Financial options in Islamic contracts: potential tools for risk management-II

Here two points are worth noting. First, when one assumes a fixed exchange rate regime, the distinction between currencies of different countries gets diluted. The situation becomes similar to exchanging pounds with sterlings (currencies belonging to the same country) at a fixed rate.
Second, when one assumes a volatile exchange rate system, then just as one can visualise lending through the foreign currency market (mechanism suggested in the above example), one can also visualise lending through any other organised market (such as, for commodities or stocks).
If one replaces dollars for stocks in the above example, it would read as: "In a given moment in time when the market price of stock X is Rs 20, if an individual purchases 50 stocks at the rate of Rs 22 (settlement of his obligation in rupees deferred to a future date), then it is highly probable that he is, in fact, borrowing Rs 1000 now in lieu of a promise to repay Rs 1100 on a specified later date.
(Since, he can obtain Rs 1000 now, exchanging the 50 stocks purchased on credit at current price)" In this case too as in the earlier example, returns to the seller of stocks may be negative if stock price rises to Rs 25 on the settlement date.
Hence, just as returns in the stock market or commodity market are Islamically acceptable because of the price risk, so are returns in the foreign currency market because of fluctuations in the prices of foreign currencies.
A unique feature of thaman haqiqi or gold and silver is that the intrinsic worth of the currency is equal to its face value. Thus, the question of different geographical boundaries within which a given currency, such as, dinar or dirham circulates, is completely irrelevant.
Gold is gold whether in country A or country B. Thus, when currency of country A made of gold is exchanged for currency of country B, also made of gold, then any deviation of the exchange rate from unity or deferment of settlement by either party is not permissible.
However, when paper currencies of country A is exchanged for paper currency of country B, the case may be entirely different. Paper currency of B is not thaman in country A. Nor is the paper currency of A thaman in country B. The price risk (exchange rate risk), if positive, would eliminate any possibility of riba al-nasia in the exchange with deferred settlement.
Another point that merits serious consideration is the possibility that certain currencies may possess thamaniyya, that is, used as a medium of exchange, unit of account, or store of value globally, within the domestic as well as foreign countries.
For instance, US dollar is legal tender within US; it is also acceptable as a medium of exchange or unit of account for a large volume of transactions across the globe. Thus, this specific currency may be -said to possesses thamaniyya globally, in which case, jurists may impose the relevant injunctions on exchanges involving this specific currency to prevent riba al-nasia.
The fact is that when a currency possesses thamaniyya globally, then economic units using this global currency as the medium of exchange, unit of account or store of value may not be concerned about risk arising from volatility of inter-country exchange rates.
At the same time it should he recognised that a large majority of currencies do not perform the functions oil' money except within their national boundaries where these are legal tender.
POSSIBILITY OF RIBA WITH FUTURES AND FORWARDS: So far, we have discussed views on the permissibility of deferring settlement of obligation of only one of the parties to the exchange. What are the views of scholars on deferment of obligations of both parties? Typical example of such contracts are forwards and futures.
According to a large majority of scholars, this is not permissible on various grounds, the most important being - the element of risk and uncertainty (gharar) and the possibility of speculation of a kind which is not permissible. This is discussed in section 3.
However, another ground for rejecting such contracts may be riba prohibition. In the preceding paragraph we have discussed that bai salam in currencies with fluctuating exchange rates cannot be used to earn riba because of the presence of currency risk.
It is possible to demonstrate that currency risk can be hedged or reduced to zero with another forward contract transacted simultaneously. And once risk is eliminated, the gain clearly would be riba.
We -modify and rewrite the same example: "In - a given moment in time when the market rate of exchange between dollar and rupee is 1:20, an individual -purchases $50 at the rate of 1:22 (settlement of his obligation in rupees deferred to a future date), and the seller of dollars also hedges his position by entering into a forward contract to sell Rs 1100 to be received on the future date at a rate of 1:20, then it is highly probable that he is, in fact, borrowing Rs 1000 low in lieu of a promise to repay Rs 1100 in a specified later date. (Since, he can obtain Rs 1000 now, exchanging the 50 dollars purchased on credit at spot rate)" The seller of the dollars (lender) receives a predetermined return of ten percent when he converts Rs 1100 received on the maturity date into 55 dollars (at an exchange rate of' 1:20) for his investment, of 50 dollars irrespective of the market rate of exchange prevailing on the date of maturity.
Another simple possible way to earn riba may even involve a spot transaction and a simultaneous forward transaction. For example, the individual in the above example purchases $50 on a spot basis at the rate of 1:20 and simultaneously enters into a forward contract with the same party to sell $50 at the rate of 1:21 after one month.
In effect this implies that he is lending Rsl000 now to the seller of dollars for one month and earns an interest of Rs 50 (he receives Rs 1050 after one month. This buy-back or repo (repurchase) transaction so common in conventional banking is termed as bai al-einah and rightly rejected by almost all Islamic scholars. Thus, forward and future contracts can be seen to be clearly unlslamic on grounds of being a source of generating riba.
THE ISSUE OF FREEDOM FROM GHARAR: Gharar, unlike riba, does not have a consensus definition. In broad terms, it connotes risk and uncertainty. It is useful to view gharar as a continuum of risk and uncertainty wherein the extreme point of zero risk is the only point that is well defined. Beyond this point, gharar becomes a variable and the gharar involved in a real life contract would lie somewhere on this continuum.
Beyond a point on this continuum, risk and uncertainty or gharar becomes, unacceptable. Jurists have attempted to identify such situations involving forbidden gharar. A major factor that contributes to gharar is inadequate information (jahl) which increases uncertainty.
This is when the terms of exchange, such as, price, objects of exchange, time of settlement etc are not well-defined. Gharar is also defined in terms of settlement risk or the uncertainty surrounding delivery of the exchanged articles.
Islamic scholars have identified the conditions which make a contract uncertain to the extent that it is forbidden. Each party to the contract must be clear as to the quantity, specification, price, time, and place of delivery of the contract. A contract, say, to sell fish in the river involves uncertainty about the subject of exchange, about its delivery, and hence, not Islamically permissible. A number of hadiths forbid contracts involving uncertainty.
An outcome of excessive gharar or uncertainty is that it leads to the possibility of speculation of a variety, which is forbidden. Speculation in its worst form is gambling. The holy Quran and the traditions of the Holy Prophet explicitly prohibit gains made from games of chance, which involve unearned income.
The term used for gambling is maisir which literally means getting something too easily, getting a profit without working for it. Apart from pure games of chance, the Holy Prophet also forbade actions, which generated unearned incomes without much productive efforts.
Here it may be noted that the term speculation has different connotations. It always involves an attempt to predict the future outcome of an event. But the process may or may not be backed by collection, analysis and interpretation of relevant information. The former case is very much in conformity with Islamic rationality.
An Islamic economic unit is required to assume risk after making a proper assessment of risk with the help of information. All business decisions involve speculation in this sense. It is only in the absence of information or under conditions of excessive gharai' or uncertainty that speculation is akin to a game of chance and is reprehensible.
Gharar and Speculation with Currency Forwards, Futures and Options Considering the case of currency forwards and futures first, where settlement by both parties is deferred to a future date, these are forbidden according to a large majority of jurists on grounds of excessive gharar. In such contracts the two parties become obliged to exchange currencies of two different countries at a known rate at the end of a known time period.
For example, individuals A and B commit to exchange US dollars and Indian rupees at the rate of 1: 22 after one month. If the amount involved is $50 and A is the buyer of dollars then, the obligations of A and B are to make a payments of Rs 1100 and $50 respectively at the end of one month. The contract is settled when both parties honour their obligations on the Future date.
Traditionally, an overwhelming majority of Shariah scholars have disapproved such contracts on several grounds. The prohibition applies to all such contracts where the obligations of both parties are deferred to a future date, including contracts involving exchange of currencies.
An important objection is that such a contract involves sale of a non-existent object or of an object not in the possession (qabd) of the seller. This objection is based on several traditions of the Holy Prophet.
There is, however, a general agreement on the view that the efficient cause (utah) of the prohibition of sale of an object which the seller does not own, or of sale prior to taking possession is gharar, or the uncertainty about delivery of the goods purchased.
Is this efficient cause (illah) present in an exchange involving future contracts in currencies of different countries? In a market with full and free convertibility or no constraints on the supply of currencies, the probability of failure to deliver the same on the maturity date should be no cause for concern.
Further, the standardised nature of futures contracts and transparent operating procedures on the organised futures markets is believed to minimise this probability. Some recent scholars have opined in the light of the above that futures, in general, should be permissible.
According to them, the efficient cause (illah), that is, the probability of failure to deliver was quite relevant in a simple, primitive and unorganised market. It is no longer relevant in the organised futures markets of today. Such contention, however, continues to be rejected by the majority of scholars. They underscore the fact that futures contracts almost never involve delivery by - both parties.
On the contrary, parties to the contract reverse the transaction and the contract is settled in price difference only. For example, in the above example, if the currency exchange rate changes to 1: 23 on the maturity date, the reverse transaction for individual A would mean selling $50 at the rate of 1:23 to individual B. This would imply A making a gain of Rs 50 (the difference between Rs 1150 and Rs 1100).
This is exactly what B would lose. It may so happen that the exchange rate would change to 1:21 in which case A would lose Rs 50 which is what B would gain. This obviously is a zero-sum game in which the gain of one party is exactly equal to the loss of the other.
Currency options provide a right without obligation to the purchaser of the option to exchange currency with a counterparty at a predetermined exchange rate within or at the end of a stipulated time period. For example, individual A may purchase an option to exchange $50 for equivalent rupees at the rate of 1:21 at the end of one month.
If the exchange rate on the maturity date is 1: 20, this implies a gain (he would gain by exchanging Rs 1000 for $50 in the market and then exercising his option to exchange the dollars for Rs 1100 and thus, make a profit equal to Rs 10 minus the option premium).
This would be the loss to the seller of the option. However, if the US dollar appreciates against Indian rupee say, to 1:23, he would be better off by not exercising his option. His losses would equal to the premium paid for purchasing the option.
This would be the gain of the seller of the option. In this exchange, the counterparty, in all probability, would have diametrically opposite expectations regarding future direction of exchange rates. Again like futures, this is a zero-sum game.
This possibility of gains or losses (which theoretically can touch infinity in specific cases) encourages economic units to speculate on the future direction of exchange rates. Since exchange rates fluctuate randomly, gains and losses are random too and the game is reduced to a game of chance.
There is a vast body of literature on the forecastability of exchange rates and a large majority of empirical studies have provided supporting evidence on the futility of any attempt to make short-run predictions. Exchange rates are volatile and remain unpredictable at least for the large majority of market participants.
Needless to say, any attempt to speculate in the hope of the theoretically infinite gains is, in all likelihood, a game of chance for such participants. While the gains, if they materialise, are in the nature of maisir or unearned gains, the possibility of equally massive losses do indicate a possibility of default by the loser and hence, gharar.
Thus, as per the Shariah objection to contracts involving excessive gharar for either or both parties to the contract, forwards, futures and options may not be admissible in the Islamic framework. The other serious objection to the former is because of their being in the nature of bai al kali hi al kali which is discussed later in section 6.
GHARAR WITH COMPLEX PRODUCTS OF FINANCIAL ENGINEERING: Another dimension of gharar is complexity which raises a question mark on the permissibility of a host of products of financial engineering involving currencies. Many such contracts have embedded conditions and can be extremely complex with the risk return possibilities that are difficult to assess.
Elimination of forbidden gharar requires that the contracts are simple and the parties to the contract have complete knowledge of the countervalues being exchanged. Complexity brings in jahl. is a source of potential conflict between parties to the contract and hence, is frowned upon.
The Islamic swap contract highlighted in section 2 is perhaps unnecessarily complex. It amounts to a composite contract equivalent to two simultaneous bai salam contracts 'entered into by both parties. It can also be seen as a composite contract involving mutual loans (qard). There is no reason why the two contracts cannot be separately executed at the same time if there is a matching need. The requirement to identify a matching need and tie up the two contracts is perhaps unnecessary.
THE ISSUE OF RISK MANAGEMENT: Currency markets across the globe are characterised by excessive volatility. In these volatile markets, economic units are faced with a need to manage currency risk. Conventional risk management tools, such as, currency options, forwards, futures and swaps are generally believed to add to the efficiency of the system by serving as tools of hedging amid risk reduction. It is therefore pertinent to examine the hedging argument from an Islamic point of view.
CURRENCY OPTIONS: Currency options provide a right without obligation to the purchaser of the option to exchange currency with a counterparty at a predetermined exchange rate within or at the end of a stipulated time period.
As a simple illustration of how currency option may enable a party to hedge against currency risk, we may reconsider the earlier example with some modifications. Assume that individual A is an exporter from India to US who has already sold some commodities to B, the US importer, and anticipates a cashflow of $50 (which at the current market rate of 1:22 mean Rs 1100 to him) after one month.
There is a possibility that US dollar may depreciate against Indian rupee during the one month in which case A would realise less amount of rupees for his $50 (if the new rate is 1:20, A would realise only Rs 1000). Hence, A may purchase an option to exchange $50 for equivalent rupees at the rate of (say) 1:21.5 at the end of one month (and thereby, is certain to realise Rs 1075).
In this case, A is able to hedge his position and at the same time, does not forgo the opportunity of making a gain if his fears do not materialise and US dollar appreciates against Indian rupee (say, to 1:23) which implies that he would now realise Rs 1150. He would obviously prefer not to exercise his option.
The premium paid for purchasing the option is akin to cost of insurance against currency risk. In this exchange, the counterparty, in all probability, would have diametrically opposite expectations regarding future direction of exchange rates and would sell this option with the hope of gaining the option premium.
Conventional options as independent contracts are not admissible in the Islamic framework and there is a near consensus among Islamic scholars on this issue. However, the Shariah does provide for introduction of options as conditions in the framework of khiyar al shart. In this framework, either or both parties to the contract retain an option to confirm or rescind the contract within a stipulated time period.
Studies have hinted at the possibility of designing Islamic contracts with embedded options within this framework. In-the context of currency exchange however, this possibility has been ruled out with the overwhelming view in favour of spot settlement and binding nature of the currency exchange contracts.
However, as discussed throughout this paper there may be a case for permissibility to settlement of foreign currency exchange contracts from one end.
In this context, the views of Imam Shams Sarakhsi seem to admit the possibility of options: "In an exchange involving fals and dirhams when there is a stipulated option (khiyar al shart) for either of the parties and both parties depart after taking possession (qabd) of countervalues, then such 0exchange is valid.
This is so because, the settlement is deemed to be complete and the contract is binding for the party which does not retain any option and possession (qabd) of at least one of' the countervalues is required here the same is not true for bai-sarf."4 I If the domestic currency because of its property of full thamaniyya is viewed similar to dirhams and foreign currency because of its property of very limited thamaniyya is viewed similar to fals, then exchange involving a foreign currency may perhaps provide for embedded options. The issue certainly deserves further research and investigation.
CURRENCY FORWARDS AND FUTURES: It is generally believed by conventional thinkers in mainstream Finance that futures and forwards are tools for risk management or hedging. Hedging adds to planning and managerial efficiency. In the context of currency markets which are characterised by volatile rates, such contracts are believed to enable the parties to transfer and eliminate risk arising out of such fluctuations.
To demonstrate this possibility with the same example as with options, individual A may enter into a forward or future contract to sell $50 at the rate of 1:21.5 at the end of one month (and thereby, realise Rs 1075) with any counterparty having diametrically opposite expectations regarding future direction of exchange rates.
In this case, A is able to hedge his position and at the same time, forgoes the opportunity of making a gain ii his expectations do not materialise and US dollar appreciates against Indian rupee (say, to 1:23) which implies that he would have Rs 1 150.
While hedging tools improve planning and hence, performance, it should be noted that the intention of the contracting party - whether to hedge or to speculate, can never be ascertained. There is little empirical data to prove or disprove any hypothesis relating to the intention of' the contracting parties.
There may indeed be an element of circular reasoning in the hedging argument and a confusion between micro-level and macro-level concerns. In volatile markets, firms or individuals at a micro level may justifiably have recourse to some tools of risk reduction.
However, permissibility to forwards and futures by enabling speculative transactions, may actually lead to greater volatility in exchange rates, thus, aggravating the problem at a macro level. The consequent instability brought into the system may at times prove to be too costly for the economy as has been demonstrated in the case of the South East Asian economies. This perhaps is the economic justification why hedging with futures and forwards is not permissible in the Islamic framework.
BAI-SALAM: It may be noted that hedging can also be accomplished with bai salam in currencies. As in the above example, exporter A anticipating a cash inflow of $50 after one month and expecting a depreciation of dollar may go for a salam sale of $50 (with his obligation to pay $50 deferred by one month.) Since he is expecting a dollar depreciation, he may agree to sell $50 at the rate of 1: 21.5.
There would be an immediate cash inflow of Rs 1075 for him. The question may be, why should the counterparty pay him rupees now in lieu of a promise to be repaid in dollars after one month. As in the case of futures, the counterparty would do so for profit, if its expectations are diametrically opposite, that is, it expects dollar to appreciate. For example, if dollar appreciates to 1:23 during the one month period, then it would receive Rs 1150 for Rs 1075 it invested in the purchase of $50.
Thus, while A is able to hedge its position, the counterparty is able to earn a profit on trading of currencies. The difference from the earlier scenario is that the counterparty would be more restrained in trading because of the investment required, and such trading is unlikely to take the shape of rampant speculation.
ISLAMIC SWAPS: The fourth form of contracting as highlighted in section 2 is supposed to be the Islamic variant of the conventional swap transactions. The conventional swaps have been generally observed to be unlslamic as they clearly involve interest payments.
Islamic swaps (al-murajaha al-Islamiyah) as highlighted in section 2 are in use by several Islamic banks. A close look at the nature of contracting reveals that the same essentially involves an exchange of two interest-free loans (qard) in different currencies which are repaid by both parties at the end of a stipulated time period.
It is easy to see that such swaps partially enable the parties to hedge their currency risk. For example, bank A in India has liquid funds denominated in US dollars and currently it expects the US dollar to weaken against Indian rupee over the next six months.
Bank B in US with its liquidity in Indian rupees has diametrically opposite expectations. It expects the Indian rupee to weaken against the US dollar over the next six months. Thus, both banks are exposed to and perceive currency risk. An Islamic swap between the two banks may help both banks to partially reduce their risk. It may comprise the following.
TODAY: A lends - 1 million US dollars - B borrows and A borrows -20 million Indian rupees - B lends After six months and A repays -20 million Indian rupees - to B And A is repaid - 1 million US dollars - by B
In the absence of the swap, bank A would have continued with its dollar liquidity or generated some dollar income by investing the same. With rupee being the reporting currency and with continued fall in the value of dollar against rupee, the bank would have faced a loss due to the currency rate changes.
With the swap now, the bank would be able to make rupee investments for the time period and generate rupee income. At the end of the time period, the bank reverses the transaction and gets back its dollar liquidity. A similar situation exists with respect to bank B which can now hedge its rupee resources against the fall in the value of rupee against dollar (dollar being the reporting currency).
The major difference of this type of' swap from its conventional counterpart is that in case of the latter, the interest payments along with the principal is swapped. In case of Islamic swap, only the principal is being swapped since the incomes to be generated on the investments are not predetermined.
Islamic swaps can also be explained using the earlier example with some modifications. Assume now that individual A is an exporter from India to US who has already sold some commodities to a US importer and anticipates a cash flow of $50 (which at the current market rate of 1:22 mean Rs 1100 to him) after one month.
There is a possibility that US dollar may depreciate against Indian rupee during this one month, in which case A would realise, less amount of rupees for his $50 (if the new rate is 1:21, A would realise only' Rs 1050). Let us also assume that B is another exporter from US who anticipates a cash flow of Rs 1100 after one month and has diametrically opposite expectations regarding future direction of exchange rates.
It is worried about a possible fall in the value of rupee against dollar which would mean a reduced dollar realisation. Now A and 13 may agree to enter into an Islamic swap under which A lends Rs I 10() to B now and borrows US $50 from him. (A and B are neither gaining nor losing with this exchange and can always find the rupees and dollars to exchange, since the current exchange rate is 1:22).
At the end of the one month A and B receive their respective dollars and rupees from the counterparties. When they reverse the earlier transaction and repay to each other it would imply an exchange rate of 1:22 again. Thus, A and B would be able to ensure that their future receipts are hedged against adverse currency rate movements.
Islamic swaps may perform many other useful functions besides serving as a tool of risk management, such as, reducing cost of raising resources, identifying appropriate investment opportunities, better asset -liability management and the like.
These are also the benefits with conventional swaps. Islamic swaps are different in that they do not involve interest-related cash flows. However, Islamic swaps, are not free from controversies and there is no consensus regarding their acceptability as would be discussed below.
Second, Keeping this principle in view, the swap transaction is not permissible because the loan of US $50 is made a precondition for accepting the loan of Rs 100. He however goes on to say that "this is my first hand opinion about this transaction... it needs further study and research."
Some scholars justify a prohibition of conditional loans based on a hadith narrated by Abdullah bin Umar "whoever advances a loan should not make it conditional with the exception of return of the loan." Mahmud Ahmed however, quoting Allama. Wahid-uz-Zaman interprets, the above hadith as that a lender should not impose any condition which confers any advantage on the lender.
Defending another financial product which has this common property as Islamic swaps, he asserts that "under the above arrangement, exactly identical values are exchanged and no advantage exceeding the h~an value received is conferred by the borrower on the lender. In fact, both parties to the contract are simultaneously lenders as well as borrowers, and there is nothing that one lends to the other which is anything less or more than either of them borrows from the other.
Unless the borrower is forced to give some kind of advantage to the lender in addition to the loan value he receives, the arrangement cannot be called conditional loan of a variety which is forbidden.".
SUMMARY & CONCLUSION: In this paper we have attempted an assessment of various conventional forms of contracting, such as, spot transactions, options, forwards, futures, swaps and various complex and composite products of financial engineering in terms of the overwhelming need to eliminate any possibility of riba, minimise gharar, jahl and the possibility of speculation of a kind -akin to games of chance.
It is obvious that spot settlement of the obligations of both parties would completely prohibit riba, and gharar, and minimise -the possibility of speculation. However, this would also imply the absence of any technique of risk management and may involve some practical problems for the participants.
At the other extreme, if the obligations of both parties are deferred to a future date, then such contracting, in all likelihood, would open up the possibility of infinite unearned gains and losses from what may be rightly termed for the majority of participants as games of chance: Of course, these would also enable the participants to manage risk through complete risk transfer to others and reduce risk to zero.
It is this possibility- of risk reduction to zero which may enable a participant to earn riba. Future is not a new form of contract. Rather the justification for proscribing may be new.
If in a simple primitive economy, it was prevention of gharar relating to delivery of the exchanged article, in today's' complex financial system and organised exchanges, it is perhaps the prevention of speculation of a kind which is un-Islamic and which is possible under excessive gharar involved in forecasting highly volatile exchange rates.
Such speculation is not just a possibility, but a reality. Independent currency options are also not permissible on this ground. Forwards and futures are prohibited also on the ground that these involve bai al kali bi alkali or exchange of debt obligations.
Islamic swaps though may be beneficial in some ways, are not free form controversy. Viewed as a composite of two bai-salam contracts, the tying up seems unnecessary. Risk management is possible with delinked bai-salam contracts too. This would be simpler and more efficient. Islamic swaps may also be questionable, when these are seen as tying up of two interest-free loans.
The form of contracting with deferment of obligations of one of the -parties to a future date falls between the two extremes of spot and future contracts. While, Shariah scholars have divergent views about its permissibility, our analysis reveals that there is no possibility of earning riba with this kind of contracting.
The requirement of spot settlement of' obligations of at least one party imposes a natural curb on speculation, though the room for speculation is greater than under tb' first form of contracting. The requirement amounts to imposition o~ a hundred percent margin which, in all probability, would drive away the uninformed speculator from the market.
This should force the speculator to he a little more sure of his expectations by being more informed. When speculation is based on information it is not only permissible, but, desirable too. Hal salam would also enable the participants to manage risk. At the same time, - the requirement of settlement from one end would dampen the tendency of many participants to seek a complete transfer of perceived risk and encourage them to make a realistic assessment of the actual risk.
There is perhaps a case for reconsideration of the definition of thamaniyya. Money is what money does and the acceptability of specific currencies as medium of exchange, unit of account and store of value varies widely across. geographical boundaries. Such an assessment is of utmost importance as many of the Shariah related injunctions amid prescriptions regarding the exchange mechanism, such as, permissibility of bai-salam in specific currencies, are dependant upon this crucial risk.
(Concluded)