Principles of Islamic banking and finance/PIBF203/Hedging and derivatives/Islamic instruments with derivatives like features

Islamic Financial Instruments with Features of Derivatives

A number of instruments /contracts exist in Islamic finance that could be considered a basis for derivative contracts within an Islamic framework. In their section we examine tWo such contracts. These are (i) the Bai Salam Contract, and (ii) the Istijrar Contract. While the Bai Salam contract has provisions and precedence, the Istijrar is a recent innovation practiced in Pakistan.

Bai Salam

Salam is essentially a transaction where two parties agree to carry out a sale/purchase of an underlying asset at a predetermined future date but at a price determined and fully paid for today. The seller agrees to deliver the asset in the agreed quantity and quality to the buyer at the predetermined future date. This is similar to the conventional futures contract. However the big difference is that in a Salam sale the buyer pays the entire amount in full at the time the contract is initiated. The contract also stipulates that the payment must be in cash form. The idea behind such a 'prepayment' requirement has to do with the fact that the objective in a Bai Salam contract is to help needy farmers and small businesses with working capital financing.

The buyer in a contract therefore is often an Islamic financial institution. Since there is full prepayment, a Salam sale is clearly beneficial to the seller. As such the predetermined price is normally lower than the prevailing spot price. This price behavior is certainly different from that of conventional futures contracts where the futures prices is typically higher than the spot price by the amount of the carrying cost. The lower Salam price compared to spot is the "compensation" by the seller to the buyer for the privilege given to him.

The Bai Salam contract is subject to several conditions, of these the important ones are as follows;

(i) Full payment by buyer at the time of effecting sale.

(ii) The underlying asset must be standardizable, easily quantifiable and of determinate quality.

(iii) Salam contract cannot be based on a uniquely identified underlying asset. This means the underlying commoditycannot be based on commodity from a particular farm/field etc. By definition such an underlying asset would not be standardizable.

(iv) Quantity, quality, maturity date and place of delivery must be clearly enumerated in the Salam agreement.

(v) The underlying asset or commodity must be available and traded in the markets through the period of contract. Given our earlier description of futures contracts it should be clear that current exchange traded futures would conform to these conditions with the exception of the first, which requires full advance payment by the buyer.

However, given the customized nature of Bai Salam, it would more closely resemble forwards rather that futures. Thus some of the problems of forwards; namely, double-coincidence, negotiated price and counterparty risk can exist in the Salam sale. Counterparty risk however would be one sided, in that, since the buyer has fully paid it is only the buyer who faces the sellers default risk and not both ways as in forwards/futures. In order to overcome the potential for default on the part of the seller, the Shariah allows for the buyer to require security which may be in the form of a guarantee or mortgage .

The contract could also form the basis for the provision of working capital financing by Islamic financial institutions. Since financial institutions would not want possession of the underlying commodity, parallel contracts may be used. Though not all jurist are in agreement about its permissibility, the literature cites two avenues for parallel Salam.

The first is a parallel Salam with the original seller while the other is an offsetting transacting by the financial institutions with a third party. In the first alternative the financial institutions after entering into the original contract, gets into a parallel Salam to sell the underlying commodity after a time lapse for the same maturity date to the original seller. The resale price would be higher and considered justifiable since there has been a time lapse. The difference between the two prices would constitute the bank's profit. The shorter the time left to maturity, the higher would be the price.

However, the requirement is that both transactions should be independent of each other. The original transaction should not have been priced with the intention to do a subsequent parallel Salam. Under the second alternative, the bank which had gone into an original contract enters into a contract promising to sell the commodity to the third party on the maturity date of that contract. Since this second transaction is not a contract the bank does not receive advance payment.

The Istijrar Contract

The istijrar contract is a recently introduced Islamic financing instrument. Introduced in Pakistan, the contract has embedded options that could be triggered if the underlying asset's price exceeds certain bounds. The contract is complex in that it constituted a combination of options, average prices and Muharabah or cost plus financing. The Istijrar involves two parties, buyer which could be a company seeking financing to purchase the underlying asset and a financial institution.

A typical istijrar transaction could be as follows: a company seeking short term working capital to finance the purchase of a commodity like a needed raw material approaches a bank. The bank purchases the commodity at a current price (P0), and resells it to the company for payment to be made at a mutually agreed upon date in the future -for example in 3 months. The price at which settlement occurs on maturity is contingent on the underlying assets' price movement from t0 to t90' where t0 is the day the contract was initiated and t90 is the 90th day which would be the maturity day.

Unlike a Murabaha contract where the settlement price would simply be a predetermined price; P* where P* P0 (I + r), with 'r' being the bank's required return learning, the price at which the istijrar is settled on maturity date could either be P* or an average price (P) of the commodity between the period t0 to t90. As to which of the two prices will be used for settlement will depend on how prices have behaved and which party chooses to 'fix' the settlement price. The embedded option is the right to chooses to fix the price at which settlement will Occur at anytime before contract maturity. At the initiation of the contract; t0 both parties agree on the following two items

(i) in the predetermined Murabahah price; P* and

(ii) an upper and lower bound around the P0. (bank's purchase price at t0). For better elucidation, the different prices are shown below in a continuum as one goes to the right. Prices increase as one goes to the right.

PLB ----P0------P* -----------PUB

Where P0 = The price that bank pays to purchase underlying commodity.

P* = Murabaha price; P* = P0 (l+r)

PLB = The Lower bound price PUB = The upper bound price

The settlement price (PS) at t90 would be;

(i) PS = P; if the underlying asset price remained within the bounds. or

(ii) PS = P*; if the underlying asset exceeds the bounds and one of the parties chooses to exercise its options and use P* as the price at which to settle at maturity.

For either party to exercise its option and thereby the settlement price at P*, the spot price during the term of the contract must have exceeded the bounds at any time. As to which party would exercise would of course depend on the direction of the spot price movement. For example, if the spot price at anytime breaks through the upper bound the buyer would get worried. But whether he will exercise or not would depend on his expectations of the spot price over the remaining period of the contract. If he believes that the price is likely to keep increasing thereby causing p at which settlement will occur to be greater than P*, it will be in his interest to 'exercise' by fixing the settlement price now at P*. Essentially, he would notify the bank that he is exercising his option and that the settlement would be P*. Should spot prices be falling such that it breaks the lower bound, the seller. in this case the bank would have the option to fix the settlement price at P*. The settlement price is determined as follows:

If Pt is < lower bound, bank exercises PS = P*

If lower bound is < or = to Pt and Pt is > or = upper bound, then PS = P.

If Pt < upper bound, Buyer Exercises : PS = P*

Where PS = Settlement price at maturity P = Average price P0 to P90 Pt = Spot price of underlying commodity of day t P* = The predetermined, cost -plus or Mudarabah price

Analyzing the istijrar contract entirely from an options viewpoint is complicated since it has two different exercise styles rolled in one. Such an instrument would be highly unusual in conventional finance. Still for our prupose here, the embedded options in the Istijrar can simply be thought of as follows. The fact that buyer get to fix the buying price at P* when the price goes higher implies that he has a call option at an exercise price of P* while the bank a put option at the same exercise price.(19)

What the istijrar contract attempts to do is to allow for the impact for price changes but to cap the benefits that accrue, as a result. By definition, since changes are allowed only within a band, the advantage to one party and the disadvantage to the other is capped. The maximum potential gain or loss is limited. Such a contract fulfills the need to avoid a fixed return on risk less asset which would be considered riba and also avoids gharar in that both parties know up front, p* and the range of other possible prices. (by definition between the upper and lower bounds).