Monetary and Capital Market Exclusive, March 2004

Monetary and Capital Market in Iran

A Comparative Study of Investment Instruments

In general Islamic financial instruments should include sharing and participation features on the risk and return side and on a fair and “informationally symmetric” basis, a meeting of the minds so to speak.

Dr. Shahin Shayan Arani, Senior Economist

There is a need to analyze the viability, design and applications of Islamic derivative instruments, with focus on the role and design (engineering) of option contracts for the Islamic financial markets.

All Islamic scholars prohibit financial transactions that include usury, deception and gambling.  Securities and investment laws in most countries prohibit investment activities that might include deception (insider information or asymmetric information flows to the contracting parties). Usually severe punishments are considered for this behavior. With regards to the notion of gambling (could be thought off as an extreme form of speculation), treatments are different. Some countries do promote this form of trading behavior and some don’t. With regards to the viability of usury, in general most non-Islamic countries are indifferent.

Two forms of usury are defined in Islam. One form deals with trades in financial instruments (such as bonds and loans) and the other deals with trades in physical assets. Usury in financial instruments involves a fixed interest charge on a loan or debt due to the passage of time. It arises where a borrower of a wealth, in any form, enters into a contract to repay to the lender a fix interest in addition to the principal that was borrowed. Usury on physical trades, involves an exchange of unequal qualities or quantities of the same commodity simultaneously, and is considered as usury or surplus.

In general Islamic financial instruments should include sharing and participation features on the risk and return side and on a fair and “informationally symmetric” basis, a meeting of the minds so to speak. This means that investment situations where risk is asymmetrically distributed or shared without any compensations or rewards will be questionable from an Islamic point of view.

The universe of non-Islamic financial instruments is diverse. It should be enough to state that the categories include many types of stocks, bonds and derivative instruments with various features that satisfy different investor risk/return profiles globally. The universe of Islamic financial instruments is very limited. Plenty of work needs to be done to engineer new Islamic instruments to satisfy the diverse risk/return needs and profiles of Islamic investors.

Validity of Islamic financial instruments is an important issue for Muslims, but equally important is how we use these instruments in the conduct of our daily businesses. How trade is conducted so that the spirit of gambling is excluded is of additional concern. As we know in the non-Islamic world, financial trades are done for three main reasons:

• Investment purposes: Buying and selling with the intention to hold

• Hedging purposes: Buying or selling with the intention to insure asset values

• Speculation purposes: Buying and selling with the intention to speculate on information or expectations

• The Islamic financial instruments most commonly used can be briefly determined as follows:

• Murabahah Instruments: Purchase of an item at a price that includes an agreed profit margin over the total cost of the seller (cost-plus financing). It is assumed that the total cost is known accurately. This instrument is usually used for short term trade and financing.

• Mudarabah Instruments: When one provides capital to an individual who needs capital and provides management and labor in return, with the intention of sharing the resulting profit/loss at a predetermined rate between the two parties.

• Musharakah Instruments: When one pays to share in the ownership of a property or the results of an endeavor. Here, all partners to a business endeavor contribute funds and have the right but not the obligation to exercise the management powers in the project. This investment vehicle is very much similar to the limited partnership concepts.

• Ijara Instruments: This represents an exchange transaction in which a known benefit arising from a specified asset is made available in return for a payment, but where ownership of the asset itself is not transferred. This is very similar to the installment leasing agreement.

• Bai-Salam: This is a contract where one pays now a predetermined fix price for the delivery of a good in a set time in the future. This could be thought of as a form of derivative instrument.

• Bai-Istisna: This is a contract of exchange with deferred delivery, applied to specific made-to-order items. This differs from Ijara in that the manufacturer must procure his own raw materials.

Islamic & non-Islamic Derivative Securities: A derivative security is a financial instrument whose value depends on the values of other tangible or intangible assets. In recent years, derivatives have become increasingly important in the field of finance. The world of derivatives is riddled with jargons. Here we will explain each derivative instrument briefly.

• Forward Contracts: A contract that commits the user to buy or sell an asset, say gold or a given currency, at a specific price on a specific date in the future, known as the maturity date. The price of the asset can be settled at the maturity date or it can be paid at the initiation of the contract. In the first case, from an Islamic point of view the contract will not be considered as a proper contract, since no asset is transferred at the time the contract was initiated. In the second case the contract will be very much like the Bai-Salam contracts in Islam. Forward contracts are mostly used for private deals between two parties. The terms and conditions of these contracts are very flexible. These instruments are not traded on the exchanges.

• Futures Contracts: A futures contract is very much like a forward contract except it is traded on an exchange. To make trading possible, the exchange specifies certain standardized features of the contract which makes the terms and conditions of the contracts structured and more easily regulated. These contracts could have Islamic validity since the payment and assets can be transferred or guaranteed to be transferred at the time of the contract origination through the exchanges.

• Swap Contracts: A contract by which two parties exchange benefits (cash flows) resulting from a given asset or liability. This is very much like a specialized, time limited barter arrangement. For example, two firms, one with a loan on a fixed interest rate over ten years and the other with a similar loan on a floating interest rate over the same period, may agree to take over each other’s interest obligations, so that the first firm pays the floating rate and the second the fixed rate. If one is careful with regards to usury on physical trades, these contracts can have Islamic justifiability and could be used regularly in the commodities swap markets.

• Option Contracts: A contract that gives the buyer the right, but not the obligation, to buy or sell a particular asset at a particular price, on or before a specific date. Whereas forwards, futures and swaps are binding commitments, an option is a form of insurance. A buyer can be charged a hefty premium, which is lost should the option not be used (exercised). There are two basic types of options. A "call option" gives the holder the right to buy the underlying asset by a certain date for a certain price. A "put option" gives the holder the right to sell the underlying asset by a certain date for a certain price. The price in the contract is known as the strike price, the date in the contract is known as the maturity. It should be emphasized that an option gives the holder the right to do something not the obligation.

Financial engineers often use options in the design of new financial instruments or in developing innovative strategies and solutions for financial problems, such as management of risk. A conventional financial option is often traded as a separate contract in itself. At times financial options are not contracts in themselves, but embedded in complex products of financial engineering (embedded options).

The issue of charging a fee (premium) for an option is akin to Bai-Urbun contracts in Islam, which is earnest money which the seller takes from the buyer with the understanding that it becomes part of the price in the event that the sale is ratified, but that it will belong to the seller in the event the buyer fails to ratify his initial agreement.

The main economic rationale for using options is their potential value as hedging or insurance devices. Most applications are for insuring the values of assets or liabilities in the banking, insurance and investment management environments.

Applications of Islamic Option Contracts: Currently Islamic investment instruments have very limited applications in the risk management area of Islamic financial institutions. Due to a limited number of available Islamic financial instruments, important issues in managing balance sheet and liquidity risks face major difficulties in Islamic banks. The inability to manage the banking risks properly has made Islamic banking activities at times more risk prone and less profitable. The Islamic banking community needs new financial instruments for risk and asset/liability management purposes.

The Call or Put option contracts are sometimes termed “plain vanilla” or “standard” option contracts. In recent years, banks and other financial institutions have been very imaginative in designing non-standard option contracts to satisfy their risk management needs. At times, these options are added to the bonds, stocks or various types of loans to make the instruments more attractive or less risky. Some non-standard options are simply portfolios of two or more “plain vanilla” options. For example buying a call and a put option simultaneously on an asset can hedge (insure) the asset value against wild fluctuations in asset prices. Other combinations are far more complex and interesting. The possibilities for designing or engineering new and interesting non-standard and embedded option contracts, termed "exotic options", seems to be virtually limitless in the world of Islamic finance.

Conclusions: Islamic scholars and financial experts must be involved in a continuous process of designing and developing new financial instruments and finding innovative solutions to financial problems within the Islamic frameworks. This is important, since many of the traditional financial engineering products, such as, the conventional options or investment products may not be permissible under Islamic law. A major justification for the financial engineering products is provided in terms of the need to manage risk or insure the values of ones assets.

Due to the fact that Islamic banks emphasize risk sharing and participation and direct forms of investments, liquidity management becomes an important issue in these institutions. The vast spectrum of embedded Islamic option contracts that could be engineered (through financial engineering) are powerful tools for the resolution of risk/return trade off and the liquidity concerns of Islamic banks. We emphasize and encourage a joint effort to create new investment instruments for the development of the Islamic financial markets.

As we know, using the Securities & Investment laws in each country, Securities & Exchange Commissions approve or reject the initial public or private offerings and monitor secondary market trading activities of all securities. In the same manner the Islamic Faghih (Jurisprudence) Counsel side by side with the Securities & Exchange Commissions of each country, can have the responsibility of approving or rejecting all initial public or private offerings and the secondary market trading activities of securities using the Islamic and Sharia principals.

On the international side, the International Organization of Securities Commissions (IOSCO) is responsible for the coordination of the Securities & Exchange Commissions of member countries. We suggest that the creation of the International Islamic Faghih (Jurisprudence) Counsel (IIFC) can coordinate the activities of the domestic Islamic Faghih Counsels in Islamic countries. This can vastly help the development and organization of the International Islamic Financial Markets and the creation of new Islamic financial instruments.