UNIVERSITI UTARA MALAYSIA

COLLEGE OF BUSINESS
SUBJECT: ISLAMIC INVESTMENT BWFS 3013 GROUP: A TITLE: DERIVATIVE INSTRUMENTS

PREPARED FOR: MDM.ROSEMALIZA BINTI AB RASHID PREPARED BY: NABIL BIN ISMAIL FATIN SYAZWANI BINTI SAFIYUDDIN NOOR IZWAIDA BINTI CHE ADNAN HANI NABILAH BINTI MAZLAN ALI 193234 201045 201093 201105

DATE OF SUBMISSION 20 DECEMBER 2011

TABLE OF CONTENT
Bil Content 1 History and evolution of the industry-focusing on legal and regulatory framework (related acts and supervisory bodies), tax implication and any government incentives to promote the industry. 2 Products and Instrument. 3 Market players-investors, issuers and intermediates. 3.1 user and uses of derivative 3.2 market player Page

3.2.1 The Hedger 3.2.2 The Speculator 3.2.3 The Regulator 3.3 Derivative Intermediaries
4 Comparison of Islamic and Conventional Products 4.1 Forward and Future Derivatives. 4.1.1 Conventional Derivatives 4.1.2 Islamic Derivatives 4.1.2.1 Bai Salam 4.1.2.2 Istisna and Joala 4.1.2.3 The Bank Offering Forward /Future Derivatives 4.2 Option 4.2.1 Conventional Derivatives 4.2.1.1 Index Option 4.2.1.2 Future Option 4.2.1.3 Foreign Currency Option 4.2.1.4 Interest Rate Option 4.2.2 Islamic Derivatives 4.2.2.1 Istijrar 4.2.2.2 Waad 4.3 Swaps 4.3.1 Conventional Derivatives 4.3.2 Islamic Derivatives 4.3.2.1 Waad Swap 4.3.2.2 Murabahah Swap 4.3.2.3 The Bank Offering Swap Derivatives Relevant statistics-current development. Contemporary issues Appendix Reference

5 6 7. 8.

1.0 HISTORY AND EVOLUTION OF DERIVATIVES

2.0 PRODUCTS AND INSTRUMENTS

3.0 MARKET PLAYERS-ISSUERS,INVESTORS AND INTERMEDIARIES 3.1. USER AND USES OF DERIVATIVE Derivatives make future risks tradable, which gives rise to two main uses for them. The first is to eliminate uncertainty by exchanging market risks, commonly known as hedging. Corporate and financial institutions, for example, use derivatives to protect themselves against changes in raw material prices, exchange rates, interest rates etc., as shown in the box below. They serve as insurance against unwanted price movements and reduce the volatility of companies cash flows, which in turn results in more reliable forecasting, lower capital requirements, and higher capital productivity. These benefits have led to the widespread use of derivatives: 92 percent of the worlds 500 largest companies manage their price risks using derivatives. The second use of derivatives is as an investment. Derivatives are an alternative to investing directly in assets without buying and holding the asset itself. They also allow investments into underlying and risks that cannot be purchased directly. Examples include credit derivatives that provide compensation payments if a creditor defaults on its bonds, or weather derivatives offering compensation if temperatures at a specified location exceed or fall below a predefined reference temperature. Derivatives also allow investors to take positions against the market if they expect the underlying asset to fall in value. Typically, investors would enter into a derivatives contract to sell an asset (such as a single stock) that they believe is overvalued, at a specified future point in time. This investment is successful provided the asset falls in value. Such strategies are extremely important for an efficiently functioning price discovery in financial markets as they reduce the risk of assets becoming excessively under- or overvalued. Derivatives serve a useful risk-management purpose for both financial and nonfinancial firms. It enables transfer of various financial risks to entities who are more willing or better suited to take or manage them. Participants of this market can broadly be classified into two functional categories, which is namely, market-makers and users. 1. User: A user participates in the derivatives market to manage an underlying risk. They are Business entities with identified underlying risk exposure.

2. Market-maker: A market-maker provides bid and offer prices to users and other marketmakers. A market-maker need not have an underlying risk. They are All Commercial Banks (excluding LABs & RRBs) & Primary Dealers (PDs). Banks and PDs should develop sufficient understanding and expertise about derivative products both in terms of staff and systems in order to undertake derivative business as market makers. At least one party to a derivative transaction is required to be a market maker. Purpose of user 1) Users - can undertake derivative transactions to hedge - specifically reduce or extinguish

an existing identified risk on an ongoing basis during the life of the derivative transaction - or for transformation of risk exposure, as specifically permitted by RBI. Users can also undertake hedging of a homogeneous group of assets & liabilities, provided the assets & liabilities are individually permitted to be hedged. 2) Market-makers - can undertake derivative transactions to act as counterparties in

derivative transactions with users and also amongst themselves.

3.2 MARKET PLAYER- (INVESTMENT MANAGER) Investment managers utilize derivative instruments in several ways in client portfolios. The most prevalent reasons for using derivatives, as opposed to purchasing physical securities, are to hedge factor exposures, obtain synthetic exposure to a security, employ leverage, or obtain diversified exposure to a basket of securities. Investment managers and other market participants also look to the derivatives market to gain insight into available liquidity and the value of credit risk. Hedging Instrument. Hedging refers to an action taken that reduces a certain risk in a portfolio. Fixed income managers commonly use derivatives to hedge various exposures in portfolios. Risks that a manager may want to hedge include interest rate risk, credit risk, currency risk, or risks unique to mortgage-backed securities, such as prepayment and extension risk. Instruments such as futures,

swaps, forward contracts, and options are used by managers for hedging purposes. For example, suppose a manager purchases several long-dated corporate bonds but wants to maintain an interest rate risk profile similar to that of its short-dated benchmark. The manager can enter into an interest rate swap that provides exposure to short-term rates at the expense of long-term rates to lessen its exposure to long-term interest rates. Another example of a transaction involving derivatives for hedging purposes involves currency risk. If a manager identifies an attractive local currency foreign bond but does not want to introduce currency volatility into the portfolio, the manager can sell a forward contract on the local currency to receive a fixed U.S. dollar rate, thus eliminating the exposure to the foreign currency. Leverage Vehicle. Leverage is the opposite of hedging in that it increases a certain risk in a portfolio rather than decreases it. While leverage is most commonly associated with opportunistic strategies such as hedge funds, transactions that introduce leverage are common in traditional long-only fixed income portfolios. Similar to hedged positions, leverage may be employed to increase the same set of risk factors while using the same set of derivative instruments. An example of a leveraged position that managers commonly employ appears in portfolios managed to an extended duration target. In those portfolios, a manager may purchase a number of physical bonds to achieve a diversified bond portfolio and purchase long-dated Treasury futures or enter into an interest rate swap that supplies long-term interest rate exposure at the expense of short-term interest rates. The manager will also have to manage a high-quality, short-term collateral pool to meet margin requirements, or collateral needed to cover the credit risk associated with obtaining the long-term interest rate position. The result is that the portfolio will be over-exposed to long-term interest rates, while a portion of assets will be managed as collateral. Synthetic Exposure. A manager may purchase or sell a derivative in order to achieve synthetic exposure to a security that the manager does not want to purchase in the cash market. Reasons for gaining exposure to a security synthetically may include cheaper transactions costs, liquidity issues associated with certain cash bonds, and the lack of supply of availability of certain physical bonds in the marketplace. A common example of managers utilizing derivatives to gain synthetic exposure to

a corporate credit is by selling protection via a credit default swap (CDS) to gain exposure to the same credit risk as a physical corporate bond. If an investment manager wants to express a position on a small issue of a corporate bond, the cash market may not provide the liquidity necessary to build such a position in a timely fashion. Instead, the manager can buy a similarmaturity Treasury bond in the cash market and sell protection of a similar-maturity CDS of the corporation to capture the credit risk associated with the corporate bond issue. Managers can also utilize the derivative markets to gain synthetic exposure to long-term interest rates that the cash market does not provide. For example, by entering into an interest rate swap, an investment manager can extend its duration exposure to 35-, 40- , 45-, and 50-years, while the longest-dated bond available in the cash market has a 30-year term structure. An investment manager may utilize such swaps in an extended duration bond portfolio that is structured to match the duration profile of a liability stream with some long-dated obligations. Diversification. A manager may purchase or sell a derivative in order to achieve diversified exposure to a basket of securities instead of purchasing each security directly in the cash market. This is a common practice when an investment manager wants to gain exposure to an asset class, such as investment-grade or high yield corporate bonds, in a diversified manner with a small amount of money. Because the dollar amount is relatively small, transaction costs would be large if the underlying bonds were purchased in the cash market. Examples of such derivatives include CDX, which is the credit default swaps index, a derivative that tracks a basket of investment grade credit, high yield corporate, or emerging market debt, the asset-backed credit derivative index that tracks baskets of home equity asset-backed securities; and CMBX, the commercial mortgage-backed securities derivative that offers exposure to various commercial mortgagebacked security indexes. The derivatives market offers numerous benefits to investment managers and the clients they serve by providing the opportunity to manage risks more effectively. Investment managers creatively use derivative strategies in client portfolios in order to mitigate risk, employ leverage, gain synthetic exposure to securities, and diversify exposure. As the derivatives market has

evolved, the instruments have become more complex in nature and their use has become increasingly common.1

3.2.1 The Hedgers This is the third in a six-article series on how to trade futures, brought to you by Bursa Malaysia Derivatives Berhad (BMD) and OSK Investment Bank Berhad, in conjunction with BMD's 'Talk Futures' campaign aimed at creating awareness and educating investors on derivatives trading. In the last segment we discussed the origins of Futures markets, now lets see how they basically work. In the last segment, we covered the fundamentals of how the futures markets worked. This then brings us to the two primary types of players in the futures market; the hedgers and the speculators. Hedgers are the people, mostly farmers, manufacturers, importers and exporters, who wish to secure a future price for a commodity in order to protect themselves against the volatility of the commodity price. In other words, hedgers use futures contracts to protect themselves against price risks. Take for example, in June; a palm oil producer expects to harvest at least 25,000 tons of Palm Oil in September. Say that the Crude Palm Oil Futures contract for September trades in June for RM3500 per metric ton. By selling the September CPO contract at RM3500 in June, he can secure a price for his palm oil price and protect himself against the possibility of falling prices of palm oil in September. Even if crude palm oil prices were to drop to RM2800 when comes to September, the produce had effectively locked in the price of RM3500 by hedging it with CPO Futures.

ENNISKNUPP|STRENGTHFROMKNOWINGSM2009Ennis,Knupp&Associ ates,Inc.

In this example: Suppose that Company JL knows that in six months it will have to buy 5,000 ounces of a certain raw metal to fulfill an order. Lets say the price for silver is $39.5 an ounce in June and the futures price for October Contract is $40 an ounce. By buying the silver futures contract, Company JL can secure a price of $40 an ounce that reduces the company's exposure to price risks. Even if Silver prices shot up to $60 an ounce JL will be able to close its futures position and have effectively bought 5,000 ounces of Silver at $40 an ounce. 3.2.2 The Speculator The speculators on the other hand, are the direct opposite of hedgers. Hedgers use futures to mitigate risk whereas speculators use futures to benefit from the risk itself. Speculators are individuals who prefer to profit from the risk that the hedgers are protecting themselves against. Since higher risks provide higher returns, the speculators enjoy such volatility as it brings them substantial benefits. Thus, speculators do not intend to own the underlying asset of their futures contract. Rather, a speculator would enter a market to seek profit and take the profit by offsetting their position in the market (buy what is sold, sell what is bought) after benefiting from the rise and fall of prices. There are many types of speculators. They all have different trading methodologies and their style varies from one to another. There are the speculators that are the member of an exchange; they used to be most likely being spotted at the trading floor in their favorite spot. For private speculators, they may specialize in a certain commodity and only trade that particular commodity day after day. For example, Joy may trade the gold futures only and she only specializes in that particular commodity and trades it every day. This will make her a private speculator. There are also traders who buy or sell contracts at the slightest move of the price; for example, fraction of a cent. These traders are called scalpers and they are very active in the market, hoping to secure a profit through the small movements of the price. There are also day traders who buy and sell contracts throughout the day and then closing their position before the session ends. There are also position traders where they will hold their position for days, weeks or months.

It is obvious that there are different speculators that embody different styles and preferences. There are no better styles or approaches. All approaches are unique to each speculator and if one can find a profitable trading strategy in a particular method; they will almost usually stick to what works for them. However, what works for one may not work for others.2

3.2.3 The regulator Global regulators have set out guidelines for standardising the reporting of derivatives trades as part of a continued drive to increase transparency and prevent the build-up of systemic risk between dealers of over-the-counter products. The International Organisation of Securities Commissions and the Bank for International Settlements said in a joint report today that all derivatives trades must be reported to central information warehouses, known as trade repositories, using a common format. Trade repositories are an important tool for regulators in gathering information on global trading, and are identified in regulation being drafted by US and European regulators as a method of cracking down on market abuses and improving transparency. The guidelines are designed to give regulators better visibility on the extent of global derivatives positions in order to prevent the build-up of systemic risk, the regulators said today. In their report, the bodies said that trades should be tagged with codes known as "legal entity identifiers", or LEIs, which would be recognised across different global trade repositories. Iosco said this is necessary in the interests of furthering understanding of the OTC derivatives marketplace and encouraging market discipline. As a universally available system for uniquely identifying legal entities in multiple financial data applications, LEIs would constitute a global public good, the report said.

http://www.bursamalaysia.com/website/bm/bursa_basics/investing_basics/why_trade_in_futures/hedgers.html

In the immediate aftermath of Lehman Brothers default in September 2008, the biggest problem facing the derivatives market was understanding which counterparties the failed bank held positions with. Lehmans interest rate swap portfolio, the most common type of derivatives contract, was worth $9 trillion. The OTC derivatives market is made up of private, bilaterally agreed trades between banks and other counterparties, meaning contracts are rarely submitted to clearers in a readily identifiable format, even when cleared. Trade repositories are private, industry led solutions that allow greater oversight of the financial system, and are competing for derivatives dealers business. This raises the possibility of a lack of unified trading data being accessible to global regulators. Iosco and BIS today recommended minimum levels of data which should be submitted to repositories, such as what counterparties are involved in a trade. It also makes further suggestions on additional data which, it says, may be useful for assessing systemic risk. These focus on reference data for affected parties in the event of a default. The infrastructure needed to support new clearing and reporting requirements as a result of post-crisis regulation, including trade repositories, will cost the derivatives industry $3.4bn this year alone, according to a recent report by US research firm Tabb Group.3

http://www.efinancialnews.com/story/2011-08-24/global-regulators-outline-derivatives-reporting-rules

3.3 DERIVATIVES INTERMEDIARIES

Name & Address

Type of General General Preference Clearing Contact Share Participants (Phone & Fax) A, B, C Tel: 603 9235 3235 Fax: 603 2032 3221

Trading Contact

AmFutures Sdn Bhd 11th, 15th & 16thFloor, Bangunan AmBank Group 55 Jalan Raja Chulan 50200 Kuala Lumpur CIMB Futures Sdn Bhd 9th Floor, Commerce Square Jalan Semantan Damansara Heights 50490 Kuala Lumpur ECM Libra Investment Bank Bhd Ground Floor, West Wing Bangunan ECM Libra No. 8, Jalan Damansara Indah 50490 Kuala Lumpur Fedrums Sdn Bhd PLO 338, Jalan Tembaga Dua Kawasan Perindustrian Pasir Gudang P O Box 80 81707 Pasir Gudang

Tel: 603 9235 3223 Fax: 603 2032 3221

futures@ambg.com.my

A, B, C

Tel: 603 2084 9999 Fax:603 2093 7782

Tel: 603-2093 2968 Fax: 603-2094 6368

futures@cimb.com

A, B, C

Tel: 603 2178 1921 Fax: 603 2031 7323

Tel: 603 - 2178 1888 Fax: 603 - 2032 5035

futures@ecmlibra.com

C (Conducts Proprietary Trading Only)

Tel: 607 268 8222 Fax: 607 251 4970

Johor Darul Takzim HDM Futures Sdn Bhd Tingkat 16 (Sebahagian), Plaza Masalam 2, Jalan Tengku Ampuan Zabedah E9 / E Section 9 40100 Shah Alam Selangor Darul Ehsan Hong Leong Investment Bank Bhd Level 6, Menara HLA No.3, Jalan Kia Peng 50450 Kuala Lumpur Innosabah Options Futures Sdn Bhd 11 Equity House, Block K Sadong Jaya, Karamunsing 88100 Kota Kinabalu, Sabah Inter-Pacific Securities Sdn Bhd West Wing, Level 13, Berjaya Times Square No. 1, Jalan Imbi 55100 Kuala Lumpur IF Derivatives Sdn Bhd formerly known as Interactive Futures Sdn Bhd) Suite 15.3, Menara A, B, C Tel: 603 5519 3398 Fax: 603 5511 5002 Tel: 603 5519 3398 Fax: 603 5511 5002

smtai@hdbs.com.my

A, B, C

Tel: 603 2163 6288 Fax: 603 2161 8109

Tel: 603 2163 6288 Fax: 603 2161 8109

futures@hlib.hongleong.com.my

A, C

Tel: 088 267 163 Fax: 088 267 162

Tel: 6088 267 163 Fax: 6088 267 162

ifsb@innosabah.com.my

A, C

Tel: 603 2117 1838 Fax: 603 2144 1686

Tel: 603 2142 7586 Fax: 603 2143 2551

ongks@interpac.com.my

A, C

Tel: 603 2781 3200 Fax: 603 2781 3201

Tel: 603 2781 3250 Fax: 603 2781 3201

enquiries@ifsbfutures.com

IMC 8, Jalan Sultan Ismail 50250 Kuala Lumpur. JF Apex Securities Bhd 6th Floor Menara Apex Off Jalan Semenyih Bukit Mewah 43000 Kajang Selangor Darul Ehsan JPMorgan Securities (Malaysia) Sdn Bhd Menara Dion, Level 27 Jalan Sultan Ismail 50250 Kuala Lumpur Kenanga Deutsche Futures Sdn Bhd 4 - 10 & 16 Floor Kenanga International Jalan Sultan Ismail 50250 Kuala Lumpur A, B, C Tel: 603 8732 3218 Fax: 603 8733 2926 Tel: 603 8734 1261 Fax: 603 873 60732

apexfutures@jfapex.com.my

A, B, C

Tel: 603 2270 4732 Fax: 603 2270 4282

Tel: 65 6882 2041 Fax: 65 6223 2712

futures.sing@jpmorgan.com

A, B, C

Tel: 603 2162 7000 (Clearing) 603 2162 6000 (Dealing) Fax: 603 2164 9799 (Clearing) 603 2164 9798 (Dealing)

Tel: 603 2162 6000 Fax: 603 2164 9798

futures@kenanga.com.my

LT International Futures (M) Sdn Bhd Suite 14-01, Level 14

A,C

Tel: 603 2166 3278 Fax: 603 2166 6578

Tel: 603 2166 3278 Fax: 603 2166 6578

info@ltif.com.my

Wisma UOA II No. 21, Jalan Pinang 50450 Kuala Lumpur Okachi (M) Sdn Bhd Level 8, Pavilion KL, 168 Jalan Bukit Bintang, 55100 Kuala Lumpur Oriental Pacific Futures Sdn Bhd Suite 21- 6 & 7, Level 21 Wisma UOA II No. 21, Jalan Pinang 50450 Kuala Lumpur OSK Investment Bank Bhd Tingkat 9, 12 (Sebahagian) & 21, Plaza OSK Jalan Ampang 50450 Kuala Lumpur Phillip Futures Sdn Bhd B-2-6, Megan Avenue II No.12, Jalan Yap Kwan Seng 50450 Kuala Lumpur RHB Investment Bank Bhd Level 10 Tower One RHB Centre Jalan Tun Razak 50400 Kuala Lumpur A,C Tel: 603 2172 7000 Fax: 603 2172 7118 Tel: 603 2172 7000 Fax: 603 2172 7118

info@okachi.com.my

A,C

Tel: 603 2162 3512 Fax: 603 2162 3584

Tel: 603 2162 3606 Fax: 603 2162 3584

rickychin@opf.com.my

A, B, C

Tel: 603 2333 8397 603 2333 8391 Fax: 603 2175 3333

Tel: 603 2164 2002 Fax: 603 2175 3209

osk_hqfutures@my.oskgroup.com

A, B, C

Tel : 032162 1628 Fax : 032162 1678

Tel: 603 2162 1628 Fax: 603 2162 1678

phillipfutures@poems.com.my

A, B,C

Tel: 603 9280 2529 Fax: 603 9286 1845

Tel: 603 9281 0088 Fax: 603 9286 1845

lee.yew.kong@ rhbinvestmentbank.com

Sunny Futures Sdn Bhd Suite 21-9 & 21-10, 21st Floor, Wisma UOA II No. 21 Jalan Pinang 50450 Kuala Lumpur

Tel: 603 2164 4468 603 2164 4469 603 2164 4470 603 2164 4472 Fax: 603 2164 4590 Tel: 603 2072 4831 603 2026 1919 Fax: 603 2072 5001

Tel: 603 2164 4468 Fax: 603 2164 4590

info@sunnyfutures.com.my

TA Futures Sdn Bhd 32nd Floor, Menara TA One 22 Jalan P Ramlee 50250 Kuala Lumpur
4

A, C

Tel: 603 2072 4832 Fax: 603 2072 5001

tafutures@ta.com.my

http://www.bursamalaysia.com/website/bm/brokers/derivatives/derivatives_tps.html

4.0 COMPARISON OF ISLAMIC AND CONVENTIONAL PRODUCT. A derivative security is a financial asset whose value is dependent on the value of the underlying asset. The underlying asset could be a basic financial asset like common stock, bonds, currencies and commodities. Since by the definition, a derivative is a claim on a claim the value of the derivative will depend on the value of the asset such as stocks or bonds on which it has a claim. Derivatives trade in both the exchange-trade and over-the-counter (OTC) markets. At a basic level, derivatives enable the avoidance of unnecessary risks. There are many of banks in Malaysia has running the derivatives investment such as HSBC Amanah Bank, RHB Investment bank, Citigroup, Standard Charted, and CIMB investment. Most of this banks are provides conventional derivatives such as Forward, Future, Short selling, Option and Swap. But they are a few of this banks are now recently has try to involve in Islamic derivatives as a new portfolio in the investment activities. Islamic Derivatives. All Islamic financial instruments in general must meet a number of criteria in order to be considered halal (acceptable). At a primary level all financial instruments and transactions must be free of at least the following five items: (i) Riba (usury) (ii) Rishwah (corruption) (iii) Maisir (gambling) (iv) Gharar (unnecessary risk) (v) Jahl (ignorance). Riba can be in different forms and is prohibited in all its forms. For example, Riba can also occur when one gets a positive return without taking any risk. As for gharar, there appears to be no consensus on what gharar means. It has been taken to mean, unnecessary risk, deception or intentionally induced uncertainty. In the context of financial transactions, gharar could be thought of as looseness of the underlying contract such that one or both parties are uncertain

about possible outcomes. Maisir from a financial instrument viewpoint would be one where the outcome is purely dependent on chance alone as in gambling. Finally, jahl refers to ignorance. From a financial transaction viewpoint, it would be unacceptable if one party to the transaction gains because of the other partys ignorance. In addition to these requirements for financial instruments, the Syariah has some basic conditions with regards to the sale of an asset (in this case a real asset as opposed to financial assets). According to the Syariah for a sale to be valid; (a) The commodity or underlying asset must currently exist in its physical sellable form. (b) The seller should have legal ownership of the asset in its final form. These conditions for the validity of a sale would obviously render impossible the trading of derivatives. However, the Syariah provides exceptions to these general principles to enable deferred sale where needed. 4.1 FORWARD & FUTURE 5 4.1.1 CONVENTIONAL DERIVATIVES6 Conventional derivatives instrument known as Plain Vanilla Derivatives. A forward contract is an agreement to buy an asset in the future for a certain price. Forward contracts trade in the over the counter market. One of the parties to a forward contract assumes a long position and agrees to buy the underlying assets on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Future contracts like forward contracts are agreement to buy an asset at a future time and traded on an exchange. This means that the contracts that trade are standardized. The exchange defines the amount of the assets underlying one contract, when delivery can be made. Contracts are
5 6

http://www.standardchartered.com.my/islamic-banking/wholesale-banking/treasury-products/en/ John C.Hull.Risk Management and Financial Inst. http://www.itradecimb.com.my/index.php?ch=st&pg=st_prod&ac=6

referred to by their delivery month. For example, the September 2010 gold future is contract where delivery is made in September 2010. Whereas only one delivery days is usually specified for a forward contract, a futures contract can often be delivered on several days during the delivery month. Most futures contracts trade actively with the futures price at any given time being determined by supply and demand. If there are more buyers than the sellers at a time when the September 2010 price of gold is $780 per ounce, the price goes up. Similarly, if there are more sellers than buyers the price goes down. One of the attractive features of future contracts is that it is easy to close out a position. If someone takes a long position in September 2010 gold futures contract in March 2009, you can exit in June 2009 by selling the same contract. Closing out a position in forward contracts usually lead to final delivery of the underlying assets, whereas futures contracts are usually closed out before the delivery month is reached. 4.1.2 ISLAMIC DERIVATIVES7 A number of instruments or contracts exist in Islamic finance that could be considered a basis for forward or futures contracts within an Islamic framework. These are (i) the Salam Contract, (ii) the Istisna Contract and (iii) Joala Contract. Each of these contracts concern deferred transactions, and would be applicable for different situations. The first and probably the most relevant of these to modern day forward/futures contracts would be the Salam Contract or Bai Salam.

http://ziaahmedkhan.hubpages.com/hub/Futures-Forwards-and-Islamic-Law

4.1.2.1 BAI SALAM Salam is essentially a transaction where two parties agree to carry out a sale of an underlying asset at a predetermined future date but at a price determined and fully paid for today This is similar to a conventional forward contract however; the big difference is that in a Salam sale, the buyer pays the entire amount in full at the time the contract is initiated. The contract also stipulates that the payment must be in cash form. The idea behind such a prepayment requirement has to do with the fact that the objective In a Bai Salam contract is to help needy farmers and small businesses with working capital financing. Since there is full prepayment, a Salam sale is clearly beneficial to the seller. As such, the predetermined price is normally lower than the prevailing spot price. This price behavior is certainly different from that of conventional futures contracts where the futures price is typically higher than the spot price by the amount of the carrying cost. The lower Salam price compared to spot is the compensation by the seller to the buyer for the privilege given him. Despite allowing Salam sale, Salam is still an exception within the Islamic financial system which generally discourages forward sales, particularly of foodstuff. Thus, Bai Salam is subject to several conditions: i) ii) Full payment by buyer at the time of effecting sale. The underlying asset must be standardize, easily quantifiable and of determinate quality. Cannot be based on a uniquely identified underlying. Quantity, Quality, Maturity date and Place of delivery must be clearly enumerated.

iii) iv)

It should be clear that current exchange traded futures would conform to these conditions with the exception of the first, which requires full advance payment by the buyer. Given the customized nature of Bai Salam, it would more closely resemble forwards rather than futures. Thus, some of the problems of forwards; namely double-coincidence, negotiated price and counterparty risk can exist in the Salam sale.

Counterparty risk however would be one sided. Since the buyer has paid in full, it is the buyer who faces the sellers default risk and not both ways as in forwards/futures. In order to overcome the potential for default on the part of the seller, the shariah allows for the buyer to require security which may be in the form of a guarantee or mortgage. Since the Salam Contract involves transacting in the underlying asset and financial institutions may not want to be transacting in the underlying asset, there are a number of alternatives available. These are in the form of parallel Salam Contracts and Offsetting transaction with third party. However not all the jurists permissible for these alternatives. i) Parallel with Seller. After entering into the original Salam Contract, the bank can get into a parallel Salam sale to sell the underlying commodity after a time lapse for the same maturity date. The resale price would be higher and considered justifiable since there has been a time lapse. The difference between the 2 prices would constitute the banks profit. The shorter the time left to maturity, the higher would be the price. Both transactions should be independent of each other. The original transaction should not have been priced with the intention to do a subsequent parallel Salam ii) Offsetting Transaction with Third Party. The bank which had gone into an original Salam Contract enters into a contract promising to sell the commodity to a third party on the delivery date. Since this is not a Salam Contract the bank does not receive advance payment. It would be a transaction carried out on maturity date based on a predetermined price. This is very much like modern day forward/futures. The difference here is being that the Islamic bank is offsetting an obligation and not speculating.

4.1.2.2 ISTISNA AND JOALA There are two other contracts where a transaction is made on a yet to exist underlying assets. These are the Istisna and Joala contracts. The Istisna Contract has as its underlying, a product to be manufactured. Essentially, in an Istisna, a buyer contracts with a manufacturer to manufacture a needed product to his specifications. The price for the product is agreed upon and fixed. While the agreement may be cancelled by either party before production begins, it cannot be cancelled unilaterally once the manufacturer begins production. Unlike the Salam Contract, the payment here is not made in advance. The time of delivery too is not fixed. Like Bai Salam, a parallel contract is often allowed for in Istisna. The Joala Contract is essentially an Istisna but applicable for services as opposed to a manufactured product. THE BANKS OFFERED. In Malaysia they are two of the banks that offer Islamic future derivative is Bank Islam Malaysia Berhad and Standard Charted Saadiq. Bank Islam Malaysia offering Foreign Exchange Product such as Features of Islamic FX Forward, Over the Counter Transaction and Wiqa Forward Rate Agreement (WFRA). WFRA is the product are based on the Shariah contract of Murabahah (cost plus basis term), an agreement of forward profit rate for a specified period based on an agreed notional principal amount in reference to a reference index (eg. KLIBOR) and as a hedging mechanism it facilitates an efficient management of asset liability of a company8. In the other hand, Standard Charted Saadiq are offering 3 products which is IFRA, FX Forward-I and Islamic Train-i9.

8 9

http://www.bankislam.com.my/en/Pages/WiqaForwardRateAgreement.aspx?mlink=Derivatives&tabs=3 http://www.standardchartered.com.my/islamic-banking/wholesale-banking/treasury-products/en/

Banks that offering Future Islamic Derivative Bank Islam Malaysia Berhad Foreign Exchange Product Features of Islamic FX Forward, Over the Counter Transaction Wiqa Forward Rate Agreement (WFRA) Standard Charted Saadiq Foreign Exchange Product FX Forward-I Islamic Train-i10 (Total Return Alternative Investments) IFRA

4.2 OPTION 4.2.1 CONVENTIONAL DERIVATIVES11 Option is traded both on exchanges and in the over-the-counter market. There are two basic types of option. A call option gives the holder the right to buy the underlying asset by a certain date for certain price. A put option gives the holder the right to sell the underlying assets by a certain date for a certain price. The price in the contract is known as the exercise price or strike price; the date in the contract is known as the expiration date or maturity. American option can be exercised at any time up to the expiration date or European option can be exercised only on the expiration date itself. Most of the options that are traded on exchanges are American. In the exchange-traded equity option market, one contract is usually an agreement to buy or sell 100 shares. European options are generally easier to analyze than American options, and some of the properties of an American option are frequently deduced from those of it European counterpart. An at-the money option is an option where the strike price is close to the price of the underlying assets. As out-of-the-money option is a call option where the strike price is above the price of underlying asset or a put option where the strike price is below the price. An in the money option is call option where the strike price is below the price of underlying asset or put option where the stick price is above the price.

10 11

http://www.alhudacibe.com/newsletter/15-30nov/international_news_11.html John C.Hull.Risk Management and Financial Inst.

It should be emphasized that an option gives holder the right to do something. The holder does not have to exercise the right. By contrast, in a forward and futures contract, the holder is obligated to buy or sell the underlying asset. Whereas is costs nothing to enter into a forward or futures contract, there is a cost acquiring an option. The cost is referred to as the option premium. OTHER LISTED OPTION Option on assets other than stocks also are widely traded. These include options on market indexes and industry indexes, on foreign currency, and even on the futures prices of agricultural products, gold, silver, fixed-income securities and stock indexes. 4.2.1.1 INDEX OPTION An index option is a call or put based on a stock market index such as the S&P 500 or the NYSE index. Index options are traded on several broad based indexes as well as on several industryspecific indexes. The construction of the indexes can very across contracts or exchanges. For example, the S&P 100 index is a value-weighted average of the 100 stocks in the Standard & Poors 100 stock group. The weights are proportional to the market value of outstanding equity for each stock. The Dow Jones Industrial Average, by contrast is a price-weight average of 30 stocks. Index option do not require that the call writer actually deliver the index upon exercise of that the put writer purchase the index. Instead, a cash settlement procedure is used. The payoff that would accrue upon exercise of the option is calculated and the option writer simply pays that amount to the value of the index. For example, if the holder of the call receives a cash payment equal to the difference 1290-1270, times the contract multiplier of $100 or $1000 per contract. 4.2.1.2 FUTURES OPTION Futures option give their holders the right to buy or sell a specified future contract using as a future price the exercise price of the option. Although the delivery process is slightly complicated, the terms of futures option contracts are designer in effect to allow the option to be written on the futures price itself. The option holder receives upon exercise net proceeds equal to the difference between the current future price on the specified asset and the exercise price of the

option. Thus, if the futures price is say $37 and the call has an exercise price of $35, the holder who exercises the cal option on the futures gets a payoff of $2. 4.2.1.3 FOREIGN CURRENCY OPTION A currency option offers the right to buy or sell a quantity of foreign currency foe a specified of domestic currency. Currency option contracts call for purchaser sale of the currency in exchange for a specified number of U.S dollars. Contracts are quoted in cent of fractions of a cent per unit of foreign currency. There is an important difference between currency option and currency futures options. The former provide payoffs that depend on the deference between the exercise price and the exchange rate at maturity. Because exchange rates and exchange rate futures prices generally are not equal, the option and futures-options contracts will have different values, even with identical expiration dates and exercise prices. Now, trading volume is currency futures option dominates by far trading in currency options. 4.2.1.4 INTERST RATE OPTION Option also traded on Treasury note and bonds, Treasury bills, certificates of deposit, GNMA pass through certificates, and yields on Treasury securities of various maturities. Options on several interest rate futures also are traded. Among them are contract on treasury bond, Treasury note, municipal bond, LIBOR, Eurodollar and British and euro-denominated interest rate. 4.2.2 ISLAMIC DERIVATIVES 4.2.2.1 ISTIJRAR12 The Istijrar Contract is a recently introduced Islamic financing instrument. The contract has embedded options that could be triggered if an underlying assets price exceeds certain bounds. The contract is complex in that it constitutes a combination of options, average prices and Murabaha or cost plus financing. The Istijrar involves two parties, a buyer which could be a company seeking financing to purchase the underlying asset and a financial institution.
12

http://ziaahmedkhan.hubpages.com/hub/Futures-Forwards-and-Islamic-Law

A typical Istijrar transaction could be as follows; a company seeking short term working capital to finance the purchase of a commodity like a needed raw material approaches a bank. The bank purchases the commodity at the current price (Po), and resells it to the company for payment to be made at a mutually agreed upon date in the future for example in 3 months. The price at which settlement occurs on maturity is contingent on the underlying assets price movement from t0 to t90. Where t0 is the day the contract was initiated and t90 is the 90th day which would be the maturity day. Unlike a Murabaha contract where the settlement price would simply be a predetermined price; P* where P* = Po (1+r), with r being the banks required return/earning, the price at which the Istijrar is settled on maturity date could either be P* or an average price of the commodity between the period t0 an t90. As to which of the two prices will be used for settlement will depend on how prices have behaved and which party chooses to fix the settlement price. The embedded option is the right to choose to fix the price at which settlement will occur at any time before contract maturity. At the initiation of the contract; to, both parties agree on the following two items (i) in the predetermined Murabaha price; P* and (ii) an upper and lower bound around the Po.

PLB

P0

P*

PUB

Po P* PLB PUB

= = = =

The price that bank pays to purchase underlying commodity. Murabaha price; P* = Po (1+r). The lower bound price The Upper bound price

The settlement price (Ps) at t90 would be; (i) (ii) Ps = ; if the underlying asset price remained within the bounds.

Ps = P*; if the underlying asset exceeds the bounds and one of the parties chooses to exercise its option and use P* as the price at which to settle at maturity.

The basic idea behind such a contract is to spread out the benefits of favorable price movement to both parties such as Not a zero sum game. Such a contract fulfills the need to avoid a fixed return on a riskless asset which would be considered riba and also avoids gharar in that both parties know up front, P* and the range of other possible prices. (by definition between the upper and lower bounds). Istijrar contract comes across as something that is the result of modern day financial engineering. Many of the products of financial engineering tend to have the complexities, bounds, trigger points etc. similar to that of the Istijrar. Diagram 1- Payoff to Istijrar

4.2.2.2 WAAD- FX OPTION13

The waad as a Sharia concept Waad or wad is a traditional Islamic product and the term occurs frequently in the Al-Quran. While it can mean to promise, to pledge or to firmly intend, in the context of commercial dealings, it is generally accepted that a waad means a unilateral promise. This unilateral nature of the waad that potentially makes it very useful and flexible tool in structuring Shariah compliant transaction. Sharia distinguishes a concept aqd which is legally binding from a promise (waad) which is not bonding except in the case of a promise made under oath before God . However, such a promise under oath is binding in religion only, the oath may be broken for a good reason. Failing to undertake a promise would therefore appear binding at the moral level only: failing to keep a promise is a sin but it is enforceable by the Islamic courts. This distinction becomes relevant in the context of legal enforceability of a waad and thereby in determining the efficacy of the use of one or more waads in structuring a Sharia compliant transaction. Use of waad for FX option. The waad can be used to structure an FX currency option. In this regard, Shariah distinguishes between the creation of an option and the trading of an option. The creation of an option for genuine trade hedging purposes is broadly viewed as permissible as it reduces uncertainty and is therefore regarded as contributing towards the public good (maslaha). However, the trading of an option without any accompanying purchase/sale of underlying tangibles, undertaken solely with objective of making a speculative gain, is regarded as impermissible by several shariah scholars as this is looked upon as increasing gharar.

13

Rafic Yunus Al-Masri, The Binding unilateral promise (wad) in Islamic Banking Operation, available http://islamiccenter.kaau.edu.sa/arabic/magallah/pdf/15/15.RAFIC.pdf

4.3 SWAPS 4.3.1 CONVENTIONAL DERIVATIVES14 A swap is an agreement between two companies to exchange cash flow in the future. The agreement defines the dates when the cash flows are to be paid and the way in which they are to be calculated. Usually the calculation of the cash flows involves the future values of interest rates, exchange rate or other market variables. A forward contract can be viewed as simple example of a swap. Suppose that it is March 1, 2010 and a company enters into a forward contract to buy 100 ounces of gold for 4800 per ounce in one year. The company can sell the gold in one year as soon as it is received. The forward contract is therefore equivalent to a swap where the company agrees that on March 1, 2011, it will swap 100 times the sport price of gold for $80,000. Whereas a forward contract is equivalent to the exchange of cash flows on just one future date, swaps typically lead to cash flow exchanges taking place on several future dates. The most common swap is a plain vanilla interest rate swap where a fixed rate of interest is exchanged for LIBOR. Both interest rates are applied to the same national principle. Plain vanilla interest rate swaps are very popular because they can be used for many purposes. For example swap can be used by company A to transform borrowing at floating rate of LIBOR plus 1% to borrowings at a fixed rate of 6%.

5% Company A LIBOR

Counterparty

A plain vanilla interest rate swap

14

John C.Hull.Risk Management and Financial Inst.

4.3.2 ISLAMIC DERIVATIVES 4.3.2.1 WAAD TOTAL RETURN SWAP15 Under a conventional total return swap, the underlying economic reasons for entering into such a transaction are, (i) that it allows a party to gain exposure to an asset which it does not necessarily need to hold on its balance sheet; and (ii) that pay-offs can be structured so that the other party can hedge against the upside or downside related to that particular asset or class of assets. Under Sharia, a similar economic profile can be generated by using a double wa'ad structure. The double waad structure has been used in a Sharia-compliant securities program to give the holder of a Certificate exposure to an underlying asset or index (the Underlying). This product was approved by the Sharia Board of Dar Al Istithmar (Sharia Advisor to Deutsche Bank), comprised of five of the world's leading Sharia scholars. Under this structure, an SPV Issuer uses the cash proceeds from an issue of Certificates to acquire a pool of Sharia-compliant assets from the market (Sharia-compliant Assets). These Sharia-compliant Assets could be shares listed on the Dow Jones Islamic Market Indexes (DJIMI). Exposure to the Underlying is pivoted on two mutually exclusive wa'ads between the Issuer and the Bank. Under one wa'ad (Wa'ad 1), the Issuer promises to sell the Sharia-compliant Assets to the Bank at a particular price (which is linked to the performance of the Underlying) (Wa'ad Sale Price), while under the other wa'ad (Wa'ad 2), the Bank promises to buy the Sharia-compliant assets from the Issuer at the Wa'ad Sale Price. The Wa'ad Sale Price is linked to the performance of the Underlying. Out of these two wa'ads, only one shall ever be enforced. At maturity, the Bank will calculate how the Sharia-compliant. Assets have performed relative to the Underlying, if:(i) The Wa'ad Sale Price is greater than the market value of the Sharia-compliant Assets, then the Issuer shall enforce Wa'ad 2 (similar to a conventional put option).

15

Rafic Yunus Al-Masri, The Binding unilateral promise (wad) in Islamic Banking Operation, available http://islamiccenter.kaau.edu.sa/arabic/magallah/pdf/15/15.RAFIC.pdf

(ii) The Wa'ad Sale Price is less than the market value of the Sharia-compliant Assets, then the Bank shall enforce Wa'ad 1 (similar to a conventional call option). The commercial significance of this structure lies in the fact that, similar to a conventional total return swap, it offers Islamic investors the opportunity to potentially swap the returns in one basket (as generated from the Sharia-compliant Assets) with the returns in another basket (the Wa'ad Sale Price, as calculated with reference to the Underlying). According to Dr. Hussein Hassan, director in the Middle East structuring team at Deutsche Bank, he said: "Driven by investor demand, the technique has been instrumental in opening up investment in asset classes that have previously been closed to Islamic investors".16 Diagram 1-Structure and Cash-Flows

16

Meeting all tastes.Risk.Sept. 2008 available at http://www.risk.net/public/showpage.html?page=813157

4.3.2.2 MURABAHAH- THE PROFIT RATE SWAP17 The Profit Rate Swap seeks to achieve Sharia-compliance by using reciprocal murabaha transactions: commercial arrangements long accepted by Sharia scholars. The murabaha is a sale arrangement whereby a financier purchases goods from a supplier (at the cost price) and then on sells them to counterparty at a deferred price that is marked-up to include the financier's profit margin. This profit margin is deemed justified since the financier takes title to the goods, albeit possibly only briefly, and hence accepts the commercial risk of their ownership. Diagram 1 The Basic Murabaha Structure

Under this profit rate swap, the parties enter into murabaha contracts to sell Sharia-compliant assets (often London Metal Exchange traded metals) to each other for immediate delivery but on deferred payment terms. A term murabaha is used to generate fixed payments (comprising both a cost price and a fixed profit element) and a series of corresponding reverse murabaha contracts are used to generate the floating leg payments (the cost price element under these reverse murabaha contracts is fixed but the profit element is floating, as further explained below). This structure, in effect, is not dissimilar to the "parallel loans" structure that was used by institutions in the earliest examples of conventional swap transactions.

17

www.allenovery.com/islamicfinance

It should be noted that a profit rate swap may also be structured as a series of Wa'ads (unilateral promises) whereby each party undertakes to the other to "swap" relevant fixed and floating rate payments at some particular point of time in the future. Diagram 2 - Primary Murabaha (Fixed leg)

Under this structure the floating rate payer (which could be a bank or a corporate, the Floating Rate Payer) sells commodities (sourced from a commodity broker for the purpose of entering into the murabaha (step 1)) to the swap counterparty (the Fixed Rate Payer - which again could be a bank or a corporate) (step 2). The value of commodities bought and on-sold will be the preagreed Cost Price sum for the transaction. The commodities are delivered on the date on which the transaction is entered into. On receipt of the commodities purchased, the Fixed Rate Payer (or its agent) will on-sell those commodities immediately to a different commodity broker (step 3) to generate cash. Payment by the Fixed Rate Payer for the commodities purchased under the Primary Murabaha is on a deferred basis in installments payable on a series of pre-agreed payment dates (step 4). Each installment will comprise both a Cost Price element (a repayment of a set percentage of the Cost Price) and a fixed profit element (paying a portion of the Floating Rate Payer's profit on the transaction).

The series of sequential Secondary Reverse Murabaha Contracts (Diagram 3)

Diagram 3 Series of Secondary (Reverse)Murabahah (Floating Reg).

Diagram 4-Full Profit Rate Swap Structure

The more complex limb to this transaction is that generating the floating leg payments. An agreement to simply make a series of payments linked to a floating rate (e.g. to make payments linked to LIBOR) on a series of future dates would not be Sharia-compliant as the rate of LIBOR by reference to which these future payments will be calculated is uncertain (Gharar). This uncertainty is mitigated by instead entering into a series of sequential Secondary Reverse Murabaha Contracts (SRMC's). The initial SRMC The first SRMC is entered into on day one (i.e. the date of entry into the Primary Murabaha) by the Fixed Rate Payer utilizing an amount equal to the Cost Price element due to be paid to it by the Floating Rate Payer on the next due deferred payment date under the Primary Murabaha to purchase commodities from its commodity broker (step 5) (Note that consequently, the commodities sold under each SRMC represent only a portion of the value of the commodities purchased under the Primary Murabaha). The Fixed Rate Payer immediately on-sells these commodities to the Floating Rate Payer for immediate delivery (step 6) and the Floating Rate Payer then immediately on-sells such commodities to the original commodity broker (step 7) to generate cash. Payment by the Floating Rate Payer is on a deferred basis by a single bullet payment comprising (i) the full value of the commodities purchased under the relevant SRMC plus (ii) the Fixed Rate Payer's profit (such profit, as discussed above, being calculated by reference to a floating rate formula (e.g. LIBOR) and thus generating the floating rate element) (step 8). Such payment is due on the next due deferred payment date under the Primary Murabaha (effectively also the Termination Date for that particular SRMC), whereupon that SRMC is settled in full and discharged and a new SRMC is entered.

From a Sharia-compliance perspective, said:"The use of LIBOR as a benchmark of pricing in no way means that interest has entered the transaction. This is because LIBOR is a notional rate". To this extent, whilst an interest rate benchmark is, amongstother elements, used to indicate the level of return received under the SRMC's (i.e. the floating rate profit element is linked to LIBOR), the return itself will not be considered an interest payment and therefore not in contravention of the Sharia prohibition of riba. Subsequent sequential SRMC's Each subsequent SRMC will have a term which runs from the Termination Date of the preceding SRMC and ends on the next due deferred payment date under the Primary Murabaha. As with the initial SRMC, at the end of that term the Floating Rate Payer will make payment in full (in respect of that SRMC) and the next subsequent SRMC will be entered into. In this way, each deferred payment date under the Primary Murabaha will also be (i) the Termination Date (and thus payment date) under a corresponding SRMC and (ii) the start date for the next SRMC (ensuring that the SRMC's are sequential). The final SRMC will terminate on the final deferred payment date under the Primary Murabaha. Consequently, on each date that a payment is made by the Fixed Rate Payer to the Floating Rate Payer under the Primary Murabaha, a corresponding SRMC will generate a reciprocal payment under which the element payable in respect of commodities purchased (the Cost Price element in the case of the Primary Murabaha payment and the full commodity value payable in respect of the relevant SRMC) is identical. However, the profit elements payable will vary, the profit element under the Primary Murabaha being calculated by reference to a fixed rate and the profit element under the SRMC by reference to a floating rate, thus generating cash flows that are generated in a Sharia-compliant manner but are similar in nature to the cash flows under a conventional interest rate swap.

THE BANK OFFERED18. The swap derivative had been offer by 4 banks which are Bank Islam Malaysia Berhad, CIMB Islamic Bank and Standard Charted Saadiq corporate with Bank Muamalat Malaysia Berhad and Kuwait Finance House The product that offering by Bank Islam Malaysia Berhad are call as Wiqa Profit Rate Swap where it is base on Mudharabah contract, an agreement to exchange profit/return/coupon rates between two counterparties and also as a tool for hedging or asset liability management19. Moreover, CIMB Islamic bank developed its Islamic Profit Rate Swap, where the worlds first Islamic derivatives product. Beside that Standard Chartered Bank

executed USD$ 10 Million Islamic Cross-Currency Swap with Bank Muamalat Malaysia where it allow Bank Muamalat to hedge the currency and interest rate risks of its investments in foreign currency denominated assets. Kuwait Finance House has recently introduced its KFH Ijarah Rental Swap-I where this product protecting customers against profit rate volatility and can be used to hedge risk in any variable of fixed ijarah auto financing, ijarah asset acquisition financing or even ijarah-based sukuk.
No. 1. Banks Products

CIMB Islamic Bank

Islamic Profit Rate Swap Wiqa Profit Rate Swap

2.

Bank Islam Malaysia Berhad

3.

Standard Charted Saadiq

Standard Chartered Bank executed USD$ 10 Million Islamic Cross-Currency Swap with Bank Muamalat Malaysia

4.

Kuwait Finance House (Malaysia) Berhad

KFH Ijarah Rental Swap-i

18

http://www.azmilaw.com.my/archives/Article_outside_publications_asian_counsel/Development_of_Islamic_Sw aps_in_Msia_Dec2006%2800125808%29.PDF
19

http://www.bankislam.com.my/en/Pages/WiqaProfitRateSwap.aspx?mlink=Derivatives&tabs=3

5.0 RELEVANT STATISTICS-CURRENT DEVELOPMENT

6.0 CONTEMPORARY ISSUES

1)

The term derivatives often carries with it a negative connotation due to the various instruments and the potential damage that can arise from

complexity of the

excessive speculative activity. It is means that not every derivative instrument merits a negative connotation, especially exchange-traded instruments such as futures and options that are collateralized by daily margin requirements mandated by the exchanges. Swaps, on the other hand, carry the potential to cause widespread problems to the capital markets, as we have witnessed with the collapse of Lehman Brothers and AIG. There are several factors that make such concerns well justified, including the size and growth of the swap markets, the lack of regulatory oversight, and counterparty risk. Futures and options are exchange-traded. The exchange serves several purposes: it provides a regulated environment in which the instruments can be purchased, sold and traded; it acts as a counterparty for all transactions; and it ensures that all parties meet minimum margin requirements on a daily basis. Swaps, on the other hand, are transactions that occur in the unregulated over-the counter (OTC) market, i.e. through the investment bank dealer community. It is the responsibility of the two parties involved to vet the creditworthiness of the other party, which introduces another layer of risk to the instrument: counterparty risk, or the risk of nonpayment on the obligation. It is also the responsibility of the two parties to ensure the counterparty posts sufficient collateral in a timely manner to meet its financial obligations set forth in individual OTC transactions and master agreements.20

20

https://ctech.rproxy.hewitt.com/hig/filehandler.ashx?fileid=4829

2) Standard Chartered Plc and Bank Islam Malaysia Bhd. plan to offer Shariah-compliant derivatives in Malaysia that will allow investors to hedge against interest rates and commodity prices. It can be explained under regulatory approval, Asia pacific market, sukuk return and rising market. Standard Chartered, the U.K. bank that earns most of its profit from emerging markets, will begin selling contracts in the first quarter that provide protection from fluctuations in the cost of items such as rice and oil, according to an e-mailed reply to questions yesterday. Bank Islam Malaysia, the countrys oldest Islamic lender, will offer swaps that allow two parties to exchange different forms of payments from an underlying asset.21 The lack of such Shariah products is hindering industry growth, Badlisyah Abdul Ghani, chief executive officer of Kuala Lumpur-based CIMB Bank Islamic Bhd., said in an interview on Dec. 20. The market will be limited to hedging after derivatives contributed to the global financial crisis, which resulted in $1.8 trillion of credit losses and write downs. The industry has gone through a set of innovations over the past 10 years to offer Shariah-compliant solutions and today the industry can say we have Islamic derivatives, Syed Alwi Mohd Sultan, director of origination at Standard Chartered Saadiq Bhd., the banks Kuala Lumpur-based Islamic banking unit, said in a telephone interview on Dec. 15. A wide acceptance of the standards will bring greater convergence of the industry. Derivatives are contracts whose values are tied to assets including stocks, bonds, commodities and currencies, or events such as changes in interest rates or the weather. Regulatory Approval Standard Chartered started offering its commodities-based contracts in the Persian Gulf in March as the International Islamic Financial Market, a Manama, Bahrain-based agency that sets guidelines, provided standardized legal documentation for Shariah derivatives the same month. The U.K. bank will be the first to provide the products in Malaysia and is awaiting regulatory approval, according to the e-mail.

21

http://www.bloomberg.com/news/2010-12-21/shariah-compliant-hedging-derivatives-start-in-malaysia-islamicfinance.html

Islamic contracts cant be traded or used as a speculative investment under Shariah law, said Aznan Hasan, assistant professor at the Kuala Lumpur-based International Islamic University of Malaysia, in an interview on Dec. 20. Standard Chartereds products are vetted by a Shariah panel of experts to ensure compliance and that they are backed by a real underlying asset, Syed Alwi said. Customers need hedging instruments; if you have a customer who needs to make payment in the future for properties the company bought overseas, they have to hedge their currency, said Aznan, who sits on several advisory boards including the one at Malaysias central bank. Asia-Pacific Market Asia Pacific overtook North America as the biggest market for derivatives in the six months through June and accounted for 38 percent of the global total, according to data from the Washington-based Futures Industry Association published in September. That compares with North Americas 33 percent market share. CIMB Islamic, the worlds top sukuk arranger this year, is exploring Shariah-compliant credit-default swaps to complement the banks Islamic profit-rate swaps, cross-currency swaps and cross currency profit-rate swaps, Badlisyah said. Its still very early days for the market but weve been receiving interest for our derivatives products from institutional investors as well as companies who need to hedge their positions, Badlisyah said. Without effective risk management, Islamic financial institutions cannot grow in a stable and aggressive manner. Sukuk Returns Malaysia, the Asian hub for Shariah-compliant finance, accounts for more than 50 percent of the $144 billion of outstanding Islamic bonds, or sukuk, globally, according to data compiled by Bloomberg. Total sales of the securities, which pay asset returns to comply with the religions ban on interest, have dropped 24 percent to $15.3 billion this year.

Shariah-compliant

bonds

returned

12.4

percent

in

2010,

according

to

the

HSBC/NASDAQ Dubai US Dollar Sukuk Index. Debt in developing markets gained 11.7 percent, JPMorgan Chase & Co.s EMBI Global Diversified Index shows. The difference between the average yield for sukuk and the London interbank offered rate shrank two basis points, or 0.02 percentage point, to 305 on Dec. 21, according to the HSBC/NASDAQ Dubai US Dollar Sukuk Index. The spread has narrowed 163 basis points this year. Rising Demand The yield on Malaysias 3.928 percent Islamic notes due June 2015 rose two basis points to 3.10 percent today, according to prices from Royal Bank of Scotland Group Plc. The debt has returned 5.8 percent since it was issued in June. The difference in yield between the Dubai Department of Finances 6.396 percent sukuk due November 2014 and Malaysias Islamic note was little changed at 339 basis points today, according to data compiled by Bloomberg. The gap shrank 59 basis points this month. Demand for services complying with Shariah law is increasing by about 15 percent a year and assets will rise to $1.6 trillion by 2012, from around $1 trillion currently, according to the Kuala Lumpur-based Islamic Financial Services Board. Bank Islam Malaysia plans to introduce new contracts that will allow an exchange of profit or return rates between two counterparties, Hizamuddin Jamalluddin, the banks assistant general manager, said at a seminar for Islamic derivatives on Dec. 14 in Kuala Lumpur. These will be in addition to its existing Shariah-compliant hedging contracts, he said. Record-low borrowing costs in the U.S. may rise in 2011, providing a timely opportunity for banks to issue swaps- based derivatives, Hizamuddin said. It is very critical that holders of sukuk have access to hedging solutions that would enable them to counter the challenges in a rising interest-rate environment, he said. Interest rates seem to have hit rock bottom.

3) Despite the popularity of derivatives based on off-balance-sheet techniques, Islamic scholars have generally not been in favor of them. RAHAYU MUSA KAMAL speaks to market players to find out why, which is about its definition and principle, and also for hedging.

Perhaps among the many Islamic finance products stirring up the market right now, what with the news overload on financial institutions creating certain types of Shariah compliant structures, derivatives have not been getting the same exposure or attention they deserve. Given that more and more breakthroughs are being reported in Islamic finance, one cant discount the fact that demand and the need for Islamic derivatives is on the rise. However, the task that Shariah scholars and industry players should probably concern themselves with at least in the near term is disseminating the most accurate information and accentuating ironing out important details. In a presentation, Dr Mohd Daud Bakar, president and CEO of the International Institute of Islamic Finance, asserted that the challenge is to create a floating and revolving mechanism to assist the parties in their swap transactions, such as giving a floating rate profit to the party seeking to match his floating payment obligations and a fixed rate profit to the party seeking to match his fixed payment obligations (in addition to achieving Quality Spread Differential, or QSD, that is spread between the fixed and variable interest rates). A bit too technical for the uninitiated perhaps, but Daud is basically offering a solution so as to make the whole transaction Shariah compliant. To structure an Islamic derivative, one must duly follow the simple rules of a Shariah compliant model. Islam permits freedom of contract, provided it is free from riba (interest) and gharar (uncertainty). The issue of riba arises if there is excess (inequality) or a delay in delivery, as the case may be, in any exchange of two similar ribawi (goods subject to fiqh rules on riba in sales) items. Or, if there is a delay in delivery in any exchange of two dissimilar ribawi items, for example, US dollar for the ringgit. 22

22

http://www.islamicfinanceasia.com/article.asp?nm_id=18543

i)

Definition and principles

Afaq Khan, CEO of Standard Chartered Saadiq (StanChart Saadiq), explained briefly that Islamic derivatives are an Islamically compliant risk management structure to manage currency risk in a global trend and yield curve risk movement to determine cost of production. Please note that Islamic derivatives are for hedging purposes ONLY, and are not approved for speculation purposes, Afaq emphasized. Abrar Mir, managing partner of NBD Sana Capital, said that there are four key principles in Islamic finance that should be applied to derivatives: there is risk sharing between the parties, the investment must be an ethical one, the contract must have substance, and there must be fairness between the parties. When it comes to structuring, particularly of derivative contracts, it involves selling the product that one party does not even own yet and eventual delivery, which falls under the clause of substance, is obviously not Shariah compliant, said Abrar. He added that this is perceived to be a riba-based methodology and is applied in the conventional derivatives structure, which is a totally different concept in Islamic finance. Abrar went on to explain that Islamic derivatives are a new concept and continue to be subjected to developmental issues in assessing whether they can be consistent with Shariah compliance. It is different when it comes to structuring instruments under derivatives, there is still a lot of work to be done to make this structure works and complies with the Shariah rulings,he said.

According to Afaq, the economic effect between Islamic derivatives and their conventional counterparts is similar, yet in spite of this, there are two major differences. First, an Islamic derivative is valid only for hedging or covering risk and not for speculation (open positions).

It requires purchase and sale of tangible assets (mostly metal on the London Metal Exchange) rather than just contractual obligations, Afaq explained, adding that since Islamic derivatives are limited to hedging, they are deemed to be more restrictive. Abrar of NBD Sana Capital noted a few key differences between Islamic and conventional derivatives. Under conventional, risk sharing does not occur between both parties unlike in Islamic finance. Also, theres the issue of substance, whereby in Islamic finance, the underlying asset must exist, must be owned by the party willing to sell and must be envisaged to be delivered, said Abrar.
ii)

For hedging only Considering the fact that Islamic derivatives are a fairly new phenomenon that is

incomparable to other better known Islamic products such as Sukuk, Islamic ETFs (exchangetraded funds) and Takaful for that matter, there are differing views on basically the permissibility of futures and options from the Islamic perspective. Many Islamic scholars have looked beyond the speculative, or gharar, element in derivatives, contending that it is not a wrongful act per se. Derivatives are not thought to contain elements of underhanded activity and dishonest trading involving futures and options. Some scholars say that derivatives are acceptable in the light of Bai al Arboon while others, including the controversial chairman of the Accounting and Auditing Organization for Islamic Financial Institutions Shariah board, Sheikh Taqi Usmani, strongly disagree.

When asked to comment on this, Afaq said the Shariah board of StanChart Saadiq had approved Islamic derivatives for hedging purposes so that customers can effectively manage risk in the business but not for taking positions in the market.

Abrar highlighted efforts to tackle this problem. The Fiqh Academy of Jeddah, for instance, with input from several scholars, has done a lot of research on this and, more recently, the Islamic Analysis of Options discussed this matter, said Abrar.

He said most scholars consider derivatives to be unIslamic but industry players are also seeking guidance from various other structures to form a bedrock for the Islamic derivatives structure. I do not think this will affect the growth of Islamic derivatives; it may be slow but it will happen in due time. One of the things that make Islam great is the differing views and not just by one authority. Through different opinions we can progress and constantly examine ourselves toward further advancement and improvements, said Abrar.

Meanwhile, Afaq of StanChart Saadiq thinks the Islamic finance market needs to have treasury risk management tools including derivatives to effectively manage and compete in the global economy. We think the market needs to have treasury. The market has accepted the solution across geographies as the alternative is to keep an open position, which results in unintentional speculation and/or to sign an interest-based derivatives contract, which is prohibited under the Shariah. We have done transactions in Saudi Arabia, Kuwait, Qatar, the UAE and Malaysia, to name a few, he said.

Abrar, who has noticed improvements in Islamic finance, particularly derivatives, said practitioners have become more innovative. The guidance from scholars and practitioners have to closely work together to structure something that works well, said Abrar. He added that derivatives are a new concept that are far from being universally accepted at this stage, and that

investment strategies have not yet been employed. There should be further development before it is universally accepted, explained Abrar.23

23

http://www.islamicfinanceasia.com/article.asp?nm_id=18543

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http://www.bursamalaysia.com/website/bm/brokers/derivatives/derivatives_tps.html

APPENDIX