Islamic Contracts and Hedge Technique - Term Paper Example

? Islamic contracts and hedge technique Islamic Finance is different from the conventional methods of financing. In the conventional modes of finance the hedging techniques are adopted in order to cover the various exposures in risks. Similar techniques are adopted in case of Islamic Finance. In this paper an attempt has been taken to analyse the different hedging techniques of the risks in the light of Islamic finance and the different perspectives of business under which the hedging techniques are being undertaken. The secondary research as done in the paper has been done with the support of the literatures already written by scholars and practitioners. The different aspects of the Islamic hedging techniques have been researched and analysed in this paper. Contents Contents 3 Introduction 4 Discussion 4 Background of Islamic Finance 4 Types of Contracts 6 Hedging Instruments of Islamic Finance 7 Profit Rate Swap 8 Foreign exchange Risk Hedging 9 Conclusion 10 11 References 12 Introduction Islamic Finance has been based on the principles of the Quran or more categorically on the principles of Sharia. According to the principles of Islamic Finance the acceptance and payment of interest is unfair. Thus Islamic Finance is devoid of any payment or receipt of interest in case of any business transaction. This kind of financing technique is adopted for the achievement of the goals which are specific to the Islamic economy. The sharing of the profit and loss is the main principle of the Islamic Sharia. According to the Sharia this measure would bring equity as well as justice in the economy. Hence the alternative names for the banks running on the principles of Islamic Finance are PLS bank. In the financial system there are various types of risks that persist which may result in a huge amount of loss. The hedging techniques are adopted in a financial market in order to cover a particular position of exposure which is generally in relation to a particular financial activity by taking a position that is opposite of what the risky situation is. Most of the banks take such hedging techniques in order to cover the exposures that arise out of the mismatches in the asset and liability of the books of accounts. These kinds of hedging techniques are also prevalent in the context of Islamic Finance. This essay looks into the various risk management measures that are being undertaken in order to provide a solution for the risk exposures and the types of instruments that are being implemented for the purpose. Discussion Background of Islamic Finance The main objectives of Islamic Finance are to promote the principles of Sharia in the ways in which business activities are being conducted. This is done with the objective of promoting growth and prosperity in the economy in a fair way. These financial services would conform to the principles of Sharia and would ensure that the distribution of income in the economy would be equitable and there would be optimal allocation of the resources in the economy in a justified manner. As opposed to the conventional modes of financing which considers interest as the opportunity cost of money, Islamic finance considers the existence of interest as an unjust practice. According to the principles of Islam, loans are provided by one party to the other to meet any kind of contingent situation that may arise. A lender should thus help the borrower to get the loan rather than taking undue advantage of it. Therefore there should be a relation of cooperation between the lender and the borrower. There is no relation of debtor and creditor as in case of commercial banking that is practice according to the general convention. The principles of Sharia state that there is simply no return that the people can actually reap unless they take any kind of risk. The principle in is practice in both the capital markets as well as the labour markets. This means that the labourers would not be eligible for wages unless they take some risks while working or bear a cost. On the other hand the capital would also not generate proper return unless the money is vulnerable and is exposed to the different kinds of risks that are inherent in a business. Thus the framework on which Islamic Finance is based is participatory in nature and is dependent on the profit and loss sharing of the entities involved. Therefore it is important to distinguish the features of Islamic finance as distinguished from the conventional banking framework. In the parlance of Sharia there are mainly four basic laws that govern the principles of Islamic finance. First of all the payment and the receipt of Riba or Interest is illegal. Secondly, there is uncertainty or gharar in the commercial transactions. Thirdly, people should not conduct certain activities which are illegal in the eyes of Islam or the society which is known as Haram. Finally, gambling or speculative transactions or maysir are disregarded as per the Islamic Sharia. There are a variety of transactions that are undertaken following the Islamic norms. These transactions are structured in different ways and are complex in nature. Thus there are a variety of financing techniques that are followed in Islam. These involve a number of contracts which constitute the base of all financial transactions as per the rules of Sharia (Usmani, 2001, pp. 14-53). These contracts include the contracts of sale like the salam or the murabaha, the contracts of lease or the ijira and the joint venture contracts between two parties like the musharaka or the mudaraba contracts (Tiby, 2011, pp. 47-57). The contracts form the basis of the hedging techniques that are adopted by the businesses and the entities that follow the Islamic Financing methods. Types of Contracts Murabaha, for example is a cost plus financing technique in which there is an agreement between three parties, i.e. the buyer, the seller and the intermediary. In this kind of a contract the intermediary would buy a commodity from a seller and would supply the same to the buyer keeping a certain percentage as the mark up profit margin. According to the principles of Sharia an intermediary can legitimately retain this percentage of profit because in this case the intermediary is buying the product and is thus exposed to the risk of holding the products. Therefore as the ownership is shifted from the intermediary to the buyer it can either be a physical possession or a constructed possession both of which are exposed to different kinds of risks. Thus Libor which is a common term used in the point of view of financial exchange is viewed as only a profit that is kept by the intermediary rather than a rate of interest on a certain amount of fund (Iqbal and Mirakhor, 2011, pp. 121-142). The murabaha is considered as a practical tool through which the liquidity or cash can be managed in case of the transactions between the banks. Thus most of the banks make use of such contracts as tools that may help in the hedging of the risks for the working capital management. For example, the risk of ownership is shifted from one person to another when a buyer buys a commodity from a seller. This kind of exchange system is prevalent in the London Metal Exchange where the commodity murabaha structure is being followed. In this kind of a hedging or the liquidity management system, one of the brokers sells the metal to the financer who in turn sells it to the end user. The end user makes deferred payments to the seller. On the other hand the end user would sell the products to the second broker who would again sell it to the earlier broker which is dealt at the spot rate of exchange (Ahmed, 1995, pp. 21-23). Thus it implies that the end user would have the cash in his hand and the bank would have to pay a certain amount with a profit margin at a future date. This is similar to the derivative technique that is practised on the present day in the non-Islamic financial markets. Hedging Instruments of Islamic Finance The banks that practice the principles of Islamic Finance over time have researched and found out the techniques that would help in the hedging of the various risks that may crop up in the context of Islamic Finance. These tools are being used by the banks as well as the clients of the banks. The Islamic Banks have a portfolio of products that are based on these fundamental principles. There are various fixed-rate products which do not depend on that of murabaha and these are mainly offered to the retail customers. On the other hand the businesses and the enterprises are offered with products that are devised based on the floating benchmark rates. Therefore there is a possibility of mismatch of asset-liability between the deposits which are generally kept with the banks for shorter periods of time and the loans which are served through longer periods of time (Choudhry, 2007, pp. 260–290). This kind of risk of mismatch also arises when some products are structured based on the fixed rates and the others based on the floating rates. The businesses also require some type of products which would help them to cover their risk exposure. These risks may crop up due to the fluctuations in the interest rates and the exchange rates. As a solution to these risks the different hedging instruments like the forward contracts and the profit rate swap have developed. Most of the financial institutions that practice Islamic finance exercise these kinds of contracts. Profit Rate Swap The profit rate swap is a kind of hedging technique that is applicable in the context of Islamic Finance. This swap deal is somewhat similar to the interest rate swap that is being conducted in the other financial markets. This kind of an agreement takes place between two parties one of which has a fixed exchange rate and the other has a floating exchange rate. Sharia contracts underlie each of these swap techniques. A contract known as wa’ad ensures that the counterparty does not fail at the end of the contract and the contract is successful. This is a unilateral assurance. At each stage of the swap contract both in the murabaha as well as the reverse murabaha stage this wa’ad contract is established between the parties (Khan, 2003, pp. 37-61). Thus each of the parties makes the promise that they would help to mature the contract at each and every stage. This is because in the entire contract of trade on party has to buy the commodity at a future date from the other party, the failure of which would lead to the expiry of the contract. However, there are a variety of ways in which this transaction can take place in conformity with the principles of Sharia and hence the different types of profit rate swap contracts. First of all, commodity murabaha structured profit swap rate is a popular tool for hedging the interest rate differentials. This is a vanilla derivative because it is directly linked with the asset-backed security of Sharia. The feature of Islamic derivatives used for hedging that distinguished it from the conventional derivatives it that it has to conform to the prohibitions which form part of the Sharia. In other words, there should be absence of riba or usury, the lack of uncertainty and any kind of gambling activity should be avoided. Hence the pricing strategy for the derivative products of Islamic finance has to be structured in a different manner so that the main binding principle is never netted off. Thus Muqasah or setting off the contract is established in a proper manner. Other form of the hedging instruments that are used in Islamic Finance is floating profit rate which is also another form of swap agreement. Like the conventional derivative instrument, in case of the Islamic swap agreement there is the presence of assurance through the wa’ad contracts. However in case of the Islamic finance there are always two sets of parallel agreements which is different from that of the conventional interest rate swap in which the derivatives exchange generally provides an advice to pay to each of the parties involved in the exchange. Foreign exchange Risk Hedging The business entities that follow the principle of Sharia can also hedge the foreign exchange risks in the most compliant manner using some of the most widely accepted measures. First of all, the forward exchange rate method incorporated the heterogeneous type of riwabi or the underlying securities that are different based on the rates of interest. There are also future contracts which may be distinguished by the names of Ba’i Salam contract, the Joa’la contract and the Istisna contract. These contracts are based on the payments and ownership which would be made at a deferred date. In case of the Salam contract the entire amount is paid at the present day on which the contract is taking place. There are various legs of this contracts each of which have to be undertaken till the end so that the contract matures. The contracts are however delivered hand to hand in the entire process which is not practised in case of the conventional derivative techniques (Mangla and Uppal, 1990, pp. 194-195). There are various other types of contracts which may be considered as tools that would be used to hedge the exposures arising out of the foreign exchange rate fluctuations. These include the back to back interest free loan, the contracts based on the murabaha contracts and the wa’ad based contracts. In the back to back interest free loans are the hedging strategies that are being used up with the help of the currencies of two different countries. On the other hand the murabaha based contracts rely on the commodity contracts between different parties. Wa’ad based contracts are those which are agreements based on the contracts made n a future date. There are several reasons why the organisations undertaking these contracts undergo the hedging techniques. The hedging methods would help the businesses to cover up the tax expenses and thereby reduce the financial distress of the companies. The companies can also hedge the risks that may arise out of the volatility in the fluctuation of the interest rates which may be specific to the country as well as the fluctuations in the exchange rates which may arise due to the differences in the value of the currencies across nations. The hedging of the risks was done in order to manage the risks that the insurance companies were exposed to. This is because in case of any incident of operational risk the insurance companies would come across huge losses. These would be covered up with the use of the financial methods used for the hedging of the risks of the insurers or the reinsurers. Conclusion From the above discussion and analysis of the hedging techniques as used in case of the Islamic finances it is clear that there is a huge possibility for the banks and the financial institutions to make use of the derivative instruments for hedging the risks of corporate as well as individuals even abiding by the principles of Sharia in the most appropriate manner. The principle of profit sharing and the interest free borrowing and lending can be undertaken and proper implementation of the hedging methods would help the entities hedge the different types of exposures arising out of the uncertainties in the economic scenario. The exotic contracts of the Wa’ad are a very practicable resource and law that would ensure that the contracts are executed till the end of the maturity. Thus the popularity of this discipline is increasing and it is becoming a widely researched topic for the scholars. References Choudhry, M., 2007. Bank asset and liability management: Strategy, trading, analysis. Hoboken, NJ: John Wiley & Sons. Iqbal, Z. and Mirakhor, A., 2011. An Introduction to Islamic Finance: Theory and Practice. Hoboken, NJ: John Wiley & Sons. Khan, M. A., 2003. Islamic Economics and Finance: A Glossary. New York: Routledge. Usmani, M. M. T., 2001. An Introduction to Islamic Finance. Washington: CQ Press. Ahmed, A., 1995. The Evolution of Islamic Banking: Encyclopaedia of Islamic Banking and Insurance. London: Institute of Islamic Banking and Insurance. Mangla, I. Y. and Uppal, J. Y., 1990. Islamic Banking: a Survey and Some Operational Issues. Research in Financial Service, Vol. 2, pp. 194-195. Tiby, A. M. E., 2011. Islamic Banking: How to Manage Risk and Improve Profitability. Hoboken, NJ: John Wiley & Sons. Read More