) undertake to sell to you $100 at a price of £76.92, on the condition that the prevailing FX spot rate in one month’s time is 1.30 or lower. If the rate is not in this range, then this undertaking is no longer valid.

As long as this halal option is used for genuine hedging purposes, then it is normally allowed by scholars. The buyer should have a genuine need to convert GBP to USD to meet a genuine payment obligation in the future.

It should not be used for speculation.

I would be interested if anyone can explain to me how this FX option could be used for speculation?

And this is how we create a Shariah compliant FX option for hedging purposes.

What do you think? Any questions? Observations?