Hedging and Hedge Funds: Why an Islamic Alternative?

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1 Hedging and Hedge Funds: Why an Islamic Alternative? Dr. Mohammed Burhan Arbouna, Shari a Board Member United International Bank Bahrain A paper presented at International Islamic Capital Market Forum on 13 November Organized by securities commission Malaysia.

2 Presentation Outline The concept of hedge and hedging The benefits and growing need to Islamic hedging techniques Ruling and conditions of acceptable hedging General issues of hedging instruments Analysing derivatives instruments under Islamic contracts Some Shari a Issues of Hedge Funds Shari a Alternatives of hedging tools Underlying Assets of hedging Shari a Advisor s or Boards role in hedge funds 2

3 The concept of hedge and hedging Hedging is a strategy designed by using and choosing contracts and structures which aim at minimizing exposure to such business risk. Hedge funds do not necessarily mean protection, but, hedging or hedge funds are about taking higher risks for higher returns for which they need to manage these risks. 3

4 Ruling of hedging The concept of hedging is about management of manageable risks. In this sense, hedging is acceptable for the following: matches with a number of Islamic contracts that aimed at minimizing risks and unwanted circumstances. Matches one of the general objective of Shari a: Protection of Wealth. A hedging against risks is a core Shari a risk management requirements for investments. We noted that The Shari a clearly required protection of contracts that are prone to risks by taking necessary protective measures, such writing down the deal, personal proof and guarantees. The Shari disapproved submitting wealth to minors. The reason is simple as that the risk of doing so is beyond residual or inherent risks and withholding the minor s wealth against his or her will concur to the concept of risk management. the mudarib is liable when investing without due diligent required from professional person in the normal course of business and investment. Al Abbass Ibn Abdul Mutallib s case is a clear evidence of risk management and hedging. 4

5 The two dimension of hedging The hedging involved two perspective: Investors perspective where investors hedge against losses of their investment with hedge funds. Hedge funds cross hedging to ensure that the returns promised are achieved. Therefore, the mechanics of cross hedging need to scrutiny from Shari a perspective. 5

6 Analyzing derivatives instruments under Shari a principles It noted that the majority of hedge funds risk management instruments are derivatives instruments. Some Islamic concepts are cited in many occasion to justify the acceptability or compatibility of these instruments to Islamic principles. The following 10 slides discussed matching and differring points of Islamic contracts and the following derivates: Forward Contracts Options 6

7 Salam Contracts and Forward Contracts Can Salam be cited as an evidence for allowing Forward Contracts? This question is raised due to the fact that Forward Contract is a deferred delivery contract like Salam Contract. There are differences between Forward Contract and Salam Contract as follows: In Salam, the purchaser pays the entire salam price on the date of signing the contract. In forward contracts delivery of price and goods take place in the future. In Salam, the source of the subject matter should not be identified. In forward contracts the source of the subject matter is identified. 7

8 Istisnaa and Forward Contract Istisnaa is the closest contract to Forward Contract, because Istisnaa is forward delivery without the requirement to pay price now. The difference between Istisnaa and Forward Contracts is: Istisnaa relates to manufacturing on description unlike forward contract which is based on ordinary sale that may amount to dispute or litigation. Istisnaa ownership of countervalue is established by signature of the istisnaa contract. 8

9 Financial Options Financial options contracts convey the right to buy or sell at apre determined and agreed price. The attaempt to compare Options and Khiyar al Shart was not successful due to the following: The Shari a options are meant to: manage damage or loss that may occur as a result of hastiness in exchanging an offer and acceptance. The Shari a introduced options to deal with regret, damage of injudicious decisions and unpleasant effects and outcome of sale and purchase. These options are meant to avoid risk of fraud (ghabn), misrepresentation (tadlees) and misconduct, among others. These options give a party to a contract a legal or contractual right to terminate the contract after its conclusion when it appears not serving the purpose of such a party. some of these options give one of the contracting parties, probably the buyer, a right to acquire discount for defects or a right of settlement. The Islamic banks need these options to meet its desire to avoid risks and manage unpleasant situations of supply and demand. The bank may stipulate these options to manage the risks of trust based modes of financing, such as murabaha where the client may, in certain circumstances, decline to conclude the contract due to nonbinding nature of this mode of financing. 9

10 The Risk Management of Shari a Options The above basic features of Shari a options suggest that these options, if put together, mange a wide range of risks including the following: Fraud risk (khiyar al ghabn) Misrepresentation risk (khiyar al tadlees) Ownership risk (khiyar mulk) Price risk (khiyar al naqd) Market risk Commodity risk (khiyar al a ib) Default risk (khiyar al ta khir) 10

11 Similarities of Shari a and Financial Options There are similarities between financial options and Shari a options as in the following: The Shari a and financial options agree on providing a right to either of the parties or both to confirm or to cancel the contract within a stipulated period. The Shari a and financial options are mainly intended to manage a wide range of risks. The Shari a options are created as a result of asset based contractual relationship. This also exists in the transactions of financial options that involve shares. The Shari a options and financial options agree on that both give the buyer an upper hand to decide on the direction of the contract. 11

12 Differences Between Shari a and Financial Options A Shari a option consists of three components, namely the option itself, the contract and the underlying assets. The subject matter of financial option is intangible event against the seller created by a contract of obligation. Shari a options are not subject of speculation and gambling. The option contracts are prone to be used as a gambling mechanism. 12

13 Differences Between Shari a and Financial Options The investors use financial options to hedge against potential price risks or losses by using the premium as consideration for the party who accepts to bear such risk or losses. The financial options are mechanisms of investment whereby investors depend on their expectation of the market and issue or buy such options. This is not the case in Shari a options. The period of option in financial options is actually not part of the contract because it precedes the contract. The period in Shari a options is an integral part of the contract. 13

14 Similarities Between Arboon sale and Options The arboon concepts is usually compared to Options for the following reasons: Arboon contract consists of an option that is exchanged with money in case the contract over an asset or usufruct is not concluded. Among the objectives of arboon contract is the management of market risk or price risks. The arboon sale entitles the buyer to gain a binding offer from the seller while the buyer is at discretion to accept or reject the offer within the period of offer in consideration for the arboon. This is similar to the call option where the option holder is entitled to buy shares or refrain from doing so against losing the paid premium. 14

15 Differences between Arboon sale and financial Options However, there are major differences between Arboon and Options as follows: The amount that is described as arboon form part and parcel of the price of the sold item whereas the premium of financial options is not considered part of the price, but rather a consideration for granting an option to buy or sell. In the arboon contract, there exists a contract whereas the contract in financial options would be categorized under Shari a principles as a mere promise because it does not fulfill the requirements of sale contract. The arboon is not tradable and financial options may be traded. 15

16 Some Shari a Issues of Hedge Funds The compliance of a hedge fund requires that the hedge fund technique and tools are free from the following: (1) Guarantee of the investment by the hedge fund manager, because of: The guarantee converts the operation of the fund to lending and borrowing in which case any amount paid as profit is considered interest. (2) Hedging through non Shari a compliant contracts and mechanics, such as interest rate swaps, derivatives, bond and conventional insurance. 16

17 Some Shari a Issues of Hedge Funds (3) Non equality in terms of bearing losses: Preferred stocks. (4) Non possession and taking daman of sold goods (short selling). (5) Non Shari a compliant elements in the agreements and contracts. (6) Sale of borrowed shares (not owned). (7) Elements of gambling 17

18 Shari a Alternatives for hedging It becomes acceptable among the Shari a scholars that some Shari a contracts and concepts may be used as hedging tools. The following are some Shari a alternative hedging techniques: Salam: entering into salam contract and payment of the price in advance. Salam is applicable to goods to produced from cultivation or to be bought from the market. Therefore, salam may be applicable to shares provided that only rating of the shares is identified and not the company. 18

19 Sharia alternatives for hedging Arboon: entering into real sale and purchase of shares or goods and payment of arboon to fix the price. The concept of capital protected funds are also based on the arboon as follows: 93% of the funds is invested in fixed profit transactions, such as Murabaha, ijara and sukuk, at a profit margin of 7 = 100 (capital is protected). 7% is paid as arboon on trade date for purchasing shares of a company today with the delivery to take place at maturity. On maturity, if the shares are performing the shares are collected and resold with higher price. If the shares under perform, the purchase will forfeit the shares. Some times the hedge is arrived by a combination of debt based contracts and direct share trading without payment of arboon (combination of debt based contract and partnership). 19

20 Shari a alternatives for hedging Parallel Wa d: Some few scholars approved by the structure of parallel promises for sale and purchase at different benchmarks. This structure ends up with the fund manager guaranteeing purchase of the shares at nominal value for which a number of scholars do not agree on this structure of hedging. 20

21 Sharia alternatives for hedging Structured Guarantee: some Islamic hedge funds used the concept of structured guarantee a fund manager will design investment analysis models using mathematical analysis which will make the fund manager achieve returns promised to the clients. The model designer guarantees the capital but on condition that the fund manager adhere to the model designers instructions as to when to invest or halt an investment. This structure is accepted by some scholars based on the fact that the fund manager is doing business based on the advice of the model designer. If the model designers analysis appears wrong, then the model designer shall be liable. 21

22 Sharia alternatives for hedging sale and buy back: this mechanism is similar to short selling concept. conditional option (khiyar al shart): unlike in arboon, in conditional option, the option holder does not pay premium. Profit Setoff (Profit rate swap): Under the parallel commodity sale and purchase, the fund managers to hedge currency risks. 22

23 Sharia alternatives for hedging Usufruct exchange/swap (mutual loan exchange): This is used for currency risk management. exchange of debts for commodity: The scholars are unanimous that receivables and debts may be sold in exchange for real commodity, even if the price of the commodity is higher than the value of the debt/receivables. 23

24 Underlying Assets of Hedging As a principle, the Shari a compliant assets are potential assets for hedging purposes. The underlying assets of hedge funds or hedging may be classified into two: Category A: are assets that are created using non Shari a compliant activity. The examples of this category are the following: Bonds and interest based Securities: this asset becomes out of the assets of Islamic hedging because of its interest nature. Debts and receivables the majority of scholars consider tripartite trade of receivables is not acceptable. Conventional insurance Trading of risks 24

25 Underlying Assets of Hedging Category B: are assets of hedging that are created through an acceptable Sharia contract and activity. The example of this category are as follows: Shares, stocks and unit trusts purchasing shares for hedging purpose will depend on the activities of the company the shares represent Commodity is an acceptable mode for hedging except that the contract used to execute it may render the hedging unacceptable, not the commodity itself. Sukuks are certificates that represent an ownership in assets. They may form an acceptable hedge funds assets. Real estate Thus, the determination of assets of hedging lies on the Shari a compliant of the assets. 25

26 What Shari a Advisors look for compliance of hedge funds? The hedging tools, strategies and techniques are nothing but management issues. The evil is in the means that created these techniques. role of the Shari a Boards may be summarized as follows: Examination of the fund structure Modification approach and ensuring compliance Examination of the underlying instruments, assets and principles of hedging. Examining the agreements and contracts Cross hedging compliance Accurate implementation of the suggested structure. 26

27 Thank You 27

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