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Risk Management in Islamic Finance

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1 Risk Management in Islamic Finance on Thu Feb 02, 2012 10:21 pm

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LIST OF CONTEMPORARY SCHOLARS
Muhammad Taqi Usmani is a retired Justice of the Shariʾat Appellate
Bench, Supreme Court of Pakistan and is globally recognized for his
contribution to Islamic Finance. He is Chairman of the Shariah Board
of Accounting and Auditing Organization of Islamic Financial Institutions
(AAOIFI) and a permanent member of OIC Islamic Fiqh Academy.
Sheikh Taqi Usmani advises a number of international financial
institutions.
Mohamed Ali El-Gari is a professor of Islamic Economics at King
Abdul Aziz University. He is an expert at the Islamic Jurisprudence
Academies of the Organization of Islamic Conference and the Islamic
World League. Dr. Elgari is member of Shariah Boards of many Islamic
Banks and Takaful Companies.
Abdullah Bin Suleiman Al-Maniya is a member of the Senior Ulema
Board in Saudi Arabia since its inception. Sheikh Abdullah is a member
of Shariah Supervisory Committees of various Banks in Saudi Arabia
and around the world.
Abdul Sattar Abu Ghuddah is the Shariʾah Advisor and Director,
Department of Financial Instruments at Al-Baraka Investment Co. of
Saudi Arabia. He is an active member of Islamic Fiqh Academy and
the Accounting & Auditing Standards Board of Islamic Financial Institutions.
Dr. Abdul Sattar advises a number of international financial
institutions around the world.
Ahmad Bazie Al-Yaseen was former Chairman of Kuwait Finance
House from 1973 to 1993. He was also Chairman of Abdullah al-Nouri
Charity Society and member of the Shariah and Islamic Studies Faculty
in Kuwait University. Sheikh Ahmad Bazie Al-Yaseen is the former
treasurer of the International Islamic Charity Committee and former
General Secretary of Social Reformation Society. He has been a board
member of Islamic University Haidarabad Pakistan, Faisal Islamic Bank
in Sudan and also the Central Bank of Kuwait. He is also a former
economic consultant for the OIC and was a member of the Chamber
of Commerce and Industry in 1970.
Ajeel Jasem Al-Nashmi is a Professor of Shariʾah in Kuwait University
and Chairman of Zakat House’s Shariah Committee in 2005. He is
currently a member of the Shariah Board for AAOFI (Accounting and
Auditing Organization for Islamic Financial Institutions) in Bahrain.
He has also been a member of the Fatwa Committee for the Ministry
of Awqaf and Islamic Affairs in Kuwait. Dr. Ajil advises a number of
international financial institutions around the world.
Muhammed Ali Al Taskhiri is Secretary General of the World Forum
for Proximity of Islamic Schools of Thought, Islamic Republic of Iran.
Wahba Mustafa Al-Zuhalli is former Dean of the Department of
Shariʾah, University of Damascus, Syria and member of Shariah Board
of several Islamic financial institutions.
Ahmad Ali Abdullah is Secretary General of the Higher Council of
the Shariʾah Supervisory Board, Sudan. He also advises a number of
international financial institutions around the world.
Mohammad Mukhtar al-Salami is the former Grand Mufti of Tunisia.
He has authored many books and article on Islamic studies and
he is a member to the Shairah Board of a number of Islamic financial
Institutions and Member of the Islamic fiqh Academy affiliated to the
Organization of Islamic Conference.
Ali al-Salus Professor of Shariah at Qatar University and Member
of the Islamic fiqh Academy affiliated to the Organization of Islamic
Conference. He has contributed a number of articles and books on
Islamic finance.
Sayyid Abdul Jabbar Shahhabudin, Former Chief Executive of the
Kuala Lumpur Commodity Exchange.
Nazih Hammad is a former Professor at the College of Shariah, Um
Alqura University in Saudi Arabia, Member of the Islamic Fiqh Academy,
Jeddah, S. A. (Organization of Islamic Countries). He also advises
a number of international financial institutions around the world.
Obiyathullah Associate Professor at the Faculty of Economics and
Business.
Zamir Iqbal is an Information Officer in the World Bank’s Treasury.
Saleh al-Marzuqi Professor of Shariah Um al-Qura University and the
secretary general of the Islamic fiqh Academy affiliated to the World
Muslim League—Saudi Arabia.
Abd Allah bin Beya of the leading contemporary Muslim scholars. He
is a professor at King Adul Aziz University and member of the fiqh
Academy of the Organization of Islamic Conference.
Abd al-Wahhab Abu Sulaiman, member of the Council of Great scholar
Saudi Arabia and former dean of the faculty of Shariah Um al-Qura
University Saudi Arabia.
Siddq Al-Darir Professor at the faculty of Laws Khartoum university,
Sudan member of a number Islamic fiqh Academies and Shariah Adviser
to several Islamic financial institutions.
Fahim Khan is associated with the Islamic Research and Training
Institute (IRTI) since 1988 serving at various positions. Fahim Khan
has more than 10 books and monographs on Islamic economics, banking
and finance.
Umar Charpa is currently serving as Research Advisor at the Islamic
Research & Training Institute (IRTI) of the Islamic Development Bank
(IDB). Before joining IRTI in 1999, he worked as Senior Economic
Advisor at the Saudi Arabian Monetary Agency (SAMA) from where he
retired after a long service of 35 years. He has made seminal contributions
to Islamic Economics and Finance over more than three decades
in the form of ten books and monographs and more than seventy papers
and book reviews.
Mohammad Hashim Kamali is currently Professor of Islamic law and
jurisprudence and Dean of the International Institute of Islamic Thought
and Civilization (ISTAC) at the International Islamic University Malaysia,
Kuala Lumpur. Professor Kamali has published 13 books and over
80 academic articles.
Rafiq al-Misri is member of the faculty of economics and Management
King Abdul Aziz University and researcher at the Center of Islamic
Economics. Dr. Al-Misri contributed a dozen of books and Articles on
Islamic economics and finance.
Abdel-Hamid al-Ghazali member of the faculty of economics and
political sciences, Cairo university. He was the Director of the Islamic
Research and Training Institute, Islamic Development Bank form 1981
to 1985. He has a number of publication on Islamic economic and
finance.
Mohammed Obaidullah is a Senior Economist with the Islamic Research
and Training Institute, Islamic Development Bank at Jeddah, Saudi Arabia.
Prior to this he also served the Islamic Economics Research Center,
King Abdulaziz University, Jeddah, Saudi Arabia and taught at the
International Islamic University Malaysia and the Xavier Institute of
Management, India.
Muhammad Akram Khan is a Pakistani scholar of Islamic law with
outstanding works on Islamic economic and finance.
Obaiyathullah Ismath Bacha Professor at the faculty of economics and
Management, International Islamic University Malaysia.
Omar Jah is a Gambia national. Dr. Omar Jah taught in many Universities
around the world and member of many Islamic organizations.
Abd al Salam Al-Abadi is Jordanian national and he is currently the
rector of Al al-Bayt University. He held a number of high positions in
his country including Minister of Awqaf. He has a number of publications
in Islamic law.
Monzer Kahf is a Professor: Islamic Economics and Banking. He is
currently a consultant and trainer on Islamic finance and economics
in the USA. He was before a Senior Research Economist at the Islamic
Research and Training Institute (IRTI) of the Islamic Development Bank
(IDB). Jeddah, Saudi Arabia, from 1985–1999. He wrote several books
on Islamic finance and banking and other areas of Islamic economics.
Sudin Haron is a Malaysian national. He is currently Dean of School
of Banking and Finance, University Utara Malaysia. He authored in
number of books and published a dozen of articles in economics and
finance.
Frank E. Vogel is the Custodian of the Two Holy Mosques Adjunct
Professor of Islamic Legal Studies and Director of the Islamic Legal
Studies Program at Harvard Law School. His writings include Islamic
Law and Legal System: Studies of Saudi Arabia (Boston: Brill, 2000),
and, with Samuel L. Hayes III, Islamic Law and Finance: Religion, Risk
and Return (Kluwer Law International, 1998). He has taught courses on
the Islamic legal system, contemporary Islamic legal thought, Islamic
contract law, Islamic constitutional history, human rights and Islam,
and the comparative law of the Arab Middle East.
Samuel L. Hayes holds the Jacob H. Schiff Chair in Investment Banking,
at the Harvard Business School, Emeritus. He has taught at the
School since 1971, Professor Hayes’ research has focused on the capital
markets and on the corporate interface with the securities markets. He
has written numerous working papers and articles on related topics in
various repute journals.
Hassan al-Jawahiri, Shariah scholar from the Islamic republic of Iran
and professor at al-Hawjah al-Ilmiyyah at Qum, Iran. He is also member
of the Islamic Fiqh Academy.
Youssouf al-Qaradawi is one of the renowned and influential contemporary
Muslim scholars and president of the Union Muslim Scholars.
He wrote hundreds of books and article on Islamic thought.
Jamal al-Din Atiyyah Professor of constitutional law at the Faculty of
Shariah and Law university of Qatar. He was a visiting professor in a
number of universities and consultant on Islamic banking issues to a
number of organizations.

Foydalanuvchi profili http://iqtisod.uzbekforum.net

2 Background of the Research on Thu Feb 02, 2012 10:23 pm

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The mastery of risk is a stupendous challenge. It may be regarded as the
distinguishing feature of modern times. Someone has rightly remarked
that the elimination of risk has replaced the elimination of scarcity as
a major preoccupation.
There are several risks which need to be managed by financial institutions,
be they Islamic or conventional. They include, among others,
market risk, interest rate risk, credit risk, liquidity risk, operational risk,
litigation risk, regulatory risk, and foreign exchange risk. The nature of
some of these risks is briefly discussed below:
Market risk is the risk originating in instruments and assets traded
in well-defined markets. Market risks can result from macro and micro
sources. Systematic market risk results from overall movement of prices
and policies in the economy. The unsystematic market risk arises when
the price of the specific asset or instrument changes due to events linked
to the instrument or asset. Volatility of prices in various markets gives
rise to different kinds of market risks. Thus market risk includes equity
price risk, interest rate risk, currency risk, and commodity price risk.
Interest rate risk is the exposure of a bank’s financial condition to
movements in interest rates. In Islamic financial institutions, due to the
prohibition against charging and paying interest, rates are not directly
affected by risk. However, they are indirectly affected by this risk in
their bid to determine their return. Islamic financial institutions use
the London Inter Bank borrowing rate (LIBOR) as a benchmark in
their transactions. Thus, the effect of interest rates can be transmitted to
Islamic banks indirectly through this benchmark. In case of a change in
the LIBOR, the Islamic banks could face this risk in the sense of their
paying more profit to future depositors as compared to receiving less
income from the users of long-term funds.
Credit risk is the risk that a counterparty will fail to meet its obligations
in a timely manner and fully in accordance with the agreed
upon terms. This risk can occur in the banking and trading books of
the bank.

Foydalanuvchi profili http://iqtisod.uzbekforum.net

3 Cont. on Thu Feb 02, 2012 10:26 pm

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Liquidity risk arises due to insufficient liquidity for normal operating
requirements, thus reducing the ability of banks to meet its liabilities
when they fall due. This risk may result from either difficulties in
obtaining cash at reasonable cost from borrowing (funding or financing
liquidity risk) or the sale of assets (asset liquidity risk). One aspect of
asset-liability management in the banking business is to minimize the
liquidity risk. While funding risk can be controlled by proper planning
of cash-flow needs and seeking newer sources of funds to finance cash
shortfalls, the asset liquidity risk can be mitigated by diversification of
assets and setting limits on certain illiquid products.
Operational risk may arise from human and technical errors or accidents.
It is the risk of direct or indirect loss resulting from inadequate or
failed internal processes, people, and technology or from external events.
While human risk may arise due to incompetence and fraud, technology
risk may result from telecommunications system and program failure.
Process risk may occur due to various reasons, including errors in
model specifications, inaccurate transaction execution, and violating
operational control limits. Due to problems arising from inaccurate
processing, record keeping, system failures, compliance with regulations,
etc., there is a possibility that operating costs might be different
from what is expected and therefore affect net income adversely. Given
the newness of Islamic banks, operational risk in terms of human risk
can be sometimes acute in these institutions. Operational risk in this
respect particularly arises as the bank may not have enough professional
personnel to conduct Islamic financial operations. Moreover, given the
nature of business, the computer software available in the market for
conventional banks may not be appropriate for Islamic banks.
Legal risks relate to risks of unenforceability of financial contracts.
This relates to statutes, legislation, and regulations that affect the fulfillment
of contracts and transactions. This risk can be external in nature,
like regulations affecting certain kinds of business activities or internal
matters related to a bank’s management or employees, like fraud, violations
of laws and regulations, etc. Legal risks can be considered as a type
of operational risk. Regulatory risk arises from changes in the regulatory
framework of a country. Given the different nature of their financial
contracts, Islamic banks face risk related to their documentation and
enforcement. As there are no standard forms of contracts for various
financial instruments, Islamic banks prepare these contracts according
to the advice of their respective Shariah Board and the needs and
concerns of local laws. Lack of standardized contracts and the absence of a litigation system to enforce contracts by counterparty increase the
legal risks associated with Islamic financial agreements.1
Thus, risk is an ever-present factor, especially in business, but industrialization
brought risks previously unknown in trade and agriculture.
Industrial production often involves long periods of time, and the longer
the period of production, the greater the uncertainty. The scope of the
market has expanded to cover the entire globe, introducing new kinds
of risk.2
In Islamic banking, the management of risk becomes more challenging
due to its peculiar risk characteristics and the requirement for
compliance to Shariah principles. While the Basel II initiatives on the
identification of credit, market, and operational risks can be assimilated
into Islamic banking, the initiatives have to be complemented with
consideration of the other dimensions of risks that are inherent in the
Islamic financial transactions. The risk management infrastructure in
Islamic financial institutions needs to identify, unbundle, measure,
control, and monitor all the specific risks in the Islamic financial
transactions and instruments. This is to ensure that the systems and
controls will be effective in the quantification and management of the
risks arising from the operations.
An important aspect of risk management is the need for the Islamic
banking industry to develop a derivatives market. In the current, increasingly
uncertain, global financial environment, investors need to be in
a position to mitigate and manage these emerging new risks. Islamic
banking institutions, in particular, have, to a large extent, long-term
assets, which include long-term Islamic housing mortgages and Islamic
financial instruments that are funded by short-term deposits, thus giving
rise to a maturity mismatch between the assets and liabilities. There
is, therefore, a need for the development of a broader range of Islamic
financial market instruments to provide the industry with effective risk
mitigating instruments.3
1 For more elaboration see Tariqullah Khan and Habib Ahmed, Risk Management:
An Analysis of Issues in Islamic Financial Industry, Occasional Paper no. 5, Islamic
Research and Training Institute, Islamic Development Bank, 2001.
2 Mohammad Nejatullah Siddiqi, “Islamic Banking and Finance,” a lecture delivered
at UCLA International Institute in a 2001 seminar for the business community.
3 Tan Sri Dato’ Sri Dr. Zeti Akhtar Aziz, “Governor’s Keynote Address” at The 2nd
International Conference On Islamic Banking: Risk Management, Regulation and
Supervision—“Building a Robust Islamic Financial System,” jointly organized by the
Islamic Research and Training Institute (IRTI) of the Islamic Development Bank andIt is important to distinguish between gambling, which is not permissible
under Islamic law and must be avoided, along with other kinds
of risk-taking. In the words of Irving Fisher, a gambler seeks and takes
unnecessary risks. Such is the nature of games of chance. But life is full
of risky situations that cannot be avoided. Business especially involves
risk because the production of wealth involves the future, and it is
impossible to have full and certain information regarding the future.
People find mutually advantageous ways to face these uncertainties.
The economies of many Muslim countries rely to a great extent on
raw materials and commodities. The production, investment, and pricing
of these commodities are largely affected by the use of derivatives
for risk management and trading in the international market. Questions
normally arise regarding the Islamic position in the use of these
instruments.
Derivatives markets deal in almost all the basic worldwide commodities,
such as corn, wheat, cotton, crude oil, heating oil, gasoline, cocoa,
palm oil, timber, rubber, aluminum copper, zinc, nickel, tin, coffee, sugar,
etc. Hence, almost everybody feels the impact of these markets.
If we take oil, for instance, one of the world’s most important commodities,
without which it is impossible to conduct world commerce, its
price is generally determined by the use of oil derivatives transactions.
Derivatives instruments largely evolved in a non-Islamic environment;
thus, they are loaded with values which may not be totally in compliance
with Islamic principles. Therefore, there is a need for a systematic
analysis of these tools of price determination as well as risk management
and hedging devices from an Islamic perspective.
More importantly, the availability of excess liquidity in many Islamic
financial institutions, which require viable and permissible channels for
investment, makes the study of these new tools of financial engineering
in the international commodities markets a timely undertaking. Many
questions arise regarding the evaluation of their compliance or disharmony
with Islamic principles and the possibilities for new avenues of
investment for Islamic financial institutions.
Furthermore, the widely held opinion that derivative instruments
do not comply with sharīʿah regulations whether due to ribā (interest),
gambling or other illegal activities, may not be entirely accurate in regard
the Islamic Financial Services Board (IFSB). Le Meridien Hotel, Kuala Lumpur,
7 February 2006.to at least certain forms of derivatives. Yet, the prevalence of this negative
attitude has hindered the Islamic institutions from venturing into
areas of investment that are open to conventional financial institutions.
Therefore, it is important to address and analyze the available alternative
avenues of investment so that Islamic financial institutions do not find
themselves in a disadvantageous position.
A series of studies on the subject have been conducted by certain
Islamic institutions such as Majmaʿ al-Fiqh al-Islāmī (Islamic Fiqh
Academy based in Jeddah), al-Majmaʿ al-Fiqhī al-Islāmī (Islamic Fiqh
Academy based in Mecca), and by individual Muslim jurists. However,
despite the welcome scholarly effort made so far, there are issues which
still call for a systematic study and evaluation of the existing works and
to address the shortcomings of some of these studies and the generalizations
of others.
The present study will focus and elaborate on those issues which have
not been well elaborated by previous works or which have been excluded
from discussion despite their fundamental importance in understanding
the issue of futures trading and derivatives.
The forward contract plays a pivotal role in the modern financial
markets and serves as the basic building block for more advanced and
sophisticated financial instruments. It is one of the most commonly used
contracts in export–import trading, especially in essential commodities.
It is also an important tool in risk management and business planning.
However, in its actual form the majority of Muslim scholars declared it
not permissible because it involves the prohibited sale of bayʿ al-kāliʾ bi
al-kāliʾ (the sale of debt for debt) and the sale of nonexistent entities.
The present study will explore these principles and look at their application
to the conventional forward contract. It also draws an analogy
between the conventional forward contract and similar contracts in
Islamic law, such as salam (A sale contract to purchase an underlying
asset at a predetermined future date but at a price paid on spot), istisnāʿ
(A contract whereby a manufacturer agrees to produce and deliver a
well-described good at a given price on a given date in the future) and
bayʿ ʿala al-ṣifa (sale by description).
Trading gold on a forward basis is a sensitive and controversial issue.
The majority of scholars held that the ʿillah (effective cause, ratio legis)
behind prohibiting the exchange of gold on a deferred basis is because
gold and silver are currencies (athmān) and, therefore, should not be exchanged
unless the exchange is hand to hand. It is maintained that the
prophetic injunctions not to trade gold and silver on a deferred basis should be upheld whether gold and silver lose their characteristic of being
thaman or not as they are money by creation. However, it is also argued
by others that if gold and silver lose these characteristics, they would be
a kind of commodity and could therefore be exchanged on a deferred
basis. Thus, there is a need to analyze the different opinions advanced
and look at their relevance to gold trading on a forward basis.
The forward currencies market is a very important mechanism in
managing price risk. However, it is commonly agreed upon among
Muslim scholars that trading currencies on a forward basis is illegal
and it contravenes the rules of ṣarf (currency exchange) in Islamic law.
Several alternatives have been suggested and there is a need to assess
the sharīʿahʾ basis of these proposals.
Although the forward contracts have been able to overcome some
of the problems associated with risk management, especially price risk
and better planning of business, they are still inadequate to meet current
business needs in some respects. Thus, the futures contract was
introduced in the modern financial system in order to overcome these
problems. A futures contract is basically a standardized forward contract
with regard to the contract size, maturity, quality, place of delivery and
the characteristic of being traded in an organized market. However,
the futures contract might contravene the principle of not selling prior
to taking possession and that of the sale of debt for debt. The present
study will elaborate on the legal aspects of these two principles and try
to find out how they could affect the legality of the futures contract.
Moreover, the study will address the relation, if any, between the futures
contract and speculation.
The futures contracts have been able to overcome some of the problems
of the forward contract associated with risk, especially price risk
and better planning of business, but they are still inadequate in some
respects. The futures contracts are associated with certain problems,
such as the possibility of exposure to subsequent price movement or
their unsuitability for the management of contingent liabilities and
contingent claims. Thus, a new tool of risk management is needed and
the options contracts have been introduced due to their potential for
managing such risks. The present study will examine the legality of
options trading from an Islamic point of view by expounding on their
concept, economic benefits, types, and scope.
Khiyār al-sharṭ (the option to rescind a sales contract based on condition)
and its variant khiyār al-naqd (the right of either of the parties
to confirm the contract or to cancel it by means of the payment of the price) seem to be the first alternative to conventional options from an
Islamic point of view. This study will address the legal basis of these
two contracts, the terms of khiyār, ownership of the commodity during
the period of khiyār, liability for damage during this period and how
khiyār al-sharṭ and khiyār al-naqd can be devised as tools to manage
risk in murābaḥah (Sale at a specified profit margin, ijārah (lease) or
stock trading).
Bayʿ al-ʿarbūn or ʿarbūn (a sale contract, in which a down payment
is paid by the buyer) on the other hand, could be a very effective tool
of risk management and an Islamic alternative to options. It should be
noted that although the legality of ʿarbūn was disputed among the classical
Muslim jurists, there is almost a consensus among contemporary
scholars that it is a valid contract. On the other hand, asserting the legal
status of ʿarbūn is of great importance in the use of ʿarbūn as an alternative
to options. Therefore, the study will investigate whether ʿarbūn is
a kind of liquidated damages or whether it is a kind of penalty or can
be used as an exchange of the right to cancel the contract.
The present study will also investigate the sale of pure rights in the
writing of classical scholars after expounding on the concept of right in
Islamic law and how it could include pure rights, like that of options.
It will also discuss the different cases involving the sale of pure rights
accepted by Muslim jurists and draw an analogy between the sale of
rights in these cases and the rights in conventional options. Finally,
the study will address the relationship, if any, between options and
gambling.

Foydalanuvchi profili http://iqtisod.uzbekforum.net

4 Objectives of the Research on Thu Feb 02, 2012 10:27 pm

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The present study analyzes the pertinent issues on derivatives which
have given rise to differences among Muslim scholars. Included among
these derivative instruments are the forward, futures and options contracts.
This study will critically address their compliance or lack thereof
with Islamic principles. The study will also analyze the other Islamic
alternatives available so that Islamic financial institutions do not find
themselves in a disadvantageous position. To summarize the main
points:
• The present study attempts to investigate the possibility of admitting
the forward contract into Islamic law. This will include the forward
contract in commodities, the possibility of forward contract in gold
trading and the forward contract in currencies. Thus, the study will
analyze the legal grounds of these contracts and the different opinions
advanced by modern scholars whether in favor of or against the
acceptance of these contracts.
• The study will also investigate the permissibility of futures contracts
by analyzing the different objections raised against the permissibility
of other related contracts, such as the sale of debt for debt, the sale
prior to taking possession, and speculation.
• An Islamic evaluation of the different functions performed by the
clearinghouse, the futures brokers, and the regulation of the futures
market is necessary for deciding the legality of the futures and options
contracts in Islamic law. Reference will be made regarding these issues
to the Malaysian Futures Industry Act and Securities Industry Act
in order to see whether these modern forms of trading comply with
Islamic principles or not.
• This study also elaborates on the permissibility of options contracts
and the possible Islamic alternative based on khiyār al-sharṭ and
bayʿ al-ʿarbūn. The sale of pure rights such as in the case of options
is generally held not to be a valid subject matter of a contract in
Islamic law. The study explores the issue based on the writing of
classical Muslim scholars. It will also draw an analogy between the
right of holding an option and other admitted rights in Islamic law
as subject matter in order to identify any similarity or dissimilarity
that may exist between them.
• Finally, the study will explore the relationship, if any, between options
and gambling.

Foydalanuvchi profili http://iqtisod.uzbekforum.net

5 THE FORWARD COMMODITIES MARKET on Thu Feb 02, 2012 10:30 pm

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A forward contract is an agreement to exchange assets in the future
at a predetermined price. It plays a vital role in the Western financial
markets and serves as the basic building block for more advanced and
sophisticated financial instruments. The primary function of the forward
market is to provide a vehicle to hedge against unexpected and
undesirable price fluctuations. The forward market directly affects the
spot market as it also offers arbitrage and speculation opportunities.
Forward markets also serve the purpose of “price discovery”—the
process of determining the equilibrium prices that reflect current and
positive demands for current and prospective supplies, and making
these prices visible to all.1
The forward contracts in commodities are the simplest type of derivatives.
In such a contract the parties could be a producer who promises
to supply the product and a consumer who needs the product. Forward
contracts are common in merchandise or commodities trading. Without
them, business trade and planning would be greatly hindered. If a small
baking company could not order flour in advance for its immediate
needs, for example, it would have to buy a large quantity at a prevailing
price and store it for future use. There would be uncertainty about what
the price would be when the next order is placed. The miller will have
a more difficult task in planning how much flour to produce without
orders in hand, and shortages would be more likely to occur.2
To see how a typical forward contract works, let us examine a simple
example of a cocoa farmer (producer) and a confectioner who needs
cocoa for his product (consumer). To simplify matters, let us say the
farmer has planted cocoa and expects to harvest 120 tons of cocoa
in six months. The confectioner, on the other hand, has cocoa in his*
1 Philippe Jorion and Marcos De Silva, The Importance of Derivatives Securities Markets
to Modern Finance, Catalyst Institute (Chicago: Catalyst Institute), p. 222.
2 Anthony F. Herbst, Commodity Futures Markets, Methods of Analysis, and Management
of Risk, John Wiley and Sons, United States, 1986, p. 3.
*inventory to last him for the next six months but will need to replenish
his inventory in six months with 120 tons. Though simplified, this
is a very common business situation. We have a producer who will
have product available at a future date and a consumer who will need
the product in the future. Clearly, both parties face risk, essentially
price risk. While the farmer will be fearful of a fall in the spot price
of cocoa between now and six months from now, the confectioner will
be susceptible to an increase in the spot price. Thus, both parties face
risk, but in the opposite direction. It would be logical for both parties
to meet, negotiate, and agree on a price at which the transaction
can be carried out in six months. Once the terms are formalized and
documented, we have a forward contract accruing to both parties. Both
parties, because of the forward contract, have eliminated all price risk.
The farmer now knows the price he will receive for his cocoa regardless
of what happens to cocoa prices over the six months. The confectioner
too has eliminated price risk since he will only have to pay the agreed
upon price, regardless of spot prices in the next six months. There is a
second benefit to this. Since both parties have “locked-in” their price/
cost, they would be in a much better position to plan their business
activities. For example, the confectioner can confidently quote to his
customers the price at which he delivers them products in the future.
This would not have been possible if he were uncertain about his input
price. The benefits of a forward contract, therefore, are often more than
merely hedging price risk.3
3 See Obiyathulla Ismath Bacha, “Derivative Instruments and Islamic Finance: Some
Thoughts for a Reconsideration,” p. 3.

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6 Economic Benefits of the Forward Contract on Thu Feb 02, 2012 10:44 pm

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Some shari.ah scholars have argued in favor of this contract. .Abd
al-Wahab Abu Sulaiman, for instance, said “The need for this contract
is not a need confined to a specific nation, it is a need for all nations
around the globe whatever their status of civilization, developed or
developing. The principle in Islamic law is that the general need could
be considered as necessity (al-h.ajah idha .ammat kanat ka al-d.arurah).”44 .Abd al-Wahhab Abu Sulaiman .Aqd al-Tawrid Dirash Fiqhiyyah Tah.liliyyah” paper
presented to the twelfth session of the Islamic Fiqh Academy, Rabat, Morocco, p. 7.

Similarly, Hòasan al-Jaw.hir. maintained that the forward contract used
by companies and governments to secure the supply and export of goods
becomes a necessity of modern transactions.5
Sheikh Mukht.r al-Sal.m. also comes out very strongly in favor of this
contract after giving some examples regarding its application, and arguing
that the need for it is the result of the technological advancements
in this world and that the Islamic world has no other alternative but to
follow. It is the necessity of modern civilization which has shortened
distances between places and made it necessary for any nation which
wants to survive to follow suit. If we are going to make it compulsory
for companies and industries to advance the payment of every transaction
they want to conclude, as it is in the salam contract, we are forcing
them not to produce and if we are making it compulsory for them not
to sell what they have not manufactured yet, we are leading them to
bankruptcy. Moreover, rejecting this contract will create hardship and
hòaraj (difficulty and hardship) to Muslims while what is important is
to protect the masòlahòah (public interest) of the ummah (community)
and its property.6
It should be noted here that despite his positive and strong analysis
of different principles related to futures trading, Ibn Taymiyyah opposed
the deferment of both countervalues (assets) in a contract or the forward
contract. According to him, such a contract has no benefit and
the dhimmah (liability, responsibility) of the two parties will be made
liable for nothing. The objective of the contract, Ibn Taymiyyah argues,
is to make delivery and since there is no delivery in this contract, the
ultimate objective of the contract is not fulfillled.7 Ibn Qayyim followed
the argument of his teacher, and reached the same conclusion.8 Refuting
this argument, Sheikh al-Dòar.r said:
The claim that there is no benefit in such a contract is unacceptable. The
buyer will own the subject matter of the contract and the seller will own
the price and the deferment of taking possession will not render the contract
without benefit. Moreover, a sane or rational person will not enter
5 Hòasan al-Jaw.hir., “Uq.d al-Tawr.d wa al-Mun.qasò.t” paper presented at the
twelfth session of the Islamic Fiqh Academy, Rabat, Morocco, p. 3.
6 See Mukhtar al-Sal.m., “Ta’j.l al-Badalayn fi al-‘Uq.d,” paper presented in Nadw.t
al-Barakah al-T.sia‘h .asharah lil iqtisò.d al-Isl.m., Makkah al-Mukarramah, 2–3
December 2000, p. 5.
7 Ibn Taymiyyah, Nazariyyat al-.Aqd, p. 235.
8 Ibn Qayyim, I’l.m al-Muwaqq‘in an Rab al-..lam.n, vol. 3, p. 9.
into a contract without having interest in it. Therefore, if the two parties
have no real interest in this contract they would not have concluded it
from the beginning.9
Moreover, as Ahòmad Hòassan rightly pointed out, it is likely that there
was no benefit for such contracts at the time of Ibn Taimiyyah and Ibn
Qayyim. They rejected this contract only on these grounds10 and not
on any other genuine legal grounds. We have already shown that this
contract does have benefits. Ahòmad Hòassan stressed that the global
material development brought about new economic transactions, which
were unknown to early Muslim jurists. Therefore, the trend of judging
such a contract as illegal without any strong legal basis is against the
objectives of the shar..ah. We do believe that any contract in Islamic law
should fulfill the following conditions to be considered as legal:
1. It should not contradict a genuine nasò (text).
2. It should not go against the general principles of mu..mal.t. (Islamic
Commercial law)
3. It should not involve a clear harm.
However, none of these three conditions is present in the forward
contract. Therefore, it is a valid contract.11 However in his book .Asw.q
al-.Awr.q al-M.liyyah, and for fear that the forward contracts may be
used for speculative purposes, Ahòmad Hòassan reversed his initial position
and concluded that it might be considered as an illegal contract.12
Ironically, he allowed such a contract to be used only for import and
export activities. He failed to rebut the strong arguments he advanced in
his previous book for the legality of this contract. Moreover, the argument
that these kinds of contract may be used for speculative purposes
may not be acceptable, especially in the commodity and share markets.
Hence, it could be used for that purpose in the currency, interest rate,
and stock index markets. Then, this possibility should not be applied to
other areas without a strong basis. Moreover, since interest rate futures
9 al-Dòar.r, al-Gharar wa Atharuhu fi al-‘Uq.d, p. 316.
10 Ahòmad Hòassan Muhy. al-D.n, .Amal Sharik.t al-Istithm.r al-Isl.miyyah fi al’Asw.q
al-..lamiyyah, Bank al-Barakah al-Isl.m. li al-Istithm.r, Bahrain, 1986, p. 320.
11 Ibid., pp. 320–321.
12 Ahòmad Hòassan Muhyi al-Din, .Asw.q al-.Awr.q al-M.liyyah wa Atharuha
al-Inm..iyyah fi al-Iqtisò.d al Isl.m., p. 323.
contracts and stock index futures contracts are excluded from the beginning
from the Islamic alternative, there are no grounds for objection.
Isawi Ah.mad also refuted the claim that there is no benefit in the
forward contract. It is not acceptable because traders and manufacturers
always compete in trading their products. Thus, if a manufacturer
would like to guarantee the sale of his product, he will enter into an
agreement with a buyer on the condition that he will receive the price
later when the commodity sold is presented. The trader on his part may
be in need of a specific commodity but he has no money for the time
being. If he has to wait until he gets the money, another trader may take
the commodity in question before him. Therefore, to avoid this risk he
has to enter into the deal with the condition that he will pay the price
at the time he receives the goods. In such a deal both payment for and
delivery of the commodity have been deferred but there is a real interest
involved. Thus, the postponement of both payment and commodity is
lawful except in the case of currency trading. Moreover, we have some
cases in which both countervalues have been deferred but the transaction
is still considered valid in Islamic law, such as the case of ijarah
(lease) and ju.alah. In both cases, a person may request another person
to do something for him in exchange for a charge which will be paid
to him after the job has been accomplished. Therefore, the contract in
which both countervalues have been deferred (the forward contract)
is a legal contract if it does not involve riba (interest) or gharar13 (risktaking).
Similar objections to Ibn Taimiyyah’s opinion are advanced
by Sheikh Mukhtar al-Salami,14 Sheikh Ah.mad .Ali .Abd Allah,15 and
Sheikh H.asan al-Jawahiri.16
However, the forward contract as a trading instrument in its actual
form has no exact counterpart in Islamic law. Some scholars have
drawn a similarity between the forward contract and bay. al-salam on
the one hand and bay. al-istis.na. on the other. Furthermore, some have
tried to establish the legality of this contract under bay. al-s.ifah (sale
by description). Therefore, we have to look into the points of similarity
and difference between salam (contract of future sale) and istis.na. on
13 Isawi Ah.mad, “Bay. al-Dayn wa Naqlihi,” pp. 169–170.
14 See Mukhtar al-Salami, “Ta.jil al-Badalain fi al-.Uqud,” paper presented in Nadwat
al-Barakah al-Tasia.h .asharah lil iqtis.ad al-Islami, Makkah al-Mukarramah, 2–3
December 2000, p. 3.
15 Ah.mad .Ali .Abd Allah, “al-Bay. .ala al-S.ifah,” paper presented in Nadwat Bank
al-Shamal lita.sil al-.Amal al-Mas.rifi, 20–21 June, 1997, Sudan, p. 4.
16 H.asan al-Jawahiri, “Uqud al-Tawrid wa al-Munaqas.at,” p. 5.
one hand, and the modern forward contract on the other. Meanwhile,
if it could be accommodated under the category bayʿ al-ṣifah then what
are the similarities and differences between the two contracts? However,
if we consider the forward contract as a new type of contract, then, we
need to study it within the general principles of Islamic commercial law.
Moreover, we have to look into the authenticity of the arguments posed
against it, such as the claim that it is a kind of bayʿ al-kāliʾ bi al-kāliʾ,
that is, the sale of what one does not possess, the sale of m’adūm (nonexistent),
and the claim that there is no benefit in such a contract.

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