Islamic derivatives

ISLAMIC DERIVATIVES

Presented by:

ALVEENA REHMAN SHAH

INTRODUCTION

WHAT IS ISLAMIC BANKING?

Modes Of ISLAMIC BANKING

Mudarabah (Profit sharing) Wadiah (Safekeeping) Musharaka (Joint venture) Murabaha (Cost plus) Ijara (Leasing)

Islamic Methodology towards Innovation

PermanentPermanent (Al-Thawabit)(Al-Thawabit)

ChangeableChangeable ((Al-MutaghayyaratAl-Mutaghayyarat))

ISLAMIC DERIVATIVES

What are derivatives?

Requisites For A Shariah Compliant Derivative Instruments

Riba (usury) Rishwah (corruption) Maysir (gambling) Gharar (unnecessary risk) Jahl (ignorance)

Hedging Products

Profit rate swap Forward Rate agreements Islamic Options Cross Currency Swap

PROFIT RATE SWAP

Interest Rate Swap

Islamic Profit Rate Swap (IPRS)

DefinitionReason

ISLAMIC PROFIT RATE SWAP

Objectives of IPRS

To match funding rates with return rates To achieve lower cost of funding To restructure existing debt profile To manage exposure to interest rate To deepen Islamic Financial Market

Receives fixed returns

THE DYNAMICS OF IPRS

ABCFinancial Liabilities

Financial Assets

Islamic Swap Counter Party

Receives floating profit rate

Pays floating obligations

Pays fixed profit rate

STAGE 1: Fixed Profit Rate

ABC


ASSETASSET

STEP 1STEP 1 ABC sells Asset to ABC sells Asset to

Islamic Swap Islamic Swap counter Party at counter Party at

notional principal of notional principal of RM500k.RM500k.

STEP 2STEP 2Islamic Swap Counter

Party sells Asset to ABC at notional principal RM500k + mark-up

based on fixed profit rate

STEP 3STEP 3Notional principal

amount of RM500k owed by both ABC and Islamic Swap

party to each other is set off

STEP 4 STEP 4 The net difference i.e. the The net difference i.e. the

fixed profit rate in Step 2 is fixed profit rate in Step 2 is paid to Islamic Swap paid to Islamic Swap

counter Party by ABC at counter Party by ABC at the agreed interval the agreed interval

payment date of say 6 payment date of say 6 monthmonth

STAGE 2: Floating Profit Rate

STEP 1STEP 1

ABC sells Asset to ABC sells Asset to Islamic Swap counter Islamic Swap counter

Party at notional Party at notional principal RM500k + principal RM500k + floating profit rate. floating profit rate.

STEP 2STEP 2Islamic Swap Islamic Swap

counter Party sells counter Party sells Asset to ABC at Asset to ABC at

notional principal of notional principal of RM500k.RM500k.

STEP 3STEP 3Notional principal Notional principal

amount of RM500k amount of RM500k owed by both ABC owed by both ABC and Islamic Swap and Islamic Swap

party to each other is party to each other is set offset off

STEP 4STEP 4

The net difference i.e. the The net difference i.e. the floating rate profit in Step floating rate profit in Step

1 is paid to ABC by 1 is paid to ABC by Islamic Swap counter Islamic Swap counter

Party at the agreed Party at the agreed interval payment date of interval payment date of

say 6 monthsay 6 month

ABC


ASSETASSET

STAGE 3 – Determination of Subsequent Floating Rate

Floating Profit Rate (Stage 2) is repeated every 6 months until maturity.

6 MONTHS6 MONTHS 6 MONTHS6 MONTHS 6 MONTHS6 MONTHS 6 MONTHS6 MONTHSMATURITMATURITYY

ABC


ASSETASSET

ISLAMIC PROFIT RATE SWAP

General Observation 1Floating rate

Entering into a new contract (Murabaha or Ijara)

ISLAMIC PROFIT RATE SWAP General Observation 2

No actual payment of Principal Principle of Muqasa (set-off)

“Contractual rate agreement entered into between two counterparties under which each party agrees to make periodic payment to the other for an agreed period of time based upon a notional amount of

principal”

FUTURE CONTRACT & ISLAMIC FINANCE

The following three contracts in Islamic finance can be considered as future/forward contracts

The Salam Contract The Istisna Contract and The Joa’la Contract

Features of Ba’i Salam

“Two parties sale/purchase an underlying asset at a predetermined future date but at a price

determined and fully paid for today”

Objective Difference

‘The lower Salam price compared to spot is the “compensation” by the seller to the buyer for the privilege given to him’


Beneficial to the seller

The predetermined price is normally lower than the

prevailing spot price

“To overcome the potential for default on the part of the seller, the Shari'ah allows for the buyer to require security which may be in the form of a

guarantee or mortgage”


One sided-Counter party

risk

It is the buyer who faces the seller’s default risk.

Features of Istisna

“A buyer contracts with a manufacturer to manufacture a needed product to his

specifications”

Price of Product Agreed upon & Fixed.

Termination Cancelled before production begins.

Payment Time of Delivery

Joala Contracts

“ The Joala Contract is essentially an Istisna but applicable for services as

opposed to a manufactured product.”

DEFINITION:-

“A cross currency (CC) swap is a foreign exchange agreement between two parties to

exchange a given amount of one currency for another”

CROSS CURRENCY SWAP

Terms and Conditions

Trade-able currency combinations Minimum Principal (EUR 1 million) Standard terms (1-10 years)

Financial contract that can be traded separately

Interest flows in different currencies

Principal amounts are Swapped at the beginning & end of the term

Three Stages of CCS

1)- Spot Exchange of Principal

3)- Re-exchange of principal at the maturity of the contract

2)- A continuing exchange of interest payments during the swap's life

Islamic Cross Currency Swap

Two simultaneous Murabaha transactions: Term Murabaha Reverse Murabaha

Murabaha“A murabaha is a sale arrangement whereby a financier purchases

goods from a supplier and then on-sells them to a counterparty at a deferred price that is marked-up to include the financier's

profit margin”

“A method where the financial institution, either directly or indirectly, will buy an asset and

immediately sell it to a customer on a deferred payment basis. The customer then sells the same asset to a third party for immediate delivery and payment, the end result being that the customer

receives a cash amount and has a deferred payment obligation for the marked-up price to the financial

institution ”

Reverse Murabaha(Tawarruq)

OPTIONS IN ISLAMIC FINANCE

Overview of Istijrar2. Istijrar involves two parties 3. Bank purchases on behalf of its customer4. The difference in price is bank’s

earning/return P*=Po(1+r) Istijrar could be P* or an average price of

commodity between the period t0 an t90. 4. Which party chooses to “fix” the settlement

price—embedded option

5. Both parties agree on following two items a) Predetermined murabaha price P* b) Upper and lower bound

Po = the price that bank pays to purchase underlying commodity

P* = Murabaha price; P* = Po (1+r). PLB = the lower bound price

PUB = the Upper bound price

PLB P0 P* PUB

At Maturity:

Ps =Avg price; 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.


Basic Idea:


Not A Zero Sum Game

Contract avoids “Riba and Gharar”

CONCLUSION“These instruments could easily be used for speculation

appears to be the key reason for objection. That derivatives form the basis of risk-management appears

to have been lost ”Evaluation on precedence

Absent for the risk management problems faced today

Objective Micro-examination instead of intend and societal benefit

Differing Sects Convergence Required

T H A N K Y O U !!!

Islamic derivatives

Education

Transcript of Islamic derivatives