Hedging Market Risk in Islamic Finance

Hedging Market Risk in Islamic Finance

Kazi Hussain is the Head of Islamic Finance, Europe Arab Bank plc, and Fahad Mehboob is Associate Director of Islamic Finance at Europe Arab Bank plc

he purpose of this article is to give the reader an understanding behind a few of the Islamic structures designed for risk management and hedging, including structures that have been developed within a Shariah framework to create the economic effects of conventional hedging tools. Thus we will consider the underlying structures of a profit rate swap and an Islamic FX swap, equivalent to (in conventional finance) an interest rate swap and an FX swap respectively. Islamic financing techniques Islamic Finance is based on the fundamental tenets derived from the Holy Qur’an and the Prophet Muhammad’s traditions, the Sunnah. These tenets are embedded in what is defined as the Shariah – a framework of Islamic law. The Shariah is as clear with regards to personal law as it is with regards to economic and commercial transactions. There are four distinct prohibitions when it comes to the jurisprudence of Shariah law in regards to commercial transactions, namely the prohibitions on: (i) receipt and payment of interest (riba); (ii) uncertainty (gharar); (iii) specific forbidden activities (haram); (iv) gambling/speculation (maysir). Given the specific injunctions listed above, the Shariah has been used to develop certain structures involving commercial contracts acceptable in Islam. The complexity of a specific Islamic transaction will be dependent on how many types of these contracts are structured so as to achieve a certain economic/commercial outcome. There are a few basic structures which have lent themselves to the foundations of modern Islamic financing techniques. These forms of Shariah contract can be divided into three main types: • contracts of sale (eg, murabaha, istisna’a, salam); • contracts of lease (ijara); and • joint enterprise arrangements (eg, musharaka, mudaraba),...