financial hedging tools and islamic finance

SUBMITTED TO: SIR ABID MEHMOOD

GROUP MEMBERS
asad hussain, sufyan memon and samiullah memon
Contents
Introduction.................................................................................................................................................2
Options used by companies for financial hedging.......................................................................................2
1. Future and Forward Contract:..........................................................................................................2
2. Options:...........................................................................................................................................2
3. Swaps:.............................................................................................................................................2
4. Diversification:................................................................................................................................2
5. Derivatives:......................................................................................................................................2
6. Insurance:........................................................................................................................................2
Islamic perspective regarding financial hedging tools.................................................................................3
Shariah – complaint alternatives of financial hedging tools:.......................................................................4
Alternative to Future and forward contracts:...........................................................................................4
Alternative to Swaps (Islamic Profit Rate Swap):...................................................................................4
Derivative Features Amongst Islamic Contracts:.........................................................................................5
Salam Contract........................................................................................................................................5
Bay Al Arbun..........................................................................................................................................5
Istijrar Contract........................................................................................................................................5
Conclusions:................................................................................................................................................6

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 FINANCIAL HEDGING

Introduction
The process of controlling price risk using a financial derivative (such as a swap, option or future
and forward contracts) to counteract the shift in value of a connected physical transaction is
known as financial hedging. Investors, companies, and individuals use financial hedging as a risk
management technique to balance or lower the risk of unfavorable price changes in the financial
markets. By establishing a stake in a financial instrument that moves in the opposite direction of
the asset or investment being safeguarded, one can hedge against prospective losses.

Options used by companies for financial hedging.

1. Future and Forward Contract: Investors can fix the price of an asset at a future date by
using forward or futures contracts. By setting a fixed price for the item later, this helps
guard against price swings. The key difference between forward and future contracts is
standardization. Future contracts are considered more formal as compared to forward
contracts. And they also traded through intermediaries.
2. Options: Options grant the holder the right, but not the duty, to purchase or sell an asset
within a given period at a defined price. Options allow for possible earnings while
providing protection against adverse price swings.
3. Swaps: Swaps are transactions in which two parties exchange financial instruments or
cash flows. Common varieties that enable entities to manage risks associated with interest
rates, currency exchange rates, or commodity prices are interest rate swaps, currency
swaps, and commodity swaps.
4. Diversification: Hedging can also take the form of distributing investments among
several asset classes or types. Investors seek to mitigate the effects of underperforming
individual investments on the portfolio as a whole by diversifying their holdings.
5. Derivatives: Diverse derivative instruments, including swaps, options, and futures, are
frequently employed in hedging tactics. These financial contracts can be used as a hedge
against price fluctuations because their value is derived from an underlying asset.
6. Insurance: Insurance is a type of risk hedging, despite not being a conventional financial
instrument. Companies frequently buy insurance policies to guard against possible losses
from occurrences like property damage.

A hedger's specific goals and market conditions are among the many factors that determine how
effective a hedging strategy is. Different hedging strategies are appropriate for different kinds of
risks and financial situations. As the risk cannot be completely mitigated but somehow it can be
managed.

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 Islamic perspective regarding financial hedging tools

The permissibility of financial hedging tools in Islam depends on their adherence to Shariah
principles. Hedging, in general, is considered permissible in Islam as it aims to mitigate risk and
protect wealth, which is an encouraged objective in Islamic finance as well. However, some
specific hedging instruments, such as conventional swaps and derivatives, may raise concerns
from a Shariah perspective due to their potential involvement in prohibited elements such as riba
(interest), gharar (uncertainty), and qimar (gambling).

Most prominent Islamic scholars have great debate on this topic, why these conventional risk
hedging tools just as (future contracts, swap contracts, forward contract etc.) are non-complaint
with shariah rules. They give some specific and concluded arguments that no doubt these
hedging tools help the individuals to mitigate their risk, but here one of shariah rule is violated,
by using swap or future contracts here one party bare lose and an other party get benefit. This
thing is clearly prohibited in Islam.

Another thing is that, it is a well recognised principle of the Shariah that sale or purchase cannot
be affected for a future date. Therefore, all Forward and Futures transactions are invalid in
Shariah.
Islamic scholars generally prohibit futures contracts in finance for two main reasons. Firstly,
Shariah principles reject sales or purchases for future dates, as stated in a hadith by Prophet
Mohammad. Secondly, many futures transactions lack the intention of commodity delivery, often
settling only price differences, viewed as speculative and akin to gambling, thus forbidden in
Islam. Scholars like Mufti Taqi Usmani support these views. While some, like Khan, find
similarities with Prophet's principles, the debate continues, with objections often rooted in
individual interpretations of Shariah and scholars' understanding of these financial instruments.

It doesn’t mean that shariah rules can’t help an individual to hedge their risk. They have also
their own hedging tools that are shariah complaint risk hedging tools :

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 Shariah – complaint alternatives of financial hedging tools:

Alternative to Future and forward contracts:

Shariah compliant contracts as alternatives to futures and forward contracts by proposing Bay’
Salam and the Wa’dan structure. Bay’ Salam is one potential contract. Bay’ Salam is a
transaction where two parties agree to trade an underlying asset at a predetermined future date
but at a price determined which is fully paid at the time of contracting. This is similar to a
conventional forward contract however, the big difference is that in Bay’ Salam, the buyer pays
the entire amount in full at the time the contract is initiated.

Another potential Shariah compliant alternative to futures and forwards is a model using two
independent unilateral promises (Wa’dan). Each promise is intended to be legally binding. If the
parties use English law, each promise will be executed as deeds, making it legally enforceable.
One party can make a unilateral promise to buy 10,000 bushels of soybean on x date at a forward
price of $3.5/bushel if the price is less than $3.5/bushel. The seller can make a unilateral promise
to sell 10,000 bushels of soybean on a specific date at a forward price of $3.5/bushel if the price
is $3.5 or more. The concept and use of Wa’dan is still debated among Shariah scholars in the
Islamic finance industry.

Alternative to Swaps (Islamic Profit Rate Swap):

The Islamic profit rate swap is an Islamic finance arrangement which is similar to an interest
rate swap but is structured to be Shariah compliant. Under a profit rate swap, two parties agree to
exchange periodic fixed and floating payments by multiplying a pre-agreed notional amount by
the applicable fixed and floating rates agreed by the parties.

It is similar to conventional rate swaps, utilizing Murabaha and Musawamah structures. There's a
debate on cost transparency between the upfront (Murabaha) and the unknown (Musawamah)
approaches. It is still continue they haven’t reached at any conclusions.

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 Derivative Features Amongst Islamic Contracts:

There are various similar conventional derivatives features in Islamic contracts:

Salam Contract: Similar to conventional futures but involving full prepayment, the Salam
contract has direct benefits for needy farmers and small businesses.

Bay Al Arbun: In Bay Al Arbun, the buyer deposits earnest money, which becomes part of the
price if the contract proceeds. It resembles a traditional call option but with the deposit becoming
part of the price.

Istijrar Contract: The Istijrar contract is a complex combination of options, average prices, and
Murabaha agreements. It involves purchasing at different time intervals under a master
agreement.

There are two types of Istijrar contracts: one where the price is determined after all
transactions (complete Istijrar) and another where the price is determined in advance, but
purchases are executed over time.

Generally Derivative Features Amongst Islamic Contracts are Various implicit and explicit
derivative contracts exist under Shariah-compliant instruments. Contracts like Salam, Bay Al
Arbun, and Istijrar share characteristics with conventional derivatives.

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Conclusions:

In conclusion, Shariah-compliant financial hedging offers a unique and ethical approach to risk
management in the financial landscape. By adhering to Islamic principles, such as avoiding
speculation and interest, these financial hedging tools provide a framework for businesses and
individuals to protect themselves against market uncertainties while staying within the bounds of
Shariah law. This not only aligns with ethical considerations but also fosters financial stability
and resilience in a manner consistent with Islamic finance principles. As the global demand for
ethical financial solutions continues to rise, Shariah-compliant financial hedging stands as a
testament to the adaptability of traditional practices in meeting contemporary economic
challenges. Financial hedging tools play a crucial role in managing and mitigating financial risks,
providing individuals and businesses with a means to navigate uncertain economic landscapes.
By utilizing these tools, stakeholders can protect profits, enhance financial stability, and
strategically position themselves in a dynamic and competitive financial environment. In Islamic
Perspective, hedging tools are employed to protect against potential losses and uncertainties,
providing a level of financial security in an unpredictable economic environment. conclusion, the
Islamic perspective on hedging emphasizes the principles of fairness, risk-sharing, and ethical
conduct in financial transactions.
Islamic finance encourages risk management practices that avoid uncertainty (gharar) and
prohibit transactions involving excessive uncertainty or ambiguity. Hedging in accordance with
Islamic principles serves as a means to protect against unpredictable market fluctuations while
upholding the values of justice and transparency. By integrating ethical considerations into
financial decision-making, Islamic hedging not only provides risk mitigation but also aligns with
the broader goal of promoting economic stability and social justice in accordance with Islamic
teachings. As the global financial landscape evolves, the Islamic perspective on hedging
continues to offer a distinctive approach that resonates with those seeking financial solutions
rooted in ethical and moral principles.