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Islamic derivatives

Presented by Syed Taha ali Group 2

Financial derivatives
SBP defines derivatives in Financial Derivatives Business Regulations (FDBR) as a type of financial contract the value of which is determined by reference to one or more underlying assets or indices. The major categories of such contracts include forwards, futures, swaps and options.

Characteristics of derivatives
Financial derivatives are financial instruments that derive their value from another transaction. Initial investment is very low or zero. Settled at a later date.

Fundamental isues:
Inexistence of contract. Lack o f actual ownership Lack of delievery. Prohibitions of riba. Prohibitions of gharar(uncertainity). Prohibitions of maysir(gambling). Bai ul kali bil kali. Finally, jahl refers to ignorance.

Guidance From Quran on Business Dealings:


. (.29 )

O Ye who believe! Eat not up your property among yourselves unduly. Let it be trade amongst you by mutual agreement.

This verse is perhaps the most important verse of Quran on economic matters. It tells us both the
dos and the donts in business dealings. First the donts.

What is Allowed in Business Contracts


The Golden Principle of Free Choice Muslims are free to determine the conditions of their contracts unless they make something forbidden as permissible or something permissible as forbidden In Islamic theory of contracts, parties are free to agree on any terms as long as known Islamic rules and principles are not violated.

Prohibition of Gambling (Maysar)


O Ye who believe, Intoxicants and Gambling, (Dedication of ) stones, And (Dedication of) arrows, are an abomination, of Satans handiwork: Eschew such (abomination) , That ye may prosper. Gambling amounts to transfer of wealth without any value added.

Guidelines for Islamic Financial derivative Contract Design


Freedom in determining the conditions of a contract within Shariah rules. Prohibition of taking others property without compensation. Conscious Agreement within Shariah limits. Mutual Benefit (Value Equivalence). Justice and Fairness (Elimination of Exploitative Clauses). Provision of Maximum Possible Information. Honoring the Spirit of Contract.

Islamic derivatives
Islamic option model based on khyar bil shart (conditional option). Islamic Profit rate swaps. Waad contracts.

Independent financial contract that are traded for a price have no clear-cut parallel in the classical Islamic theory of contracting. The informationally disadvantaged party at the time of entering into the contract has the option to cancel the contract within a specified time period. A person has also the right to undo his purchase if the seller specifically allows as part of the sale.

Islamic option model based on khyar bil shart (embedded conditional option).

Khiyar relates to a halal contract of exchange that has already taken place, whilst a modern option relates to an exchange that is yet to take place.
Premium charged under share options is not allowed. In case of khiyar , the exchange of one or both counter values is effected immediately while in case of modern option contract future delivery apply to both payment and underlying asset.

PROFIT RATE SWAP


In PRS, only cash flow is changed. This cash flow is in the same currency. Therefore, the exchange involved is to change the flow of the fixed profit rate with the floating profit rate. In the present Islamic profit market, there are two variations or structures employed byIFIs: a) PRS based on waad and murabahah principles. b) PRS based on waad and musawamah principles.

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 of KIBOR or LIBOR To deepen Islamic Financial Market

THE DYNAMICS OF IPRS


Islamic Swap Counter Party

Pays fixed profit rate

Receives floating profit rate

Financial Liabilities
Pays floating obligations

ABC
Receives fixed returns

Financial Assets

STAGE 1: Fixed Profit Rate


STEP 1 ABC sells Asset to Islamic Swap counter Party at notional principal of RM500k. STEP 3 Notional principal amount of RM500k owed by both ABC and Islamic Swap party to each other is set off

Islamic Swap Counter Party

STEP 2 Islamic Swap Counter Party sells Asset to ABC at notional principal RM500k + mark-up based on fixed profit rate STEP 4 The net difference i.e. the fixed profit rate in Step 2 is paid to Islamic Swap counter Party by ABC at the agreed interval payment date of say 6 month

ASSET

ABC

STAGE 2: Floating Profit Rate


Islamic Swap Counter Party STEP 1 ABC sells Asset to Islamic Swap counter Party at notional principal RM500k + floating profit rate. ASSET
STEP 3 Notional principal amount of RM500k owed by both ABC and Islamic Swap party to each other is set off STEP 4 The net difference i.e. the floating rate profit in Step 1 is paid to ABC by Islamic Swap counter Party at the agreed interval payment date of say 6 month STEP 2 Islamic Swap counter Party sells Asset to ABC at notional principal of RM500k.

ABC

STAGE 3 Determination of Subsequent Floating Rate


Islamic Swap Counter Party

ASSET

ABC
6 MONTHS 6 MONTHS 6 MONTHS 6 MONTHS MATURITY

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

CONTRACT OF WAAD:
A promise thus is non-binding. It is also unilateral therefore both parties can choose not to make good their promise. Under Shariah because of the unilateral nature of the promise, the details of the promise are not as carved in stone as any other contract. Those restrictions donot apply to the contact of waad.

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