Islamic Derivatives Products

Malaysia has been a pioneer in Islamic banking and finance, with impressive growth in Islamic banking and asset management. Key developments over the past decade, such as the Islamic Interbank Money Market, Shariah-compliant equity indices, and sukuk markets, have driven this growth. This has led to increased need for with derivative instruments to manage the resulting exposure.   An Islamic equity index includes stocks deemed halal for Muslim investors. Derivatives, especially financial ones, remain controversial. The general view among Islamic scholars is to use on-balance sheet risk management techniques, despite the many disadvantages of on-balance sheet techniques. This article is divided into three sections: the first examines requirements for Islamic Derivatives, the second describes Islamic derivatives (Forwards, futures and options), and the third discusses Shariah-compliant risk management tools and scholars' perspectives on derivatives.

Understanding Islamic Derivatives

Derivatives are financial instruments whose value depends on the performance of underlying assets such as stocks, bonds, commodities, or currencies. Conventional derivatives, including futures and forwards, are widely used for hedging risks arbitraging or speculating on price movements. However, these instruments may involve elements prohibited by Shariah, such as excessive uncertainty (gharar), gambling (maysir), and interest (riba). 

Before examining existing instruments in Islamic finance with derivative-like features, it is crucial to understand the necessary features for Islamic financial instruments. All Islamic financial instruments and transactions must be free of the following five items to be considered halal: 

• riba (usury or interest), 
• rishwah (corruption), 
• maysir (gambling), 
• gharar (unnecessary risk or uncertainty), and 
• jahl (ignorance). 

Riba refers to any guaranteed increments in return without risk, while gharar involves uncertainty or deception in contracts. Maysir pertains to outcomes purely dependent on chance, and jahl relates to exploitation due to one party's ignorance. These principles ensure that transactions are fair and just for all parties involved. The Shariah aims and emphasizes for fair play and justice in all transactions. 

For the sale of real assets (as opposed to financial assets), Shariah requires that the underlying asset must be halal, exist, in its final physical form and be legally owned by the seller. These requirements would make anticipating hedging with derivatives challenging, but it is always necessary to maintain compliance with Islamic principles. 

Fortunately the Shariah provides exceptions to allow deferred sales when necessary, accommodating practical needs while adhering to Islamic guidelines. Islamic finance seeks to structure derivatives in a way that aligns with Shariah principles, ensuring that transactions are based on tangible underlying assets and real economic activities, thereby avoiding excessive uncertainty and speculation. By meeting these requirements, Islamic financial instruments can offer Shariah-compliant alternatives to conventional derivatives, promoting transparency, fairness, and stability in financial markets. Existing derivative like shariah compliant contract or instruments.

A number of shariah compliant contracts or instruments exist which have derivative like features. These are the Ba'i Salam, Istisna, Istijrar and Joa'la contracts. In addition there are later innovations like IPRS and waád based currency futures and options contracts. We examine these instruments below: 

1. Ba’i Salam 

Ba’i Salam is a transaction where two parties agree to a sale/purchase of an underlying asset at a future date but at a price determined and fully paid today. The seller commits to delivering the asset at the agreed future date and quantity. Unlike conventional forward contracts, the buyer pays the entire amount upfront in cash. This prepayment is aimed at assisting needy farmers and small businesses with working capital financing. As a result, the Salam price is often lower than the prevailing spot price, serving as compensation from the seller to the buyer for the prepayment privilege.

Several conditions apply to Ba’i Salam contracts, including full payment by the buyer at the time of sale, standardisability and quantifiability of the underlying asset, and clear enumeration of quantity, quality, maturity date, and place of delivery. The underlying asset must also be available and traded in the market throughout the contract period. 

Counterparty risk in Ba’i Salam contracts is one-sided, with the buyer facing the risk of the seller's default since the buyer has fully paid. To mitigate this risk, the Shariah allows the buyer to request security in the form of a guarantee or mortgage. Ba’i Salam contracts can also facilitate working capital financing by Islamic financial institutions (IFIs). Parallel contracts may be used to manage the underlying commodity without the IFI taking possession. Two types of parallel Salam are cited: one with the original seller and another with a third party. These parallel transactions must be independent of each other, and the original transaction should not be priced with the intention of a subsequent parallel Salam.

While exchange-traded futures generally meet these conditions except for full advance payment, Ba’i Salam contracts resemble forwards more closely due to their customized nature. Which also implies that the Salam like forwards can have  to issues like potential for price squeeze and counterparty risk.

In addition to Ba’i Salam, two other contracts that involve transactions on a "yet to" exist underlying asset are Istisna and Joa’la contracts. 

2. Istisna and Joa’la Contract

The Istisna contract involves a buyer contracting with a manufacturer to produce a specified product. The price is fixed, and the agreement can be cancelled by either party before production begins but not once productions it starts. Payment is not made in advance, and the delivery time is negotiated. These requirements minimize if not eliminate gharar. A parallel contract is allowed in Istisna, making it suitable for product financing by Islamic banks. 

The Joa’la contract is like Istisna but applies to services instead of manufactured products. For example, if a school needs uniforms, they could contract a tailor using Joa’la. The conditions for Joa’la are the same as those for Istisna, ensuring consistency in the application of these contracts. 

3. The Islamic Profit Rate Swap (IPRS) 

Islamic banks in Malaysia and other countries operate within a dual banking system, coexisting alongside conventional banks. This setup results in a shared customer base and financial ecosystem, which means changes in conventional banking deposit rates often necessitate corresponding changes in the profit rates of Islamic banks to prevent significant fund outflows. Consequently, Islamic banks, like their conventional counterparts, are susceptible to interest rate risks.

Interest rate fluctuations can cause substantial instability in bank balance sheets, underscoring the need for effective risk management strategies for Islamic banks operating in such environments. One innovative solution developed to address this challenge is the Islamic Profit Rate Swap (IPRS), approved by the National Shariah Advisory Council (NSAC) of Bank Negara Malaysia. The IPRS serves as a vital tool for Islamic Financial Institutions (IFIs) to manage their interest rate risks, despite the seeming irony of Islamic banks' exposure to such risks in a dual banking system.

Islamic banks in Malaysia typically have assets (such as customer loans) based on fixed-rate contracts like Bai Bithamin Ajil (BBA) or Murabaha. However, the cost of their deposits fluctuates in tandem with conventional bank interest rates, creating a mismatch that can lead to large positive duration gaps in their balance sheets. Conventional banks mitigate this risk through floating or adjustable-rate customer financing a strategy, not available to Islamic banks reliant on deferred sale contracts. The IPRS, therefore, emerges as a timely instrument for managing rate risk.

The mechanics of the IPRS involve two stages. In the first stage, the Islamic bank sells an asset to a counterparty for a notional amount, and the counterparty resells the asset to the bank at the notional principal plus a fixed markup profit rate. This stage results in the Islamic bank becoming the fixed profit payer, with payments due according to the reset period (e.g., quarterly or semi-annually).

Sources: Obiyathullah (2019) Islamic Capital Market; A Comparative Approach World Scientific Publisher.

In the second stage, the Islamic bank sells an asset to the counterparty for a notional amount plus a floating rate based on an agreed-upon reference rate. The counterparty then resells the asset to the Islamic bank for the notional amount. As a result, the counterparty becomes the floating profit rate payer, and upon completion of both stages, the Islamic bank is positioned as the fixed profit rate payer and floating rate receiver. The counterparty assumes the opposite roles.

This arrangement allows the Islamic bank to manage interest rate risk effectively. The floating rate received from the swap offsets the fluctuating costs on the liability side of its balance sheet (i.e., customer deposits), while the fixed rate payment aligns with the fixed rate payments received from its customers. Essentially, the IPRS functions similarly to a plain vanilla, fixed-for-floating interest rate swap, designed to manage interest rate risk while complying with Shariah requirements by involving underlying physical assets to base the cash flows.

Result: Managing Rate risk with IPRS

Sources: Obiyathullah (2019) Islamic Capital Market; A Comparative Approach World Scientific Publisher.

4. Waád based Currency Forwards and Options

Given the need for shariah compliant derivatives to manage currency risks, a number of waád based instruments have been innovated. The two must common are the Islamic FX Forward and the FX Waád Option. 

a. The Islamic FX Forward 

The most popular waád based forex product is probably the Islamic FX forward. Known alternatively as the Islamic FX outright, FX forward waád -I, or by other names, it involves the use of a unilateral waád. Under this arrangement, an IFI provides a unilateral promise ( waád ) to a customer in return for a fee. Depending on the customer need’s need, the waád by the IFI could be either to buy or sell a currency in exchange for another at a predetermined price and future date. Depending on the IFI’s product structure, there may be another unilateral waád by the customer to the IFI. The customer’s waád would obviously be in the opposite direction that is promising to deliver or take delivery of the currency from the IFI at a pre-determined price or exchange rate. By way of these waád arrangements, a customer effectively “locks in” the exchange rate at which he will buy or sell a currency to the IFI. In essence, this waád arrangement replicates a conventional forward contract.

For example, A Malaysian importer has Taiwan Dollar (TWD) 30 million payable to ACER Corp. for a shipment of notebook computers. Payment is due in 60 days. The Malaysian company is afraid of any appreciation of the TWD against the Ringgit. To hedge the risk, the Malaysian company enters an Islamic FX forward waád contract. Assuming the IFI charges a fee of say RM 2,500 for the unilateral promise it makes to the Malaysian co. the importer would lock in a MYR cost of 30 million TWD @ 9.5 = RM 3,157,894.74 + fee charges RM 2,500 so the Hedged cost = RM 3,160,394.74

Notice that the hedged cost of RM 3,160,394.74 to the Malaysian company locked-in on Day-0. Thus, over the following 60 days, the Malaysian company is unaffected by any changes in the MYR/TWD rate. 

Illustration as below: 

Source: Obiyathullah (2019) Islamic Capital Market; A Comparative Approach World Scientific Publisher.

b. The FX waád  (FX Option)

This is another waád -based forex product offered by IFI’s. This Shariah-compliant product effectively replicates a conventional currency option. A customer intending to use this product will “buy” a promise from the IFI to either buy or sell one currency for another foreign currency, for a fee. In essence, the customer is buying the right to buy or sell a currency at a predetermined rate in essence for a fee. At a maturity date, the customer can exercise this right. If a customer buys the right to sell a foreign currency under this waád arrangement, he is effectively purchasing a put option on the currency in conventional terms. A waád arrangement to buy a currency would constitute a long call position. 

Notice that with waád option, one is not “locking in” a cost as was the case with the waád based forward. With the option, one establishes instead a maximum cost or a “ceiling” on the payable amount. To see why this is so, suppose the TWD (Taiwan dollar) depreciates against the Ringgit over the next 60 days, it may be better for the Malaysian company to not exercise the waád option with the IFI, but instead purchase the TWD at the lower spot rate. Depending on how much the TWD depreciated, the cost of the shipment would be lower. 

For example, let us say the FWD depreciates against the Ringgit such that on Day 60, the rate is: 

Spot rate on Day 60 = 12 TWD per MYR

Or = 0.0833 MYR per TWD

It is obvious that not exercising the waád option would be better. 

The cost of the TWD 30 million will be RM 2.5 million if purchased in the spot market. The company’s total cost will be RM 2.502 million if the RM 20,000 fee paid to the IFI earlier is included.

Explanation on example: Suppose the Malaysian company in the earlier example wants to use a waád-based option rather than the waád forward arrangement. Here the Malaysian company is effectively buying a 60-day call option on TWD 30 million for a fee. This fee is very much like the premium for a call option. Cash flows would be as follows: 

Step 1, t= Day 0

Step 2: t = Day 60; If Malaysian company chooses to exercise. 

Suppose the IFI charges a fee of RM 20,000 for the waád  option, then the Malaysian company is assured that its maximum cost on the shipment from Taiwan is Payment exercise = RM 3,157,894.74

Fee (Premium) paid to IFI = RM 20,000

Maximum cost = RM 3,177894.74

> Sources: Obiyathullah (2019) Islamic Capital Market; A Comparative Approach World Scientific Publisher.

Thus, with the waád option, the Malaysian company is buying itself insurance against appreciation of the TWD. While the forward protects against TWD appreciation but does not allow the company to take advantage of TWD depreciation, the option contract does. It is this flexibility of the option that makes it more attractive. Given that options allow one to hedge against unfavourable movements while also providing the opportunity to take advantage of favourable movements, their cost (premium) would be much higher. So, the fee paid to the IFI in the waád forward would much lower that the paid for the waád option. 

Future Prospects of Islamic Derivatives

The future of Islamic derivatives, including futures and forwards, appears promising as the demand for Shariah-compliant financial instruments continues to grow. Several factors contribute to this positive outlook:

1. Market Expansion: The global Islamic finance market is expanding rapidly, driven by increasing awareness and demand for Shariah-compliant products. This growth creates opportunities for the development and adoption of innovative Islamic derivatives.
2. Regulatory Support: Governments and regulatory bodies in Muslim-majority countries are increasingly supportive of Islamic finance, creating favourable environments for the development and regulation of Islamic derivatives. Initiatives to harmonize Shariah standards globally are also underway, which could further boost market confidence and growth.
3. Technological Advancements: Fintech innovations, such as blockchain and smart contracts, hold significant potential for the Islamic finance industry. These technologies can enhance transparency, reduce transaction costs, and ensure compliance with Shariah principles, making Islamic derivatives more accessible and attractive to investors.
4. Educational Initiatives: As knowledge and understanding of Islamic finance grow, more financial institutions and professionals are gaining expertise in structuring and managing Shariah-compliant derivatives. This increased expertise will facilitate the development of more sophisticated and diverse Islamic derivative products.

Conclusion

Islamic derivatives, specifically shariah forwards and options, represent a vital component of the Islamic financial system, offering risk management tools while adhering to Shariah principles. Through innovative structuring methods such as parallel salam, istisna, wa'ad-based futures and forwards, and commodity murabaha, these instruments provide Shariah-compliant alternatives to conventional derivatives. As the Islamic finance market continues to expand, supported by regulatory advancements and technological innovations, the future of Islamic derivatives looks promising, paving the way for more robust and diverse financial products in the years to come.

References: 

Bacha, O. I., & Mirakhor, A. (2019). Islamic capital markets: A comparative approach. World Scientific.

Muhammad, M., Sairally, B. S., & Habib, F. (2015). Islamic capital markets: principles & practices. In ISRA eBooks. https://ikr.inceif.org/handle/INCEIF/2122