Topic 11

Investment in Derivatives
 Derivatives
• Derivatives are contracts that derive their
values from the performance of a particular
underlying assets like common stocks,
bonds, currencies or commodities.
• Basically, the contract is arranged between
two parties that specify conditions
(especially the dates, resulting values and
definitions of the underlying variables, the
parties' contractual obligations, and
the notional amount) under which payments
are to be made between the parties.
 Purposes of Derivatives
• Three common purposes of derivatives:
i. Hedging
ii. Speculation
iii. Arbitrage opportunities
 Purposes of Derivatives
i. Hedging – a strategy to minimize (or even
eliminate) the risks associated with the
fluctuations in the price of underlying assets.
• Example: A paddy farmer and a miller could
sign a future contract to exchange a specified
amount of cash for a specified amount of
paddy in the future. Both parties have
reduced the risk:
✓ Farmer – the uncertainty of price.
✓ Miller – the availability of paddy.
 Purposes of Derivatives
ii. Speculation – instead of minimizing risk, a
derivative could also allow individual or
institution to acquire risk by way of
speculation.
• Speculators buy an asset in the future at a
low price according to a derivative
contract when the future market price is
high, or to sell an asset in the future at a
high price according to a derivative
contract when the future market price is
low.
 Purposes of Derivatives
iii. Arbitrage
• Arbitrage is the simultaneous purchase and sale of
an asset to profit from an imbalance in the price.
• It is a trade that profits by exploiting the price
differences of identical or similar financial
instruments on different markets or in different
forms.
• Arbitrage exists as a result of
market inefficiencies and would therefore not exist
if all markets were perfectly efficient.
• As a simple example of arbitrage.
• The stock of Company X is trading at $20 on the New
York Stock Exchange (NYSE) while, at the same moment,
it is trading for $20.05 on the London Stock Exchange
(LSE). A trader can buy the stock on the NYSE and
immediately sell the same shares on the LSE, earning a
profit of 5 cents per share. The trader could continue to
exploit this arbitrage until the specialists on the NYSE run
out of inventory of Company X's stock, or until the
specialists on the NYSE or LSE adjust their prices to wipe
out the opportunity.
• A more complex example of arbitrage (triangular
arbitrage):
• Assume you begin with $2 million. You see that at 3
different institutions the following currency exchange
rates are immediately available:
✓ Institution 1: USD=Euros = 0.894
✓ Institution 2: Euros=British pound = 1.276
✓ Institution 3: British pound=USD = 1.432
• First, you would convert the $2 million to euros at the
0.894 rate, giving you 1,788,000 euros. Next, you would
take the 1,788,000 euros and convert them to pounds at
the 1.276 rate, giving you 1,401,254 pounds. Next, you
would take the pounds and convert them back to U.S.
dollars at the 1.432 rate, giving you $2,006,596. Your total
risk-free arbitrage profit would be $6,596.
 Evolution of Derivatives
• Derivatives were the result of financial
innovation that responded to the existing
need to help manage risk in increasingly
sophisticated business environments.
• Originally, derivatives begin with forward
contracts for risk-management of agro-
based products, the instruments were later
innovated as risk environments changed.
• Common forms : Forwards, Futures, Options,
Swaps.
 Evolution of Derivative
Instruments

Forward Futures Options Swaps

 Forward Contract
• A forward contract is a customized contract between
two parties to execute a transaction at a future date
with the price determined today.
• A forward contract can be customized to any
commodity, amount and delivery date. A forward
contract settlement can occur on a cash or delivery
basis.
• Example: cocoa farmer undertakes to sell 100 tons of
cocoa in 6 months to a chocolate confectionary which
undertakes to buy the cocoa at a price of RMxx per ton
today.
• Benefits: both parties have locked-in the price and
hedged against adverse price movements.
 Futures Contract
• Futures contracts evolved as a results of problems
with the forward contract. Among the problems are:
i. Double coincidence of wants – counterparty must
have opposite needs in respect of underlying
asset, timing and quantity.
ii. Differing bargaining positions – often lead to
biased pricing.
iii. Counterparty risk of default due to price
movements, financial and operational
circumstances.
iv. Costly search and transaction costs.
 Futures Contract
• Futures contract is essentially a standardized
forward contract in respect of contract size,
maturity, product quality, place of delivery etc.
• Futures contracts are traded on exchanges that
mediate the transactions of all buyers and sellers.
• Since many buyers & sellers transact through an
exchange, problems of double coincidence,
differing bargaining positions, counterparty risk and
transaction costs are solved.
 Futures Contract
• How the exchange works?
• The exchange requires each party to deposit initial
deposits, known as initial margins.
• To minimize risk, the exchange use:
i. Margining process
ii. Marking to market .
• Marking to market (during settlement) – gain or loss
in each contract position resulting from changes in
the price of the futures contracts at the end of each
trading day are added or subtracted from each
account balance.
 Futures Contract
• Process Flow to Buy Futures:

Deposit margin
Arrange for margin
Get a trading money with broker
money (% of the
accounts who passes it on to
contract value)
the exchange

Place buy/sell order Exchange match your

with trader order
 Options Contract
• Given that prices have been locked-in, futures
contract cannot give benefit from favorable price
movements. Hence, option contract is introduced.
• An option contract entitles the holder the right but
not the obligation to buy (or sell) the underlying
assets at a pre-determined price at (or anytime
before) maturity.
• To acquire this right, payment of premium is
required.
• If the option holder decides not to exercise the
option (inactive) and the option expired, the
premium paid will be lost.
 Options Contract
• Two basic types of option:
• Call Option: Option holder has the right but not the
obligation to buy the underlying asset at a
predetermined price before maturity of the option
contract. In exchange, the seller is paid a non-
refundable premium.
• Put Option: Option holder has the right but not the
obligation to sell the underlying asset at a
predetermined price before maturity of the options
contract. In exchange, the seller is paid a non-
refundable premium.
 Options Contract
• For example, in a simple call options contract, a trader
may expect Company ABC's stock price to go up to
RM90 in the next month. The trader sees that he can
buy an options contract of Company ABC at RM4.50
with a strike price of RM75 per share. The trader must
pay the cost of the option (RM4.50 X 100 shares =
RM450).
• The stock price begins to rise as expected and stabilizes
at RM100. Prior to the expiry date on the options
contract, the trader executes the call option and buys
the 100 shares of Company ABC at RM75, the strike price
on his options contract.
• He pays RM7,500 for the stock. The trader can then sell
his new stock on the market for RM10,000, making a
RM2,050 profit (RM2,500 minus RM450 for the options
contract).
 Swap
• A swap is a derivative contract through which two
parties exchange financial instruments. These
instruments can be almost anything, but most swaps
involve cash flows based on a notional principal amount
that both parties agree to.
• The rate at which the payments are exchanged is pre-
determined based on either fixed amount or reference
measure.
• Conventionally, there are:
a) Interest rate swap
b) Currency swap
c) Commodity swap
d) Equity swap
A is currently paying floating, but wants to pay fixed. B is currently
paying fixed but wants to pay floating. By entering into an interest rate
swap, the net result is that each party can 'swap' their existing
obligation for their desired obligation. Normally, the parties do not
swap payments directly, but rather each sets up a separate swap with
a financial intermediary such as a bank.
 Evolution of Derivative
Instruments
• Each step of the evolution chain would add value
to the instrument.
• Forward Futures would reduce:
a. Problem of double coincidence
b. Counterparty risk
c. Different bargaining power
d. Transaction costs
 Evolution of Derivative
Instruments
• Each step of the evolution chain would add value
to the instrument.
• Futures Options would:
a. Increase flexibility
b. Have ability to take advantage of favorable price
movement
c. Manage contingent claims/liabilities.
Islamic Perspectives on Futures*
• The majority of scholars (except SAC of SC)
does not consider futures contract as
permissible
• Among the reasons:
a. “Sell not what is not with you”
b. Sale prior to taking possession (Qabd)
c. Debt clearance sale (bai’ al-dayn bil-dayn)
d. Negative effect of speculation.

• * Datuk Prof. Dr. Azmi Omar

 “Sell not what is not with you”

• Jaafar ibn Abi Wah Shiyah reported from Yusof ibn

Mahil, from Hakim ibn Hizam (who said): I asked the
prophet;”O messenger of Allah! A man comes to
me and asks me to sell him what is not with me, so I
sell him (what he wants) and then buy the goods for
him in the market (and deliver). And the prophet
said;”sell not what is not with you”.
 “Sell not what is not with you”
• Jurists who approve of futures contracts argued
that:
✓ The hadith only applies to sale of specified and
unique objects.
✓ The purpose of hadith is to avoid gharar
✓ Salam sale is permissible
✓ Market place at that time was small and giving no
assurance of regular supply of goods
✓ Clearing house guarantee function of futures
exchange.
 Sale Prior To Taking Possession
• Abdullah ibn Umar has reported that the prophet
said: He who buys foodstuffs should not sell it till he
has received it”.
• The stipulation seeks to protect the buyer against
loss in the event that the object of sale was
damaged or destroyed before delivery.
• As-Shafie interpreted the hadith to include anything
subject to sale, not just perishable food.
 Sale Prior To Taking Possession
• Jurists who approve futures contract argued that:
✓ Only a very small percentage of futures contracts
lead to actual physical delivery of underlying
assets.
✓ The majority of contracting parties of futures
contracts will close out their positions by entering
into reverse transactions (cash settlement).
✓ Hence, delivery is never an issue most of the time.
 Bai’ al-dayn bi al-dayn
• Bai’ al-dayn bi al-dayn (or known also as bai’
al-khali bi al-khali) is deemed impermissible in
shariah.
• Example: Mr. C borrowed some wheat from Mr.
D to returned in 3 months. Two months later, Mr.
D sells the (yet to be received)wheat to Mr. E to
be delivered in 1 month.
• Futures trading is said to have such elements of
bai’ al-dayn bi al-dayn arising from common
practice of offsetting sale and purchase.
 Bai’ al-dayn bi al-dayn
• Jurists who approve futures contracts argued
that:
• The rationales for disapproving bai’ al-dayn
bi al-dayn is gharar. In futures trading,
offsetting transactions is a basic function of
the clearing house. Parties acknowledge
and mutually agree upon their obligations,
hence there is no uncertainty with regards
to contractual responsibilities.
Effects of Speculation
 Permissibility of Futures?
• There are attempts to advocate the
permissibility of futures contracts by
associating them with the Islamic contracts
of Salam and Istisna’.
• However, there is no consensus on the
permissibility of futures contracts.
• The primary objection to futures contracts is
that they are susceptible to speculative
trading & gharar given that both delivery of
goods and payment will take place in the
future.
 Permissibility of Option?
• Some scholars have attempted to justify the
permissibility of option with bai’ al-arbun:
✓ The buyer deposits some money with the
seller as down payment.
✓ If buyer proceeds to purchase the goods,
the down payment is considered as part of
payment of the price
✓ If the buyer does not proceed to buy the
goods, the buyer forfeits the down payment.
 Bai’ al-Arbun in Option?
• Hanbali scholars view al-arbun as
permissible based on the athar of Caliph
Umar;
✓ Nafi bin Harith, Caliph Umar officer,
purchased a house (for conversion into
prison) from Safwan bin Umayyah & paid
400 dirham deposits on condition that if
Caliph approved of it then the deal would
go through. Otherwise, Safwan could keep
the deposits of 400 dirhams.
 Bai’ al-Arbun in Option?
• Other fiqh schools viewed al-arbun
unacceptable.
• They consider the retention of down
payment by the seller akin to
misappropriation of the property of others.