final draft pdf 2nd revised

Islamic Derivatives in Saudi Arabia

Done By:

Khalid Jamal Zaidan: Major Finance, Minor Marketing

Mohammed Umair Jafri: Major Finance, Minor Accounting

Mohammed Shafiq Abu Laban: Major Finance, Minor Insurance

Hisham Raed Kashman: Major Finance

Abdul Aziz Mohammed AL-Khudir: Major Finance

2 SENIOR PROJECT: ISLAMIC DERIVATIVES IN SAUDI ARABIA AL-YAMAMAH UNIVERSITY

Table of Contents

Acknowledgement………………………………………………………………………………........4

Abstract…………………………………………………………………………………………......…5

1. Introduction ……………………….…………………………………………………..6

1.1 What are Derivatives…………………………………………………………..7

1.2 What is Islamic Finance……………………………………………………....10

2. What are Islamic Derivatives………………………………………………………...13

3. Forward Contracts………………………….………………………………………...28

3.1 Types of Forward Contracts…………………………………………………..33

3.2 Advantages and Disadvantages of Forward Contracts………………………..34

3.3 Islamic Forward Contract…………………………………………….……....35

4. Futures Contracts……………………………………………………………………..37

4.1 Types of Futures Contracts……………………………………………………42

4.2 Advantages and Disadvantages of Futures Contracts ………………………...43

4.3 Contemporary Futures in the Scope of Islamic Law (Sharia)…………………44

4.4 Islamic Future Contract…………………………..……………………………46

5. Options Contracts……………………………………………………………………...48

5.1 Basic Trades of Stock Options…………………………………………….…...49

5.2 Advantages and Disadvantages of options………………………………….....53

5.3 Options in the Scope of Islamic Law (Sharia) ……………………………...…54

5.4 Islamic Option Derivatives……………………………………………….….....56

6. Recommendations for Islamic Derivatives in Saudi Arabia……..……………….…58


7. Conclusion ………………………………………………………………………….…...61

8. References, Sources and Citation……………………………………………………….…...….63.

9. Index: Glossary of Terms…………………………………………………………………..…… 67


ACKNOWLEDGEMENT

This dissertation would have been impossible without the leadership and the help of several

individuals who in one way or another contributed and extended their valuable time, assistance

and support in the preparation and completion of this study. We acknowledge the contributions

of Dr. Kabir Hasan, a financial economist, consultant in Islamic Finance and an expert in product

development and financial engineering. We are also grateful to Mr. Omar Jazar, an investment

advisor and a wealth manager in Saudi Fransi Bank.

We would like to thank the Dean of Business College of Al-Yamamah University Dr. Yosser

Gadhoum for directing our senior project from its initial stages to finalization. Mr. Mazen Ali for

giving us continuous support and encouragement as our dissertation advisor. The faculty of

Finance, Economics and Islamic Studies of Al-Yamamah University including Mr. Chadli

Belarbi, Mr. Hatim Faris, Dr. Ali Omar, Fayak Akyla, Mr. Anwar Morar and Mr. Ahmad Al-Arif

for their continuous support and previous knowledge.

We would also like to thank all the authors of different books, magazines and research papers for

making a strong base for our knowledge for completing this project in an efficient and a

productive manner. Last but not the least our family members and our friends for sharing their

insights and giving moral support for completion of this project.


ABSTRACT

This project is a window to financial engineering in Islamic Derivatives in the Kingdom of Saudi

Arabia and its various forms of trading and practices in contrast to traditional derivatives traded

all around the world. Islamic derivatives are classical examples of innovative and new financial

instruments in the contemporary financial markets however they are yet to be explored and

developed in a full-fledged, mature and standardized manner. As an alternative form of

investment Islamic derivatives are similar to traditional derivatives, where the inherent values of

those instruments are based on certain other assets. It is important to understand the motivation

and conditions of Islamic financial derivatives in contrast to conventional ways of dealing and

trading derivatives.


1. INTRODUCTION

In this research paper, we will explore how we can apply Islamic derivatives in Saudi

Arabia along with its compliance with the Islamic laws (Sharia). The study looks at empirical,

legal, naturalistic and most importantly Islamic perspective of how investments in futures,

forwards and options can be embedded together to form new forms of Sharia complied

derivatives. The methodology used in this research paper is twofold. The two research methods

used in this paper are primary and secondary research, where in the former interviews with

financial experts, Islamic scholars and other focus groups were conducted and in the later

financial magazines, books, publications and with the help of other creative and thoughtful

papers provide an intellectual foundation for our study for this research paper.

According to CFA Institute, derivatives are sort of a hypothetical and synthetic financial

instruments where the value is based on some other asset classes such as index, commodity,

bond and other similar assets.1 Islamic finance has emerged on international financial landscape

in a relatively short period of time and we believe that Islamic derivatives are a niche which can

be beneficial to all types of hedgers, investor, bankers and society as a whole within the Islamic

financial arena. The derivatives market has speculators, hedgers, arbitragers and it is used for

price discovery. In this paper we will analyze what are the differences between Islamic and

Conventional derivatives.

1 (2010). Derivatives and Alternative Investments. “Derivatives Market and Instrument”. CFA program

curriculum. Volume 6. Level 1 2010. Pearson Custom Publishing.


1.1 WHAT ARE DERIVATIVES?

Derivatives is a word which comes from the word “derive” which means something

deduced from logical reasoning of something else. According to Chicago board of trade and

Chicago mercantile exchange, derivative is a financial contract where the value of that

instruments dependent upon the price of some other asset (underlying), commodity, security or

index. Derivatives and alter and shift the price of risk associated with holding and trading various

kinds of assets, thereby modifying the return and risk characteristics of portfolios. 2 There are

various reasons why derivatives are traded such as hedging, speculation and arbitrage which are

going to be discussed in later sessions.

Managers‟ guide to the world‟s most powerful financial instruments says that, derivatives are

synthetic and only have hypothetical connection to this world compared to people who live in the

real world of assets, event, index or other benchmark that they interact with. Derivatives

instruments can be standardized contracts or customized contracts with can be traded either over

the counter or exchanged traded. 3 The total notional amount outstanding from derivatives

according to a recent press release from International SWAPs and Derivatives Association was

around $466.8 trillion (US dollars) on June, 2010.4 A table on the next page shows a graphical

statistics from the year 1998 to 2007.

2 Myra Valladares. (2009). Overview of Derivatives. MRV Associate. Chicago Board of Trade and Chicago

Mercantile exchange (CME Group). 3 Johnson. (1999). Derivatives: Managers Guide to the World‟s most powerful financial instruments.

4 (2010). ISDA. International SWAPs and Derivatives Association Inc.


Investors can trade derivatives in several ways they can be either over the counter or traded over

a specialized trading market like CME Group and Korea Exchange.

Based on CFA Institute curriculum guide, an exchange traded derivatives trades on an organized

and regulated exchange (e.g. a futures exchange or an options exchange), where the contracts are

standardized. An exchange-traded derivatives transaction is not a private transaction but a public

transaction. Exchange-traded derivatives have standardized terms (e.g. notional size and

expiration date); operate during specific hours; offers performance guarantees through the use of

margin and daily marked to market procedures supervised by a clearing house and are overseen

by extensive federal and industry regulation.

5 (2010). Derivatives (Finance). World wealth vs. Derivatives. Wikipedia.

Source: Wikipedia. 5


On the other hand, over the counter (OTC) derivatives does not trade on an exchange and it is

sort of a private transaction. OTC derivatives can be fully customized to suit the needs of the

parties to the agreement. For example, an investor looking for a derivative that expires in exactly

fifty days will like use OTC derivatives. It has high degree of flexibility and customization in

contracts, the information is usually not public information regarding prices and the ways in

which contracts will be made and it has less federal regulatory oversight to protect market

participants from fraud and market manipulation. There is no central exchange to publish all

transaction prices and no clearinghouse to minimize credit risk. 6

There are many different types of derivatives instruments used across the world, however due to

the nature of this paper and the time constraint we will keep our discussion focused and specific

to 3 different types of derivative instruments and in later stages we will discuss these instruments

in further detail and in context to the Islamic and Sharia Laws. The 3 types of derivatives will be

analyzed and discussed in this senior undergraduate project are: Forwards, Futures and Options.




References from the Holy Quran O you who have believed, do not consume usury, doubled and multiplied, but fear Allah that you may be successful. (Qur’an 3:130) The riba that is practiced to increase some people's wealth, does not gain anything at God. But if people give to charity, seeking God's pleasure, these are the ones who receive their reward many fold. (Qur'an 30:39)

1.2 WHAT IS ISLAMIC FINANCE?

In recent years Islamic finance has emerged on an international financial landscape and

has grown significantly in terms of transactions, scope and activity. According to one of the

recent books on Islamic Finance, finance is a study of management of funds and Islamic finance

is a way by which financial and business transactions are carried out with reference to the

principals of Islamic Law – Sharia.7 It entails referenced derivations from the Holy Quraan and

the Sunnah (habits and usual practices) of the Holy Prophet Muhammad (Peace Be Upon Him).

Today, Islamic finance attracts financial institutions, tycoons, multinational companies,

corporate firms and customers across the retail spectrum, manufacturing and project financings.

Islamic finance confers to the ways mentioned in the Islamic sculpture and traditions of the last

Prophet in Islam. It is an interesting phenomenon because it presents itself as an alternative to

conventional finance not only in the Muslim countries but also in Non-Muslim countries.

There are various things which are

allowed in Islam and various things

which are not allow or considered

Haram (Prohibited). “The most

critical and distinguishing feature of

such a system is the prohibition of




riba (interest), which includes the payment and receipt of interest as understood in today‟s

financial markets.” 7 To provide one of the examples from the Holy Quran, the justification of

riba (interest) is given in the Quranic verses above.

Islamic finance is based on the principal of flourishing the economy and making the society

prosperous. Islamic Laws or Sharia are also called fiqh Al-Muamalat (Islamic rules on

transactions). The primary sources of reference are Quran and Sunnah and other secondary

sources are opinions collectively agreed among Sharia scholars (ijma‟). Based on a Islamic

Banking book, there are various Sharia concepts in Islamic Finance such as Wadiah

(Safekeeping), Mudharabah (Profit Sharing), Murabahah (Cost plus), Musharakah (Joint

venture), Ijarah (Hire purchase), Wakalah (Agency), Qard (Interest-free loan), Sukuk (Islamic

Bonds) and Hibah (Gift).8

The Industry outlook of Islamic finance has grown astonishingly over the past 3 decades

especially in the way it has emerged with new financially engineered products. According to Ijlal

Alvi, Islamic financial assets are worth $400 billion and money market has a value of 30-50

billion. They have been extensive development in sophisticated corporate banking products,

innovative financial solutions to projects and competitive retail offering.9

8 Banking Info. (2009). Your guide to basic principles of Islamic Banking. What is Islamic Banking? Bank

Negara Malaysia. 9 Ijlal Alvi. (ND). Challenges of Islamic Financial Market Development. International Islamic Financial Market.

The world Islamic Banking


Prerequisites for a Sharia Compliant Instruments:

All Islamic financial instruments in general must meet a number of criteria in order to be

considered hall (acceptable).At a primary level all financial instruments and transactions must be

free of at least the following four items: riba (usury), maysir (gambling), gharar (unnecessary

risk) and jahl (ignorance).

1. Riba can be in different forms and is prohibited in all its forms. For example, Riba can also

occur when one gets a positive return without taking any risk.

2. Gharar, there appears to be no consensus on what gharar means. It has been taken to mean,

unnecessary risk, deception or intentionally induced uncertainty. In the context of financial

transactions, gharar could be thought of as looseness of the underlying contract such that one or

both parties are uncertain about possible outcomes.

3. Masyir from a financial instrument viewpoint would be one where the outcome is purely

dependent on chance alone – as in gambling.

4. Jahl refers to ignorance. From a financial transaction viewpoint, it would be unacceptable if

one party to the transaction gains because of the other party‟s ignorance.

In addition to these requirements for financial instruments, the sharia has some basic conditions

with regards to the sale of an asset (in this case a real asset as opposed to financial assets).

According to the sharia for a sale to be valid, (a) the commodity or underlying asset must

currently exist in its physical sellable form and (b) the seller should have legal ownership of the

asset in its final form. These conditions for the validity of a sale would obviously render

impossible the trading of derivatives.


2. WHAT ARE ISLAMIC DERIVATIVES?

The Islamic derivatives are a new word for some people. They start to think how you can

combine a forbidden thing in Islamic Law. Sharia explains different types of transaction

(Maamlat), each transaction used in different way and different situation. Throughout this

project, we verify the Islamic transaction (Maamlat) that could be used within the Islamic

derivatives. Furthermore, we explain the time to use it and the way to practice within the other

solutions that we offered. These transactions are:

1- Murabaha:

Murabaha is the sale of commodity at the price that seller has purchased it, with the addition of

stated profit known to both the seller and the buyer. It is the cost-plus-profit sale in which the

seller expressly discloses the profit. It is based on trust (Amanah), whereby the seller expressly

tells the purchaser how much cost he has incurred and how much profit is going to charge. Both

Quran and Sunah are permitting sale in general and gives indirect proof of Murabaha. For

example from Quraan "and Allah has permitted trade.10

There are three main elements in Murabaha which are:

1. The subject matter: the subject matter in Murabaha transaction involves the product and

the selling price.

10 Dennis Estrada. (ND). What is Murabaha Financing. Ezine Articles


2. The contracting parties: the seller as the financier and the buyer as the customer.

3. Offer and acceptance: the contract of the offer by one party and the acceptance by

another party.11

Murabha can do with some conditions which are:

Knowing of the initial price of the commodity, if the seller does not examine the initial

price the contract is invalid.

Knowing of the profit margin for both parties, otherwise it will not be Murabaha.

No Rabawi item be involved in the contract because they are prohibited in Islam. These

items are gold for gold, silver for silver, wheat for wheat, dates for dates, salt for salt,

barley for barley unless the measurements and the calculation are equal.

Initial contract must be valid, the traded commodity must be lawfully owned by the seller

according to Islamic law. 11

How Murabaha works:

If the client defaults in payment at the due date, the price cannot be increased, because one the

priced is fixed it can't be increased. If the bank took specific amount of money in case of default,

the client should be sure that this amount of money don not goes to the profit of bank. On the

other hand, no rescheduling in Murabaha payment because it is not loan.

There are some elements considered to be prohibited in Murabaha contract which are:

1. Using Murabaha as document to obtain funds without intension to purchase any specific

commodity.

11 Qazi Irfan. (2008). Murabaha Financing vs Lending on Interest. A thin line in making a big difference in

understanding of Riba


2. Entering into a Murayama contract on commodities already purchased by the clients from

third party. 12

In some Murabaha contract, the financier ask third party to secure the transaction and that is

allowed in Islam. But, the third party will be involved in the operational deal only in case of

default in the payment at the due date agreed between the buyer and the financial institution.

Also, the third party liability will be part of the agreement, and considered as bank and standing

point to grant the financing to the client. 12

12 Qazi Irfan. (2008). Murabaha Financing vs Lending on Interest. A thin line in making a big difference in

understanding of Riba


How Murabaha Works:

1. The buyer of goods defines his needs and negotiates in advance the specifications and

2. Characteristics of the goods with the seller (goods should be permissible and not

forbidden (Haram) by the Sharia).

3. The buyer promises to buy the goods from Islamic Bank (IB). The promise could be

binding or not depending on the agreement between the two parties.

4. IB enters into a sales contract with the seller. IB buys the goods as agreed between the

buyer and the seller (step 1). IB could buy the goods directly (as principal) or could

appoint an agent to buy the goods. Usually IB appoints the buyer as its agent to buy the

goods.

5. The seller delivers the goods to IB.

6. IB enters into a Murabaha agreement with the buyer and sells back the goods to the

buyer at a higher price (price with a mark-up). The second sale is a deferred payment sale

or installment credit sale.

Source: Hassan Kabir


2- Salam:

Salam or (Salaf) is defined as the sale or purchase of a deferred commodity in exchange for

price paid on the spot. In Salam contract, the price is paid in advanced while the commodity is

deferred in future date. Hanbili defined it as the sail whereby the seller undertakes to supply

some specific goods to the buyer at future date in exchange for an advanced price fully paid on

the spot. Quran and Sunah permitted the Salam contract in indirectly way. Example from Quran,

is Surah al-Bakarah (282) Allah says you who believe when you deal with each other in

transactions involving future obligations in a fixed period of time, put them in writing}. This

verse includes the Salam contract because it is a transaction involving future obligation. Because

the delivery of the subject matter of Salam occurs in the future. 13

How Salam Work Diagram:

13 (ND). Bay As Salam. Islamic Finance.



How Salam work:

The scholars unanimously agree on the permissibility of Salam and there is no disagreement on

that. Moreover, Salam is considered as an exception to the general principles and rules of Sharia

in business and trade. Also, the permissibility of this contract was based on the needs of farmers,

who needed fund to spend on their business. Scholars consider this contract as special form of

license to the people to facilities their business. 14

The benefits of Salam contract for both parties:

It is beneficial to the seller because he receives the price in advance.

It is beneficial to the buyer because normally the price in Salam tense to be lower than

the market price compared to a spot sale.

The capital of Salam must pay in full on the spot, the immediate and full payment of the price is

necessary. Since the delivery of the goods in Salam is in the future, banks and financial

institution are allowed to request the seller to furnish a security, which may be in the form of a

guarantee or in the form of a mortgage to cover the risk of non delivery. Furthermore, in the case

of default, the guarantor may be asked to deliver the same commodity. Also, if there is a

mortgage the buyer of the financier may sell the mortgage property and the sale proceeds can be

used either to realize the required commodity by purchasing it from the market, or to recover the

price advanced by him. 14

14 (ND). Salam. Financial Islam. All About Islamic Banking and Insurance.


3- Istisna:

Istisna is sail contract between the ultimate buyer (Al Mostasni) and the seller (Sani), whereby

the seller based on an order from the ultimate buyer undertakes to have the manufactured or

otherwise acquired product (Al Masnoo). The subject matter of the contract will manufactured

according to specification and sell it to the ultimate buyer for an agreed upon price and method

of settlement whether that be in advance by installment or deferred to a specific future time. It is

a condition of the contract that the seller should provide either the row material or the labor.

In order for the contract to be valid there are some conditions must be fulfilled these

requirements which are:

The subject matter or the good to be manufactured must be identified. This includes its

kind, type, measure, quality, and quantity or any related specification.

The subject matter must be goods that can be manufactured and not commodity.

The subject matter can't be an existing item.

The manufacturer must undertake to construct, build the subject matter with his own

material.

The buyer supplies the row material to the manufacturer it will be considered as Ijara not

Istisna. 15

The prohibited elements in this contract are as follows:

It is prohibited that the subject matter be already in existing at the time of the contract.

The subject matter must be identifying by specification, quality and quantity to be

manufactured in the future.

15 (ND). Istijrar. Finance Al Islam. Pakistan.


The price could no increase or decrease because of the increase or decrease in commodity

prices or other factors.

The row material of the subject matter are provided by the manufacturer and cont be

supplied by the buyer.

It is permitted for the manufacturer to stipulate a condition in the contract agreement of

the Istisna that he will not be liable for defects in the subject matter.

In a parallel Istisna, the institution or the bank cannot simply act as financial intermediary

between the ultimate buyer and the actual manufacturer to avoid the element or Rib, the

two contracts must be indecently contracted. 16

There two types of Istisna:

1. Ordinary Istina: this is the common type of Istina whereby an agreement between the

buyer and manufacturer is concluded based on agreed specification and time of delivery

in the future.

2. Parallel Istisna: is a contract of two independent contract agreements but inter-related. 16

4- Urbon

Urbon is a deposit given to the seller with a condition that if the contract is continued it will be

counted in as part of the purchase price, or otherwise it will be for fitted by the seller. There are

different goals of Urbon which are: To secure a right, to secure more time, risk mitigation tool

and to make profit. 16

16 Kabir and K. Lewis. (2007). Handbook of Islamic Finance. Edward Elgar Publishing Limited. United Kingdom


How the two types of Istisna work:




The Basic Rules of Urbon are:

Urbon is an amount in paid in lieu of the right given to the buyer to have a waiting period

whether to continue or withdraw from the contract.

The deposit paid will be considered as part of the purchase price if the buyer decides to

proceed with the contract.

If the buyer withdraws, the seller will have the right to keep the deposit. 17

The importance of Urbon in the Islamic finance:

Urbon is mechanism that allowances the person who is unsure about the benefits of the

transaction that he has entered into, to pay a part of his property in order to reserve for

himself the right to either continue or revoke the contract.

Urbon can be used as a tool for risk mitigation and risk management.

There is a compensation for the buyer for his righting and their right given to the buyer

without harming the seller. 17

There are two types of Urbon, which are:

The first type when is the down payment given by the buyer, this advanced payment will

be considered as part of purchased price. If he decides to withdraw from the contract, the

advanced payment will be refunded to him. 17

The second type of Urbon is the down payment will be for fitted by the seller, if the purchaser

chooses to discontinue the contract.



Imam Ahmad bin Hanbal and the majority of Hanbilies ruled that there is not haram in this sale,

even though the period of Urbon is not determined. Some of the Hanbilies have ruled that this

type of Urbon is only valid if the waiting period of Urbon is determined. 18

The application of Urbon in the modern practice as follows:

Using Urbon in currency exchange: it cont be used in currency exchange because (Saraf)

as contract does not accommodate deferment in the exchange and taking position.

Urbon in commodities: Urbon can be used in commodity whereby the buyer secure his

deal and the potential of loose by using Urbon as tool in his financial transaction.

Urbon in leasing: Urbon can be used in leasing as well, and the same hedging mechanism

used in sale can be used as well in leasing.

Urbon in portfolio management: this can be exercised when the invested fund is divided

to three types of investment as follows:

1- The first one goes to short term investment to secure the availability of liquid.

2- The second will be placed in Islamic bonds.

3- The third one will be place in down payment (Urbon) to purchase common stock in a

future date which consist of small portion of the portfolio, if the stock is in favor, the

manger liquidate Murabha and buy the stock, of the market is not favor he will leave

the un exercised and the loose of that be will composited by other portfolio. 18



Tawaroq:

Tawaroq in Islamic law is a particular way to be used in order to obtain liquidity needed without

getting involved in borrowing on interest. It involved a purchase of an asset as mean obtaining

liquidity. Tawaroq by definition is transaction based on the purchasing of commodity on credit

and selling it to a person other than the initial seller for lower price on cash. Tawaroq transaction

is concluded between three parties, whereby the person who needs liquidity purchases assets

from seller on credit basis; subsequently sell it in the market to any potential buyer with lower

price other than the original seller. The Motawreq is not looking for business opportunity to

make profit, but he is looking to dispose the commodity faster to get the liquidity to fulfill his

need and obligation. The purpose of tawraq is not making business and generates profit but to

secure cash and liquidity through a valid transaction from Islamic law perspective.19

Conditions required concluding a valid Tawaroq transaction:

In order to conclude a valid Tawarq transaction the seller should have the item in his

possession at the time of the sale contract.

The seller must have the ownership of the subject matter.

Tawraq is a sale transaction; therefore it should fulfill the Sharia requirement in sale

contract.

The second sale in Tawraq transaction should be concluded with buyer other than the

original seller.19

19 Siddiqui. (2007). Economics of Tawarrq. How is it mufasid overwhelm Masaliah.


How to Apply Tawarruq:

Source: Mohammad Amin


Istijrar:

Istijrar contracts are more complicated. They involve two parties: the buyer, which is usually a

company seeking financing to purchase an underlying asset, and a financial institution. The

financial institution buys the commodity at the existing price and resells it to the company at a

price to be paid at a specified date in the future. The actual price at that date depends on the

underlying asset's price movement from the day of the contract initiation to the day of maturity.

The contract also includes an upper-bound option and a lower-bound option, by which the parties

can choose to fix the price at which settlement will occur at any time before contract maturity. 20

How it works:

2) Resells Asset at a price to be determined at a future date

A B

1) Financial institution buys the assets

2) A company has the option to fix price

if it falls such that it breaks the lower

bound before date of maturity (put option).

3) B has the option to fix the price of the commodity before the maturity date if the

price of the commodity moves upward to predetermine level (call option).



Wa'ad:

Wa'ad is a promise or undertaking. It is unbinding and has no value; however, in certain

circumstances a promise will be valuable and binding.

The OIC fiqh puts the following requirements for a wa'ad to be binding:

1. It must be unilateral.

2. It must have caused the promise to have incurred some costs/liabilities.

3. If the promise is to purchase something, then the actual sale must take place at the

appointed time by the exchange of offer and acceptance. Mere promise itself should not

be taken as the concluded sale.

4. If the promissory reneges, the court may force them to either purchase the commodity or

pay actual damages to the seller. The actual damages will include the actual losses

suffered by the promise and will not include the opportunity lost. 21

21 Siti Razali. (ND). The concept of Wa‟ad in Islamic Financial Contract. Dept. of Business Administration.

Kulliyah.


3. FORWARD CONTRACTS

It is a non standardized contract, which occurs between two parties (buyer and seller) on

a trading (underlying) asset, at a known forward time and at a price that is agreed on it today. It

does not cost anything to enter forward contact. This contract as future contract has a long

position and a short position. However, it differs from the future contract in the names, in which

the price that is agreed on today is called delivery price.22

More specifically, forward contracts are done through over the counter market (OTC), meaning

the trading is done through a network that is linked with the dealer markets. Investors in the OTC

market trade via telephone or internet that linked with the network of that market. Trading

forward contract in OTC market has high volume of trading; however the risk in such market is

very high risk. For this reason, OTC market is not a standardized market and trades can be

customized and tailored to meet the need of the sellers and buyers.

The Uses of Forward Contract:

Investors go for forward contracts to purchase or sell the value based on certain assets

without adding any direct cost. According to Wiki Invest "This feature makes it attractive to

many corporate treasurers, who can use forward contracts to lock in a profit margin, lock in an

interest rate, assist in cash planning, or ensure supply of scarce resources". 23

22 (2011). “Forward Contract”. The Free Encyclopedia. Wikipedia.

23 (2011). “Forward Contract”. Wiki Invest.


In addition speculators use forward contracts to gain and to maximize their profits and at the

same time they are willing to take high risks, opposite to hedgers who look for the stable income

with the minimum risk. Many corporations and banks are going for forward contracts to hedge

risk. For this reason they can lock prices to avoid the fluctuations of the products. These are the

usual agreements that happen between the corporations and the suppliers. These types of

investors try to avoid huge changes in the price and are satisfied with a stable income for the

suppliers.

How Do A Forward Contracts Work?

In Al-Yamamah derivatives class with Mr. Mazen Ali, we defined the forward contract

as a contract or an agreement to buy or to sell a value derived from known assets at a certain

future date for a certain price. The contact parties will be obliged to perform or exercise the

contract at the expiration date or in between maturity and initial, depending on American futures

and European futures. To be more professional in speaking we have two sides in the contract the

long position and short position.

The long position is the buy position where it is assumed that a contract will be purchased for the

value of certain assets for a certain price at a forward date. On the other hand in the short

position the seller is assuming to sell a certain assets for a certain price at forward date.24


http://www.wikinvest.com/wiki/Forward_Contract?action=edit&section=2


How Pay Offs Are Calculated?

The pay off in such contract is known as

sub zero game in which either the buyer

or the seller is gaining or loosing. If the

long position party gained, the short

position party will face a loss and vice

versa. To make it more clear, if the spot

price is higher than the forward contract

price this mean that the one who is

performing long position will gain and

short position will lose. Therefore, the

buyer (long position) buys the value of

assets with a price that is lower than the

market and the seller needs to sell it with

a price lower than the market, to gain

economic gains. On the other hand, if

the price of the assets (strike price) is

lower than the forward contract price,

then the buyer (long position) will lose

and the seller (short position) will gain. 25


Source Wikipedia 13

Source Wikipedia 13


The value of forward option at maturity is more dependable on the relationship the delivery price

(K) and the underlying price (ST) at the same time. We have two types' long payoffs and short

payoffs.

.

The delivery price is the price agreed upon, which is equal to the forward price at the time the

contract is entered into. In a forward contracts agreement there is always a seller and a buyer,

who together agree upon a particular price, contractual agreements, quantity, and date in the

future on which exchange is going to happen. At the date of the maturity of the contract, the

buyer (long position holder) pays the seller (short position holder) the price which was initially

agreed and then the buyer receives the agreed upon quantity of the asset. 26

Here is an example

Suppose that Khalid wants to buy Al-Bilad Bank stock of 1000 shares, where the price is equal

SR100, 00 per stock today and he wants to buy it a year from now. At the same time, suppose

that Ahmad currently owns Al-Bilad stocks with a value of SR 100,000 today that he wishes to

sell a year from now. Both parties could enter into a forward contract with each other. Suppose

that they both agree on the sale price in one year's time of SR104, 000 (more below on why the

sale price should be this amount).


Long Position Payoff: fT = ST – K

Short Position Payoff: fT = K − ST


Khalid and Ahmad have entered into a forward contract. Khalid, because he is buying the

underlying stock, is said to have entered a long forward contract. Conversely, Ahmad will have

the short forward contract.

Now suppose that after a year from now the stock prices was 110,000 and the swap contract was

about 104,000 as agreed on between them. Then Ahmad is obliged to sell the stock to Khalid

with SR. 104,000 in which Khalid has made a profit of 6000 and Ahmad has made a potential

loss of $6,000, and an actual profit of $4,000.


3.1 TYPES OF FORWARD CONTRACTS

1. Equity Forward Agreements: an equity forward contract is an agreement to buy or sell

and individual stock, a stock portfolio, or a stock index at an agreed price at some point

in the future.

2. Bond Forward Agreements: forward contracts on zero coupon bonds are typically

treasury bills contract where the buyer of the contract agrees to buy a treasury bill at a

future date and at a price agreed to today. Treasury bills are a discount security that

matures at face value. Interest is received implicitly by buying the treasury bills at a

discount to face value.

3. Currency Forward Agreements: another active forward market is the currency

forward market. Currency forwards involve two parties who agree to exchange

currencies at a future date and a specific exchange rate.

4. Commodity Forward Agreements: a forward market where commodities like gold,

silver, wheat, livestock are exchanged for a future date and future prices by seller and

buyer usually for hedging and arbitrage purpose and at times for speculation.27




3.2 ADVANTAGES AND DISADVANTAGES OF FORWARD

CONTRACTS

There are various advantages and disadvantages of forward contracts and agreements in

the contemporary world.

28 (2010). Derivatives. Chapter 15. CFA Level 1 Online Study Guide. Investopedia.

AADDVVAANNTTAAGGEESS

1. Unregulated Market: The

primary advantage of forward

contract is that they are

unregulated over the counter

transactions, so the two

counterparties can negotiate

any terms that they find

mutually agreeable. i.e.

customize contracts.

2. Flexibility and low cost: Forward are very flexible and

normally no commissions are

paid on the trade. Forward

contract has three major

disadvantages.

3. Hedging: (al/at-tahawwut) a

risk management technique

used to reduce, mitigate and

eliminate risk.

4. Speculation: attempts to

profit from price

movements.15

DDIISSAADDVVAANNTTAAGGEESS

1. Liquidity: they are often illiquid.

Counterparties to a forward

contract usually design them to

meet specific needs. The buyer

may find it difficult to sell the

position to a third party because

of its specificity. If no third party

emerges the buyer may try to

cancel the agreement at a fair

price.

2. Credit default risk: they have

credit risk. Each party to the

agreement must trust that its

counterparty will perform in the

agreed upon manner. This

exposes both contracting parties

to the risk that the counterparty

might default on its obligation.

3. No Organized Market: they are

unregulated no formal body has

the responsibility of setting down

rules and procedures designed to

protect forward market

participants. Generally, only

contract low protect parties

involved in the OTC forward

market.15


3.3 ISLAMIC FORWARD CONTRACT:

God (Allah) has put the instructions and the principle of Sharia to be as a guide for

everything in our life for wisdom from him, but if we looked into it deeply we can understand

from his wisdom little by looking deeply toward today tools and problems. God has prohibited

any transaction that may lead us to Reba but the reason from this prohibition and warning for the

people who use Reba is to avoid the crises that will case financial crises, economy crises, social,

crises and so on. These are the consequences that will happen in life as a punishment which it's

just a part of the punishment that God prepared for the traders in Reba. For this reason, Allah is

blaming the people who trade in Reba in helping in destroying the system of life and hurting the

shield of the society. 29

29 Saiful Rosly. (2005). Critical Issues on Islamic Banking and Financial Markets. AuthorHouse


From this point, after knowing the advantage and disadvantage of the forward contract and the

reason for prohibiting this kind of tools we reached some solutions:

1. First make sure that there is available money in the account of both parties.

2. Secondly, the traders should have the ability to negotiate directly.

3. Thirdly, both parties must know with whom they are trading with.

4. Fourthly, Must avoid any interest rate in any contract even from the third party (the bank).

5. Fifthly, the underlying assets must be known and the certainty is the major part of the

contract.

6. Doing contract that combine Murabha and Tawaruq can act as a forward contract. Doing

these steps make us have a forward contract under the shadow of Sharia principles.

7. Doing the other two types of contracts which are Salam and Istisnaa.


4. FUTURES CONTRACTS

— Future contracts are standardized contracts, where there is an agreement between

two parties to buy or sell as assets at a certain time in the future for a certain price in a market

place. They are traded on an exchange market, and to make this trading possible, the exchange

market specifies a certain standardized features of the contract like contract size, the settlement

date, and delivery arrangement. Firstly, the two parties of the contract do not necessarily know

each other. Also, the exchange provides a system or a clearing mechanism that gives the two

parties a guarantee that the contract will be guaranteed. There are many markets which have the

future contracts, one of the biggest ones are Chicago Board of Trade (CBOT) which is located in

United State of America. Also, there are the Chicago Mercantile Exchange (CME), LIFFE

(London), Eurex (Europe), BM&F (San Paulo ,Brazil), and TIFFE (Tokyo).30

—

Many commodities are a part of future contracts in the modern futures trading, such as wheat,

live cattle, sugar, wool, lumber, platinum, aluminum, gold, and tin. Similarly, traders can

exchange different types of financial assets, such as stock indices, currencies, and Treasury

bonds. To accomplish the full future contract it must have some features. Firstly, there is an

exact delivery date which is usually not specified. (Contract is referred to by its delivery month,

and the exchange specifies the period during the month when delivery must be made).30

In

commodities contract, the delivery period sometimes the while month, and the holder of the short

position has the right to choose the time during the delivery period when he or she will make the

delivery.

—




Moreover, contracts with different delivery months are traded at any one time. So, the

commodities have different maturity time, but the buyer trades them at the same time. In case of

assets, the exchange market specifies the amount of the assets to be delivered for one contract

and the way that future price is to be extracted. On the other hand, in case of commodity, the

exchange market specifies the product quality and the delivery location. Like other derivatives

types, there are three different types of traders who practice the future contract. These traders are

Hedgers, Speculators, and Arbitrageurs.

To trade in an official way, traders must deposit margins. A margin is cash or marketable

securities deposited by an investor with his or her broker.31

The balance in the margin account is

adjusted to reflect daily settlement. Also, margins minimize the possibility of a loss through a

default on a contract. The delivery of the future contract has some rules. Firstly, if a futures

contract is not closed out before maturity, it is usually settled by delivering the assets underlying

the contract. Also, when there are alternatives about what is delivered, where it is delivered, and

when it is delivered, and the party with the short position chooses. Moreover, a few contracts (for

example, those on stock indices and Eurodollars) are settled in cash. Maturity is the time period

of settlement or expiration of an agreement which describes when the contract must be full field.

Settlement price is the price just before the final bell each day.31



.


There are some regulations of

future contract in order to protect

the public interest. Regulators try

to prevent uncertain trading

practices by either individual on

the floor of the exchange or

outside groups.

The diagrams on the right shows,

how a short and a long futures

contract work.

Open Outcry

All future trading must be done by open outcry. Open outcry means that bids and offers must be

publicly disclosed to all market participants. No side trading is allowed, and in fact, it is a

violation of exchange rules that carries stiff penalties. In addition all trades are recorded for all to

see.32

Open interest

When one party buy and counterparty sell a contract, these are viewed as the two sides of one

complete contract thus, every long/short position per constitutes one unit of contract volume.




The total number of contracts long/short positions pairs (with obligations to deliver is called the

open interest. Thus, open interest is the sum of the entire long, or the entire short, positions that

are open, but not both.33

Closing out future positions

Offsetting transaction: a party can effectively close out a contract position buy entering into a

reverse position in another contract with the same underlying asset, settlement date, and contract

size as the contract that is being closed out.

Delivery of underlying asset: delivery is making (taking) possession of the physical asset

underlying the contract according to the terms and conditions specified by the contract. In this

case, at the time the contract settles, the long position pays the invoice price to the short position

in exchange, the short position delivers the contract size of the underlying asset to the long

position at the place, time, and in the form specified in the contract.

Cash settlement: some contract are settled for cash on the day the contract expires, the loss

realized by one party to the contract is paid, in cash, to the other party to the contract becoming

that party‟s realized gain. Most financial derivatives use cash settlements. 34

Calculating loss and gain contract

Gain on long position = loss on short position =

[Number of Contracts x Contract Size x (FT – FO) ]

FT = is the contract price when the trade is initiated.

FO = is the contract price at the time the position is closed.34


curriculum. Volume 6. Level 1 2010. Pearson Custom Publishing. 34

John Hull. (2009). Options Futures and other derivatives. Fifth Edition.


Role of the Clearing House

The clearing house act as the counterparty for each side of the trade, this makes it

possible for one party to close out its position in a contract simply by selling its long position or

covering its short position at any time, without actually locating and negotiating with some

specific counterparty. This provides liquidity to the market, thereby, eliminating one of the

disadvantages of the forward contract market. In addition, the clearing house enforces margin

requirements to ensure that market participants honor their commitments.35

Margin

Initial Margin: is an amount of money that traders must deposit with their brokers before

executing a future transaction.

Maintenance margin: is the minimum level below which the margin account is not permitted to

fall without a margin call. If the value of the margin account falls below the maintenance margin,

the trader will receive a margin call (a notice from the clearing house) to deposit additional funds

or securities in his or her margin account.

Daily settlements: the clearing house requires daily settlements of all gains and losses. Every

day, any gain or lose incurred by the holders of the long and short positions resulting from

changes in the market price of the futures contract are added to the subtracted from each trader‟s

margin account. This process is called marking to market.35




4.1 TYPES OF FUTURE CONTRACTS

1. Commodities: commodities make up the raw material used in production of this group.

There are 3 basic categories of commodity contracts used:

1) Agricultural products: such as animals, fruits, grain and fiber

products.

2) Metals: such as gold, silver and copper.

3) Energy: such as oil, natural gas and gasoline.

2. Interest Rate Futures: there are two types of interest rate futures. 1) Short term interest

rate futures contracts are traded for US treasury bills and Euro dollar accounts. 2)

Intermediate and long term interest rate futures, US treasury notes and bonds make up the

underlying assets of intermediate and long term interest rate future contracts.

3. Stock Index Futures: stock market futures S&P 500 index value line index, major

market index, NIKKII index and so forth (are very popular investment vehicles, index

futures contracts are quoted based on the underlying index, such as the S&P 500 index,

that is continually reported throughout the day.

4. Currency Future: currency future is also popular, although currency forward

predominates. The underlying assets are units of the foreign currency. These contracts

call for physical delivery of a stated amount of currency at an exchange rate specified in

the contract.36




4.2 ADVANTAGES AND DISADVANTAGES OF FUTURE

CONTRACTS

There are various advantages and disadvantages of future contracts and agreements in the

contemporary world.



1. Organized Market: The

future market provide a

mechanism that is sought to

overcome difficulties by

making it possible for buyers

and sellers to enter the market

for price discovery, high

liquidity and standardized

contracts.

2. Credit Default Risk is less:

Due to the clearinghouse the

act of failing by one party to

pay its financial obligation is

minimized or almost reduced

to null.

3. Margin Accounts: Deposits

in sellers and buyers accounts

are marked to market daily

with the price movements.

4. Hedging: (al/at-tahawwut) as

a function of the futures

acquires much significant in

the fast moving goods and

capital and volatile exchange. 23


1. Obligation to complete the

contract: The long and short

position holders have the

obligation but not the option to

carry out a transaction.

2. No customization of

contracts: The contracts

cannot be tailor-made, like in

forward contracts (which are

mutual agreements between

sellers and buyers) after

certain exchange of promises

or contracts.

3. Complex options: some

options strategies are

dangerous for new

inexperienced traders

4. Excessive Trading

5. Speculation. 37


4.3 CONTEMPORARY FUTURES IN THE SCOPE OF ISLAMIC

LAW (SHARIA):

According to the Hadith “SELL NOT WHAT IS NOT WITH YOU”, reviewers who

have disputed the acceptability of futures in Islamic law have highlighted the following five

points in their evaluation:

1) Futures proceed over goods that are non-existent at the time of contract agreement.

Hence, a futures contract is mostly a paper transaction and not a sale of a genuine good.

2) Futures consist of sales in which the seller does not own the item he sells.

3) Futures involve excessive speculation that margins on gambling.

4) In the contemporary futures contracts there is no requirement of qabd (taking

possession of the good) prior to resale. In other words, it is an optional thing and not a

necessary requirement.

5) Delay of both sides of the bargain to a future date turns futures into the sale of one

debt for another.38

Although the Sharia principle of acceptability (ibāha) that renders all commercial transactions

(mu’amalat) permissible in the absence of a clear prohibition, one is confronted with the decision

of some Fiqh Academies and scholars who have declared futures trading forbidden. This body of

opinion is founded mainly in the premise that futures trading do not fulfill the requirements of

the conventional law of sale as specific in the fiqh al-mucāmalāt. The fact that futures represent a

new market phenomenon is almost totally ignored.38

38 Sherin Kunhibava. (2010). Derivatives in Islamic Finance. International Sharia Research Academy for Islamic

Finance. Research Paper


The basic justification of taking possession of the subject matter of sale is clearly to prevent

gharar on account of uncertainly over the seller's ability to deliver. If gharar can be effectively

removed, then it follows that the requirement of qabd may be relaxed or totally lost. Some

scholars said that the future due to their non-existence at the time of contract. This is because

delay of the transfer of ownership in proprietary contracts (cuqūd al tamlīk), such as sale, to a

future date is a form of gambling, and therefore prohibited. Sale must, in other words, transfer

ownership immediately.39

The Makkah-based Fiqh Academy has taken an unsure view of futures. While the Academy

acknowledged the benefits of futures to farmers and commodity traders, this was not reflected in

its final judgment on the subject. The Academy also acknowledged that futures trading had

developed into a variety of different transactions, and need to be evaluated on that basis, but this

view was also not reflected in its final resolution, which is prohibitive on futures as a whole and

does not attempt to address individual issues. Futures are forbidden, as they involve the sale of

assets the seller does not own nor possess nor do they exist at the time of contract. The parties to

a futures contract were also not interested in making or taking delivery and that brings futures

closer to gambling rather than trading. 40

39 Sherin Kunhibava. (2010).Derivatives in Islamic Finance. International Sharia Research Academy for Islamic

Finance. Research Paper 40

Mohammad Kamali. (ND). Commodity Futures: An Islamic Legal Analysis. International Islamic University

Malaysia.


4.4 ISLAMIC FUTURE CONTRACTS:

As a result of these opinions in prohibiting the future contracts in the view of Islamic Low,

and understanding the advantages and disadvantages of future contracts; here are the solutions

that might solve the issue:

1- Open a market under the control of committee which consist of finance and Islamic

scholars who will be responsible for any contract done on that market.

2- The market will open for one day per a week and that is for many reasons. Firstly, in

order to grantee liquidity for one week better than unguaranteed liquidity for every day.

Secondly, both parties will be able to trade after studying the contract affect and they can

make the best decision for their sides. Thirdly, they will have enough time to repair the

contract which must follow the Islamic law. Fourthly, if the contract were prohibited in

Islam, both parties have enough time to revise it and practice it on the week after, so they

still have the chance to do it. Fifthly, the buyer and the seller can find within the week the

best offer for them, and they can decide the condition of the contract. Finally, companies

can repair themselves either to buy or to sell within a week.

3- The market will have some rules in order to practice any type of contracts. Firstly, the

contract must follow the Islamic law. Secondly, commission must pay to the market in

order to make any contract. This commission considers being the profit of market

resulting of their controlling and managing the market. Thirdly, contract must submit two

days before in order to check the validity of contract within Islamic law. Fourthly, traders

reprehensive must have authorization letter from the company in order to have the

contract. Fifthly, any contracts must apply on the commodities which are specified and


halal in the Islamic law. Finally, contracts can be canceled if and only if reach the

unavailability in the contracts regulation.

4- There are two alternative contracts allowed for the Islamic future market which is Istisna

(definition). We can also use the contract Al-Salam in this type of contract.

5- Each week the market will check all the contracts in case of payment, delivery,

ownership, and all the rules of Istisna or Al-Salam.

6- In the Islamic futures market there will be an automatic mechanism that sought to

overcome all the problems of conventional futures by making it possible for sellers and

buyers to enter the market whenever they needed to at comparatively lower costs for

purchasing or selling a contract.

One of the most important features in Islamic futures will be that it will allow new possibilities

for risk management, efficient and effective investment planning and also new ways to market

these financially engineered products. 41 42




Malaysia.


5. Options Contracts

“An option is a derivative financial instrument that establishes a contract between two

parties concerning the right - and not the obligation - of the buying (call options) or selling (put

options) of an asset at a reference price during a specified time frame.”43

in this period, the party

which acquires the option will possess the right - but not the obligation - to be involved in

activities affecting the underlying asset. On the other hand, the writer of the option gains from

the fluctuating value of the underlying asset which is usually a bond, or a stock, or a currency or

a futures contract. Furthermore, the writer of the option also gains from the premium paid by the

acquirer, which is based upon the maturity date of the given option, the maturity of options is

usually after a year of acquiring it, however, it is not always the case.

“An option which conveys the right to buy something is called a call; and an option which

conveys the right to sell something is called a put.”44

Furthermore, every option has a given

strike or exercise price, at which the trader could use the respective acquired option. Using the

already acquired option is referred as exercising it. It is also important to mention that -usually-

most options have a given expiration date, and if the acquired option is not exercised before the

predetermined expiration date it will be considered worthless and void.

The writer of the option receives a payment from the buyer which is referred to as a premium.

Furthermore, and if the option is exercised the writer should be able to either deliver the

underlying asset, or the equivalent of the underlying asset in cash.

43 (2011). “Options Basics: What Are Options”. Investopedia.

44 (ND). “Beginners Guide to Options”. Traders EdgeIndia.


An option can be traded on over the counter markets it is also traded -sometimes- on anonymous

options exchanges.

5.1 THE BASIC TRADES OF STOCK OPTIONS

1. Long call

Buying a call is one of the many basic trading strategies. It is a contract in which a trader

believes that the price of an underlying asset will increase, and hence will buy the right to

purchase the given asset, rather than the asset itself. The long call acquirer will have the right,

and not the obligation to buy the underlying asset up to the date of expiry. Furthermore, if the

price of the asset at the expiration date is above the exercise price by more than the premium

paid, the acquirer will register profit. And if the asset price at the expiration date is lower than the

exercise price, the acquirer will let the call contract expire with a loss, and hence, will only lose

the amount paid as a premium. Traders might favor buying the options over buying the shares;

this is so because they will be able to control a larger number of shares with the same amount of

money which would be needed to buy the actual shares.


Long put

A Long put, which is buying a put option, is one in which a trader believes that the price

of an underlying asset will decrease, and hence will buy the right to sell the given asset, rather

than the asset itself. The long put acquirer will have the right, and not the obligation to buy the

underlying asset up to the date of expiry. Furthermore, if the price of the asset at the expiration

date is bellow the exercise price by more than the premium paid, the acquirer will register profit.

And if the asset price at the expiration date is higher than the exercise price, the acquirer will let

the call contract expire with a loss, and hence, will only lose the amount paid as a premium.

Traders -in this case as well- might favor buying the options over buying the shares, this is so

because they will be able to control a larger number of share with the same amount of money

which would be needed to buy the actual shares.


2. Short call

Selling a call is another option basic trading strategy. It is a contract in which a trader believes

that the price of an underlying asset will decrease, and hence will sell the right to buy the given

asset, rather than the asset itself. The short call acquirer will have the right, and not the obligation

to sell the right to buy the underlying asset up to the date of expiry. Furthermore, if the price of

the asset at the expiration date is below the exercise price by more than the premium paid, the

acquirer will register profit. And if the asset price at the expiration date is higher than the

exercise price, the trader might register unlimited losses.


3. Short put

Selling a put is another option basic trading strategy. It is a contract in which a trader believes

that the price of an underlying asset will increase, and hence will sell the right to sell the given

asset, rather than the asset itself. The short put acquirer will have the right, and not the obligation

to sell the right to sell the underlying asset up to the date of expiry. Furthermore, If the price of

the asset at the expiration date is above the exercise price by more than the premium paid, the

acquirer will register profit. And if the asset price at the expiration date is lower than the exercise

price, the trader might register unlimited losses.


5.2 ADVANTAGES AND DISADVANTAGES OF OPTIONS

CONTRACTS

There are various advantages and disadvantages of options contracts and agreements in the

contemporary world.



Advantages of Options Trading

1- Flexibility. Options can be used in a

wide variety of strategies, from

conservative to high-risk, and can be

tailored to more expectations than

simply "the stock will go up" or "the

stock will go down."

2- Leverage. An investor can gain

leverage in a stock without committing

to a trade.

3-Limited Risk. Risk is limited to the

option premium (except when writing

options for a security that is not already

owned).

4-Hedging. Options allow investors to

protect their positions against price

fluctuations when it is not desirable to

alter the underlying position.


Disadvantages of Options Trading

1-Costs. The costs of trading options

(including both commissions and the

bid/ask spread) is significantly higher on a

percentage basis than trading the

underlying stock, and these costs can

drastically eat into any profits.

2-Liquidity. With the vast array of

different strike prices available, some will

suffer from very low liquidity making

trading difficult.

3-Complexity. Options are very complex

and require a great deal of observation and

maintenance.

4-Time decay. The time-sensitive nature

of options leads to the result that most

options expire worthless. This only applies

to those traders that purchase options -

those selling collect the premium but with:

5-Unlimited Risk. Some option positions,

such as writing uncovered options, are

accompanied by unlimited risk.


5.3 OPTIONS IN THE SCOPE OF SHARIAH

When options are viewed solely as a promise to buy or sell an asset at a predetermined

price within a stipulated period, Sharia scholars find nothing objectionable with options.

However, it is in the trading of these promises and the charging of premiums that objections are

raised by sharia scholars. These objections are generally based upon two main arguments; one

arguments states that options involve Ghirar (un-necessary risk/uncertainty), and another states

that options involve Maisir (unearned gains).

The contemporary options, used by the world's non-Islamic economies, are not allowed in

Islamic finance given that the trading and charging of a premium -in an option- for the promise

is not acceptable by Islamic Sharia, This ban is not very beneficial to Islamic economies given

that hedging, arbitraging -using options - are undoubtedly useful. Hedging -aside from enabling

businesses to plan better- reduces fluctuations of product prices, which can help reduce costs and

thereby provide a tangible benefit to society. Consumers would benefit – from allowing options

trade- since producers need charge lower risk premiums. Also, Arbitrageurs by means of their

activities ensure that prices in different markets do not diverge from each other. Arbitrage

activity enhances the price discovery process, for example, arbitrage between markets in

different countries “internationalizes” product prices. This forces less efficient producers to

enhance productivity in order to remain in business. Furthermore, it should be noted that

speculating activities in trading options are -on the contrary to previously mentioned activities-

more harmful than they are beneficial.


As we have previously mentioned, Islamic scholars have two main objections regarding

the use of options. These objections mainly revolve around Ghirar and Maisir. The first

objection states that Options trade involves Ghirar because there is uncertainty and a potential

for default in such financial instruments. However, this objection might have ignored the fact

that exchanges place margin requirements on sellers of options precisely to prevent default. It is

also important to note that buyers of options would by definition not default since their

maximum possible losses is the premium (long call and long put), all of which is fully paid for at

the time of purchase. The second objection states that Options trade involves Maisir (unearned

gains). However, this Objection ignores the fact that both the buyer and the seller take on risk

and that the buyer also has at stake the premiums he has paid. Furthermore, the change in an

option's value arises from changes in underlying asset value and not by chance or gambling. If

such gains are unearned then that implies that all capital gains income could also be considered

unearned.

Aside from individual interpretations, the differing opinion among the different Islamic

mathematicians complicates the situation further. Thus, an options contract may be found

objectionable for exactly opposite reasons. While some Islamic mathematicians in Hanbalis

school of thought have been broader in their acceptance, the Shafi‟ and Hanafis have been less

so. The Hanbalis for example are somewhat liberal when it comes to Option of stipulation

(Khiyar-al-Shart). The Hanbalis hold that stipulations that remove a hardship, fulfills a legitimate

need, provide a benefit or convenience, or facilitate the smooth flow of commercial transactions

are generally valid as a matter of principle.


5.4 ISLAMIC OPTIONS DERIVATIVES

The solution for options might be found within the Islamic financial concept of “Istijrar”

and “Wa'ad”. “Istijrar” is defined as an agreement whereby a buyer purchases something -in a

specified period of time- in which there is no offer or acceptance or bargain, and there is only

one master agreement where all terms and conditions are finalized. Furthermore, Istijrar

Contracts involve two parties: the buyer which is usually a company seeking financing to

purchase and acquire an underlying asset, and a financial institution. The financial institution

buys the commodity or the underlying asset at the market price and resells it to the company at a

price to be paid at a specified date in the future. The actual price to be paid -at the previously

specified date- depends on the underlying asset's price movement from the day of the contract

initiation to the day of maturity.

“Wa'ad”, which is a promise or undetaking, can be introduced and used as a tool to create

Islamic Derivatives. A “Wa'ad” (promise) is usually unbinding and has no value, however; in

certain circumstances a “Wa'ad” (promise) will be binding and of value.

The following are requirements for a “Wa'ad” to be binding:

1. It must be unilateral

2. It must have the caused the promise to have incurred some costs and/or liabilities.

3. If it is a “Wa'ad” to purchase something -such as a commodity- , then the actual sale


must take place at the previously appointed time by the exchange of offer and acceptance.

The “Wa'ad” (promise) itself should not be taken as the concluded sale.

4. If the promisee fails to fulfill the “Wa'ad” (promise), the court may force them to either

purchase the commodity or pay actual damages to the seller. The actual damages incurred

by the seller will include the actual losses suffered by the “Wa'ad” promise; however, it

will not include the opportunity lost.

If such conditions were imposed and attached to a given “Wa'ad”, it would be -probably-

possible to create a groundbreaking Islamic financial product infused with characteristics of

contemporary options. 46 47




Malaysia.


6. RECOMMENDATIONS FOR ISLAMIC DERIVATIVES IN SAUDI

ARABIA

There must be Sharia Finance Committee, which should have a role in the Saudi Community to

put the right rules and regulations for trading in Islamic banking and they must form consensus

with regards to how derivatives should be traded. This committee must be well chosen, have a

PHDs in Islamic Finance. The members must be chosen by the trust of H.E. King Abdullah.

Other organizations and banks in the private and government sector must go back to this

committee in every issue they face. Also, these organizations do not have the right to hire a

committee that can give the approval or solutions to any issues in Islamic banking, because they

can be blamed to take advantage from the opportunity.

The Saudi Financial economy is growing at a steady rate and there is a need for a focus on the

stable growth. It is starting to attract more and more of the international investors with it stable

growth and the huge financials steps that are taken. Rather than focusing on neighbors in the

region, where the growth is very fast, investors see it very risky to invest as we found from our

interviews. This kind of a problem became a reality in Dubai economic crises. On the other hand,

Saudi Arabia is drawing a long term plan that will be ready after 20 to 25 years. Furthermore,

looking to today King Abdullah Financial City, Riyadh Financial City on Qassim Road and the

new rules in Tadawul Stock Index shows the focus of the King and the government for the

growth of the financial sector to the economy. Our recommendation to the Saudi Government is

to avoid big steps and to make stricter step by step and stable growth for the sector in compliance

with the Sharia rules and regulations.

Moreover, so that Saudi Arabia can avoid competition with neighboring countries, to focus on

new features and new tools for new potential Islamic investors. There is also a need for


motivation in the Islamic financial society to search for how to be unique and to invent new

tools, instrument and features that will add value to our financial center. For Example, adding

derivatives to Islamic finance to attract new investors and specially Muslims who are avoiding

conversion investments.

There is also a need for a futures market which has standardized contracts, with the amount

quantity of good specified, color specified, quality specified and with regards to the goods

complied with the Islamic rules and regulation. This will attract more and more investor not only

from Saudi Arabia but also all around the world to invest in the potential Saudi Futures Market

Exchange.

We know that most participants in the future market are hedgers, who always look for the zero

risk investment that does not exist in the real life. Furthermore, the need for the Islamic investor

is very important which can make the Saudi Arabia the world leader in Islamic Finance and the

attract hedgers. Starting with certain Islamic derivatives with consensus as starting point can be a

good set up, where the Saudi government can be the first country that provides tools for all

interested investors in Islamic derivatives in the region.

Derivatives are a very risky financial instrument in general and it is said to be the main reason

for having the financial meltdown in the United States and the rest of the other world. However,

in implementing derivatives in Islamic finance can reduce the risk to a large extent, yet it still

needs to be coordinated by Islamic committee in Saudi Arabia along with recommendations from

Islamic banks. In addition, there must be a maximum limit between individual traders and a limit

for the daily transaction to achieve the quartile target or limit in the year that is decided by the

financial analyst and the policies defined by the potential organized exchanges‟ in Saudi Arabia.


Given the advantages incurred by hedging and arbitraging, and the benefits which consumers and

producers will obtain from such activities; we believe that Islamic finance scholars and scientist

should approach options on the basis of "Maslaha Morsala"; this is so, because there are no clear

texts which forbid or allow such financial tools. This proposed Islamic option solutions will not

be similar to any contemporary option, in that it will not allow speculation "Ghirar", and there

will be a physically existing underlying asset in order for these activities to not be considered

"Maisir". Any Islamic option should have its price directly connected to the underlying asset,

and some scholars say that it should have a maturity date of three days or less based on the

concept of "options of stipulation".


7. CONCLUSION

The overall image of Ulema, for conventional derivative instruments appears to be in doubt and

suspicion. That these instruments and contracts could easily be used for speculation as it appears

to be the key reason for objection. That derivatives form the basis of risk-management appears to

have been lost. The problem is that the analysis has always been from a purely juridical

viewpoint. And like most juristic analysis and evaluation, have relied on precedence? However,

there is no precedence or any equivalence for the kind of risk-management problems faced

today. When extrapolating/inferring: the template may be wrong. 48

The object of juridical evaluation appears to be a micro examination of each and every feature of

a derivative instrument to see if it passes a subjective rather than objective religious filter. Apart

from individual interpretation, the differing opinion among mazhabs / imams (sects or schools in

Islamic religion) further complicates the situation further. Thus, for example an options contract

may be found objectionable for exactly opposite reasons. While some mazhabs like the Hanbalis

(primarily Saudi Arabia) have been broader in their acceptance, the Shafi‟ and Hanafis have been

less so. The Hanbalis in Saudi Arabia for example are somewhat liberal when it comes to Option

of stipulation (Khiyar-al-Shart). 49

The Hanbalis in Saudi Arabia, also hold that stipulations that remove a hardship, fulfills a

legitimate need, provide a benefit or convenience, or facilitate the smooth flow of commercial

48 Obiyathulla. (ND). Derivatives in Islamic Finance – an overview. International Islamic

University, Malaysia. Power point Presentation. 49

Obiyathulla. (ND). Derivatives in Islamic Finance – an overview. International Islamic

University, Malaysia. Power point Presentation.


transactions are generally valid as a matter of principle. Clear understanding is need for a more

coordinated evaluation; need based rather than purely juristic/precedent driven. The solutions

given in this research paper are just a probable solutions to be further researched in a more

scientific and Islamic manner at the same time for potential Islamic financial engineering.


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Islamic Financial Market. The world Islamic Banking. Research Paper.

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erivatives&source=bl&ots=3HKvu1ZY8t&sig=hE74cQObNq2566a340xyi_lcBoA&hl=e

n&ei=YAgnTdKrN4qYnwfT2IGNAQ&sa=X&oi=book_result&ct=result&resnum=7&v

ed=0CEEQ6AEwBjgK&safe=active#v=onepage&q&f=false

http://www.tradersedgeindia.com/beginners_guide_options.htm


http://finance.alislam.pk/Istijrar.aspx


http://www.financialislam.com/salam.html

http://ezinearticles.com/?What-Is-Murabaha-Financing&id=476110

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6g4Qa_3tS2Cg&sa=X&oi=book_result&ct=result&resnum=1&ved=0CBIQ6AEwAA#v=onepage&q

=istijrar%20parallel&f=false

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Islamic University Malaysia.

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Trade and Chicago Mercantile exchange (CME Group). Retrieved on 20th

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derivatives.html

22. Obiyathulla. (ND). Derivatives in Islamic Finance – an overview. International Islamic

University, Malaysia. Power point Presentation.

23. Qazi Irfan. (2008). Murabaha Financing vs. Lending on Interest. A thin line in making a

big difference in understanding of Riba Retrieved on 1st January, 2011 from

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AuthorHouse. Book

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Academy for Islamic Finance. Research Paper

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Retrieved on 5th

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http://www.hazariba.com/Murabaha_Financing_VS_Lending_on_Interest.pdf

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http://en.wikipedia.org/wiki/File:Total_world_wealth_vs_total_world_derivatives_1998-2007.gif#filelinks


9. INDEX: GLOSSARY OF TERMS

1. Al-Muamalat (Islamic rules on transactions): the transactions that is used in the

Islamic finance and they represented in fiqh al muamalat which is presents a framework

for conduct in the civil arena. It deals in part with economic functions in an Islamic

society but not comprehensively with factors impacting upon economic behavior since it

is concerned solely with legal relationships between members of the society. Under

muamalat, any action that is not specifically or generally described as prohibited or

haram automatically becomes permissible or halal.

2. Arbitragers: A type of investor who attempts to profit from price inefficiencies in the

market by making simultaneous trades that offset each other and capturing risk-free

profits.

3. BM&F (San Paulo, Brazil): The BM&FBOVESPA (; in full, Bolsa de Valores,

Mercadorias & Futuros de São Paulo) is a São Paulo-based stock and futures exchange. It

is the fourth largest exchange in the Americas in terms of market capitalization, behind

the New York Stock Exchange, NASDAQ, and Toronto Stock Exchange.

4. Bond Forward Agreements: forward contracts on zero coupon bonds are typically

treasury bills contract where the buyer of the contract agrees to buy a treasury bill at a

future date and at a price agreed to today.

5. Call options: financial contract between two parties, the buyer and the seller of this type

of option. It is the option to buy shares of stock at a specified time in the future. Often it

is simply labeled a "call."

6. Cash settlement: some contract are settled for cash on the day the contract expires, the

loss realized by one party to the contract is paid, in cash, to the other party to the contract

becoming that party‟s realized gain. Most financial derivatives use cash settlements.

7. Chicago Board of Trade (CBOT): The Chicago Board of Trade (CBOT), established in

1848, is the world's oldest futures and options exchange. More than 50 different options

and futures contracts are traded by over 3,600 CBOT members through open outcry and e

Trading.

8. Clearing house: act as the counterparty for each side of the trade. Also, enforces margin

requirements to ensure that market participants honor their commitments.

9. Commodity Forward Agreements: a forward market where commodities like gold,

silver, wheat, livestock are exchanged for a future date and future prices by seller and

buyer usually for hedging and arbitrage purpose and at times for speculation.


10. Contract size: The actual amount of a commodity represented in a contract.

11. Daily settlements: the clearing house requires daily settlements of all gains and losses.

12. Default risk: The possibility that a bond issuer will default, by failing to repay principal

and interest in a timely manner. Bonds issued by the federal government, for the most

part, are immune from default (if the government needs money it can just print more).

Bonds issued by corporations are more likely to be defaulted on, since companies often

go bankrupt. Municipalities occasionally default as well, although it is much less

common. Also called credit risk.

13. Delivery of underlying asset: delivery is making (taking) possession of the physical

asset underlying the contract according to the terms and conditions specified by the

contract.

14. Delivery price: the price that is agreed on today in case of buying or selling contracts.

15. Derivatives: Is sort of a hypothetical and synthetic financial instrument where the value

is based on some other asset classes such as index, commodity, bond and other similar

assets.

16. Equity Forward Agreements: an equity forward contract is an agreement to buy or sell

and individual stock, a stock portfolio, or a stock index at an agreed price at some point

in the future.

17. Eurex (Europe): Eurex is the world's largest futures and options exchange, providing

European benchmark derivatives featuring open and low-cost electronic access globally.

18. Exchange (LIFFE ,pronounced 'life'): is a futures exchange based in London. LIFFE is

now part of NYSE Euro next following its takeover by Euro next in January 2002 and

Euro next‟s merger with New York Stock Exchange in April 2007.

19. Exchange market: A physical or virtual facility where the exchange of goods, services ,

information, and payment is conducted (For purposes of this project ,distribution

infrastructures are considered virtual exchange markets.

20. Exchange traded: derivatives trades on an organized and regulated exchange (e.g. a

futures exchange or an options exchange)

21. Face value: The nominal value or dollar value of a security stated by the issuer. For

stocks, it is the original cost of the stock shown on the certificate. For bonds, it is the

amount paid to the holder at maturity (generally $1,000). Also known as "par value" or

simply "par".

22. Forward contract: It is a non standardized contract, which occurs between two parties

(buyer and seller) on a trading (underlying) asset, at a known forward time and at a price

that is agreed on it today.

http://www.investorwords.com/521/bond.html

http://www.investorwords.com/2654/issuer.html

http://www.investorwords.com/1350/default.html

http://www.investorwords.com/7199/repay.html

http://www.investorwords.com/3839/principal.html

http://www.businessdictionary.com/definition/and-interest.html

http://www.businessdictionary.com/definition/Federal-Government.html

http://www.businessdictionary.com/definition/government.html

http://www.businessdictionary.com/definition/need.html

http://www.investorwords.com/3100/money.html

http://www.investorwords.com/8191/print.html

http://www.investorwords.com/1140/corporation.html

http://www.investorwords.com/9376/cut_down_on.html

http://www.investorwords.com/992/company.html

http://www.investorwords.com/415/bankrupt.html

http://www.businessdictionary.com/definition/municipality.html

http://www.investorwords.com/10174/less.html

http://www.businessdictionary.com/definition/common.html

http://www.investorwords.com/1210/credit_risk.html

http://www.investopedia.com/terms/f/facevalue.asp


23. Fluctuations: move or sway in a rising and falling or wavelike pattern; "the line on the

monitor vacillated.

24. Future contracts: are standardized contracts, where there is an agreement between two

parties to buy or sell as assets at a certain time in the future for a certain price in a market

place.

25. Gharar (unnecessary): It has been taken to mean, unnecessary risk, deception or

intentionally induced uncertainty. In the context of financial transactions, gharar could be

thought of as looseness of the underlying contract such that one or both parties are

uncertain about possible outcomes.

26. Halal (acceptable): are the things that are accepted to practice, have, eat, or apply in

Muslims life according to the Islamic Law.

27. Hanafis: The Hanafi (Arabic ( الحنفي school is one of the four Madhhab (schools of law)

in jurisprudence (Fiqh) within Sunni Islam. (The other three schools of thought are

Shafi'i, Maliki, and Hanbal.

28. Hanbilies: Hanbali ( حنبلى ) is one of the four schools (Madh'habs (rites) of Fiqh or

religious law within Sunni Islam (the other three being Hanafi, Maliki and Shafi`i). The

jurisprudence school was started by the students of Imam Ahmad bin Hanbal (d. 855... .)

29. Haram (Prohibited): The things that are prohibited in Islam according to the source of

Islamic laws.

30. Hedgers: are the people who making an investment to reduce the risk of adverse price

movements in an asset. Normally, a hedge consists of taking an offsetting position in a

related security.

31. Hibah (Gift): This is a token given voluntarily by a debtor to a creditor in return for a

loan. Hibah usually arises in practice when Islamic banks voluntarily pay their customers

a 'gift' on savings account balances, representing a portion of the profit made by using

those savings account balances in other activities.

32. Ijarah (Hire purchase): means lease, rent or wage. Generally, Ijarah concept means

selling the benefit of use or service for a fixed price or wage. Under this concept, the

Bank makes available to the customer the use of service of assets / equipments such as

plant, office automation, motor vehicle for a fixed period and price.

33. Initial Margin: is an amount of money that traders must deposit with their brokers

before executing a future transaction.

http://www.investopedia.com/terms/h/hedge.asp


34. Islamic finance: is a way by which financial and business transactions are carried out

with reference to the principals of Islamic Law – Sharia.

35. Istijrar: They involve two parties: the buyer, which is usually a company seeking

financing to purchase an underlying asset, and a financial institution. The financial

institution buys the commodity at the existing price and resells it to the company at a

price to be paid at a specified date in the future.

36. Istisna: is sail contract between the ultimate buyer (Al Mostasni) and the seller (Sani),

whereby the seller based on an order from the ultimate buyer undertakes to have the

manufactured or otherwise acquired product (Al Masnoo).

37. Jahl (ignorance): refers to ignorance. From a financial transaction viewpoint, it would

be unacceptable if one party to the transaction gains because of the other party‟s

ignorance.

38. Khiyar-al-Shart: A right, stipulated by one or both of the parties to a contract, to cancel

the contract for any reason for a fixed period of time.

39. Leverage: An investor can gain leverage in a stock without committing to a trade.

40. LIFFE (London): The London International Financial Futures and Options.

41. Liquidity: The degree to which an asset or security can be bought or sold in the market

without affecting the asset's price. Liquidity is characterized by a high level of trading

activity. Or is the ability to convert an asset to cash quickly. Also known as

"marketability".

42. Long position: is the buy position where it is assumed that a contract will be purchased

for the value of certain assets for a certain price at a forward date.

43. Maintenance margin: is the minimum level below which the margin account is not

permitted to fall without a margin call. If the value of the margin account falls below the

maintains margin, the trader will receive a margin call (a notice from the clearing house)

to deposit additional funds or securities in his or her margin account.

44. Margin: is cash or marketable securities deposited by an investor with his or her broker.

45. Maturity: is the time period of settlement or expiration of an agreement which describes

when the contract must be full field. Settlement price is the price just before the final bell

each day.

46. Maysir (gambling): a financial instrument viewpoint would be one where the outcome is

purely dependent on chance alone – as in gambling.

47. Mudharabah (Profit Sharing): is a special kind of partnership where one partner gives

money to another for investing it in a commercial enterprise. The investment comes from

http://www.investopedia.com/terms/l/liquidity.asp


the first partner who is called "rabb-ul-mal", while the management and work is an

exclusive responsibility of the other, who is called "mudarib"

48. Murabaha (Cost plus): Murabaha is the sale of commodity at the price that seller has

purchased it, with the addition of stated profit known to both the seller and the buyer. It is

the cost-plus-profit sale in which the seller expressly discloses the profit. It is based on

trust (Amanah).

49. Musharakah (Joint venture): is an agreement between two or more partners, whereby

each partner provides funds to be used in a venture. Profits made are shared between the

partners according to the invested capital. In case of loss, each partner loses capital in the

same ratio. If the Bank provides capital, the same conditions apply.

50. Offsetting transaction: a party can effectively close out a contract position buy entering

into a reverse position in another contract with the same underlying asset, settlement date,

and contract size as the contract that is being closed out.

51. OIC fiqh: organization of Islamic council.

52. Open interest: When one party buy and counterparty sell a contract, these are viewed as

the two sides of one complete contract thus, every long/short position per constitutes one

unit of contract volume.

53. Open outcry: means that bids and offers must be publicly disclosed to all market

participants.

54. Option: is a derivative financial instrument that establishes a contract between two

parties concerning the right - and not the obligation - of the buying (call options) or

selling (put options) of an asset at a reference price during a specified time frame.

55. Ordinary Istina: this is the common type of Istina whereby an agreement between the

buyer and manufacturer is concluded based on agreed specification and time of delivery

in the future.

56. Over the counter (OTC): meaning the trading is done through a network that is linked

with the dealer markets.

57. Parallel Istisna: is a contract of two independent contract agreements but inter-related.

58. Pay off: in such contract is known as sub zero game in which either the buyer or the

seller is gaining or loosing.

59. Premiums: the amount that something in scarce supply is valued above its nominal

value. Or is payment for insurance.


60. Profit margin: A ratio of profitability calculated as net income divided by revenues, or

net profits divided by sales. It measures how much out of every dollar of sales a company

actually keeps in earnings.

61. Put options: is a financial contract between two parties, the writer (seller) and the buyer

of the option. The buyer acquires a short position with the right, but not the obligation, to

sell the underlying instrument at an agreed-upon price (the strike price.

62. Qard (Interest-free loan): This is a loan extended on a goodwill basis, and the debtor is

only required to repay the amount borrowed. However, the debtor may, at his or her

discretion, pay an extra amount beyond the principal amount of the loan (without

promising it) as a token of appreciation to the creditor

63. Quran: the sacred writings of Islam revealed by Allah to the prophet Muhammad during

his life at Mecca and Medina.

64. Riba (interest): which includes the payment and receipt of interest as understood in

today‟s financial markets

65. Salam or (Salaf): defined as the sale or purchase of a deferred commodity in exchange

for price paid on the spot. In Salam contract, the price is paid in advanced while the

commodity is deferred in future date.

66. Scarce resources: A resource with an available quantity less than its desired use. Scarce

resources are also called factors of production.

67. Settlement date: Settlement Date is a securities industry term describing the date on

which a trade (bonds, equities, foreign exchange, commodities etc) s. That is, the actual

day on which transfer of cash or assets is completed.

68. Shafi: The Shāfi„ī madhhab ( شافعي) is one of the four schools of fiqh, or religious law,

within Sunni Islam. The Shāfi„ī school of fiqh is named after Imām ash-Shāfi„ī. The other

three schools of law are Hanafi, Maliki and Hanbali.

69. Sharia Laws: the Muslims law, the custom-based body of law based on the Koran and

the Sunah of the prophet Mohammed and the scholars of Islam.

70. Sharia scholars (ijma’): the scholar in Islam who responsible for judgment regarding to

any issue based on the Islamic Law.

71. Short position: the seller is assuming to sell a certain assets for a certain price at forward

date.

72. Speculators: A person who trades derivatives, commodities, bonds, equities or

currencies with a higher-than-average risk in return for a higher-than-average. Profit

http://www.investopedia.com/terms/p/profitmargin.asp

http://www.investopedia.com/terms/s/speculator.asp


73. potential: Speculators take large risks, especially with respect to anticipating future price

movements, in the hope of making quick, large gains.

74. Sukuk (Islamic Bonds): is the Arabic name for financial certificates that are the Islamic

equivalent of bonds. However, fixed-income, interest-bearing bonds are not permissible

in Islam. Hence, Sukuk are securities that comply with the Islamic law (Sharia) and its

investment principles, which prohibit the charging or paying of interest. Financial assets

that comply with the Islamic law can be classified in accordance with their tradability and

non-tradability in the secondary markets.

75. Sunnah: The way of life prescribed as normative in Islam, based on the teachings and

practices of Muhammad and on exegesis of the Koran. Also called hadith

76. Tadawul Stock Index: Saudi Stock Exchange ( السوق المالية السعودية) or Tadawul ( تداول) is

the only stock exchange in Saudi Arabia. It is supervised by the Capital Market Authority

(Saudi Arabia). The Tadawul All-Share Index (TASI) reached its highest point at

68,236,02 on 25 February 2006.

77. Tawarruq: in Islamic law is a particular way to be used in order to obtain liquidity

needed without getting involved in borrowing on interest.

78. Treasury bills: A short-term debt obligation backed by the U.S. government with a

maturity of less than one year. T-bills are sold in denominations of $1,000 up to a

maximum purchase of $5 million and commonly have maturities of one month (four

weeks), three months (13 weeks) or six months (26 weeks).

79. Underlying assets: 1- The physical and financial asset to which a security holder or a

class of security holders has a claim. An analyst may believe that a stock is underpriced

on the basis of the value of the firm's underlying assets and the potential earning power of

those assets. Or the asset that underlies and gives value to a security. The underlying

asset of a stock option is the stock that the option can be used to purchase.

80. Unilateral: relating to, occurring on, or involving one side only: unilateral development;

a unilateral approach.

81. Urbon: is a deposit given to the seller with a condition that if the contract is continued it

will be counted in as part of the purchase price, or otherwise it will be for fitted by the

seller.

82. Wa'ad: is a promise or undertaking. It is unbinding and has no value; however, in certain

circumstances a promise will be valuable and binding.

83. Wadiah (Safekeeping): a bank is deemed as a keeper and trustee of funds. A person

deposits funds in the bank and the bank guarantees refund of the entire amount of the

deposit, or any part of the outstanding amount, when the depositor demands it.


84. Wakalah (Agency): This occurs when a person appoints a representative to undertake

transactions on his/her behalf, similar to a power of attorney.

http://encyclopedia.thefreedictionary.com/Power+of+attorney


Islamic Derivatives In Saudi Arabia

All rights reserved by Al-Yamamah University 2011-2012

Summary

Surah Al Nesaa: (Quran 4.29) (YUSUFALI: O ye who believe! Eat not up your property among yourselves in vanities: But let there be

amongst you Traffic and trade by mutual good-will: Nor kill (or destroy) yourselves: for verily Allah hath been to you Most Merciful!)

This book is a product of five senior students from Al-Yamamah University. It provides information about Islamic Derivatives in Finance. This research mainly discusses Islamic

finance and derivatives -in brief-, it also touches upon the probable solution for the integration of financially engineered Islamic Derivatives in the Kingdom of Saudi

Arabia’s economy. This research –also- illustrates the reasons behind forbidding some contemporary derivatives in Islam and what other Islamic financial instruments can be used as alternatives to conventional contemporary derivatives. In addition, this book

contains the writers’ recommendations to Saudi Arabia's economy and to Islamic banks to -further- strengthen this sector in the Kingdom of Saudi Arabia. We are trying to

convey our message to the financial community in Saudi Arabia -as well as the rest of the world-So that the application of derivatives is exercised properly and in an efficient

manner, an application which is in compliant with the rules and regulations set by Sharia or Islamic Law.

final draft pdf 2nd revised

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