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Hedging
in
Islamic Finance
Sami Al-SuwailemSafar 1427 - March 2006
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Objectives
Explore dimensions of risk
Develop criteria for acceptable risks
Outline strategy for product design
Derive Islamic instruments for hedging
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State of Risk
Markets are becoming more volatile
Economic instabilities are rising
Solutions?
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Dow Jones
0
50
100
150
200
250
300
02/01/1990 02/01/1993 02/01/1996 02/01/1999 02/01/2002 02/01/2005
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Commodities
0
20
40
60
80
100
120
140
160
Dece
mber-91
July-93 January-
95
July-96 January-
98
July-99 January-
01
July-02 January-
04
July-05
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Currencies: USD
0
20
40
60
80
100
120
140
160
180
29/12/1989 29/12/1992 29/12/1995 29/12/1998 29/12/2001 29/12/2004
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Rising Instabilities
1990-1994 2000-2004
mean median mean median
DJ 38.6 27 159.4 199
S&P 500 52.1 36 156 176
FTSE 53.9 57 158.9 174
Commodities 57 52 123 124
USD 106.5 100.5 134.4 138
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Experts Views
Bernstein (1996): Volatilities seems to be proliferating rather than
diminishing.
Krugman (1999): The world economy has turned out to be a much
dangerous place than we imagined.
Tumpel-Gugerell (2003): Volatility of leading stock markets has doubled
since 1997. Financial volatility is transmuted into
volatility of real output.
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Derivatives
Exponential growth
Controversial impact
Questionable validity
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0
50,000
100,000
150,000
200,000
250,000
300,000
350,000
Jun-98 Dec.
1998
Jun-99 Dec.
1999
Jun-00 Dec.
2000
Jun-01 Dec.
2001
Jun-02 Dec.
2002
Jun-03 Dec.
2003
Jun-04 Dec.
2004
Jun-05
OTC OE
Size of Derivatives
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Structure of Derivatives
Zero-sum games
Separate risk from ownership
Allow hedging only through speculation
Dominated by speculators
Threaten system stability
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Risk Dilemma
Economic activities always involve risk
Excessive risk hurdles performance
Pure risk trading transforms into
wagering
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Unresolved Issues
Ken Arrow (2003): Derivatives can be used to reduce risk but
people gamble on them.
Speculators are adding to the swings ratherthan reducing them.
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Unresolved Issues
Kreitner (2000): No analytical formula could distinguish
gambling from risk allocation.
The question of gambling was eventuallyswallowed and internalized, as if the
problem were solved.
The contract law stopped worrying and
learned to love risk.
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The Challenge
How to have hedging withoutunproductive speculation?
How to distinguish legitimate risk
taking from gambling?Where to draw the line?
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Islamic Framework
Acceptable risk (ex ante): Minor, likelihood of success is high
Inevitable, inseparable from real activities
Payoff structure (ex post): Non-zero-sum-game
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Statistical Measure
Expected utility is a statistical mean
Allows for gambling
Statistical median:
Excludes low probability events
Immune to outliers
Consistent with Islamic concept ofgharar
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Payoff Structure
Zero-sum games: conflict of interest
Positive sum games: cooperative
Non-zero-sum games: mixed
Mixed games are acceptable if the
positive outcome is dominant
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Zero-sum Games
(+ )( +)
(A, B)
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Positive Games
(+ , +)( ,)
(A, B)
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Mixed Games
(+ +)( +)
(A, B)
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Product Design
Mixed games allow risk transfer withwin-win outcome
Combine best of both worlds
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Islamic Product Development
Strategies for product development
Imitation dilutes values
Islamic finance becomes a follower
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Hedging Instruments
Instrument Risks HedgedAsset-Liability alignment General
Delta-hedging General
Mutual hedging General
Bilateral mutual adjustment Rate of return
Conditional mudharabah Capital, misreporting
Combining musharakah and
deferred sale
Capital, rate of return
Third party hedging Capital, rate of return
Diversified deferred price Capital, rate of return, liquidity
Value-based hybridsalam Capital, rate of return, liquidity
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Natural Hedge
Align costs and revenuesShift some operations to the same
region
Borrow in the same currency
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Cooperative Hedge
Non-profit arrangementsNo legal guarantee
Risk is shared by members
Suite all kinds of risks
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Bilateral Adjustment
Murabaha cannot have a changing rateAdjust installment but keep total debt
fixed
If market rate is up: increase installment,reduce balance
If market rate is down: reduce installment,
increase balance
Done with mutual agreement
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Diversified Deferred Price
Also formurabahaHave the price in two components:
Principal: in money
Markup: in liquid assets
Allow return to adjust to market
If markup is large, total price becomes
tradable
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Parallel Murabaha
Replaces currency forwardsIntegrates currency hedge with goods
traded
Murabaha can be for financing or forhedging
Integrates risk transfer with value-
creation
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Conclusion
Strategies for product developmentVision for the value of the industry
Capitalize on Islamic principles
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