is experiencing an impressive and rapid growth as a part of the global
financial sector. According to the Ernst and Young World Islamic Banking
Competitiveness Report (2016)
there are more than 700 Islamic financial institutions all around the world
with an estimated assets worth of US$1.2 trillion in more than 85 countries. The
Islamic financial industry is growing at a rate of 15-20 percent a year and
could serve roughly 50 percent of the global Muslim population within this
The growth of
the Islamic financial industry has led to an increase in Muslim involvement in
the international trade and global financial playground. This increase in international investments,
international trading, and international service activities has exposed the
Islamic financial industry to higher levels of risk mainly pertaining to the movements
of foreign currencies. Conventional tools are available to mitigate such
foreign currency risks, but their use is rather limited due to their
incompatibility with Sharia, the guiding tenets of Islamic law. Thus, it is
important for the Islamic financial industry to devise and offer alternatives
to meet the risk management needs of modern Muslim consumers.
are now more aware of the increasing need for hedging as a risk mitigating tool
(Mohamad, Othman, Roslin, Lehner, & Alam, 2014).
This, together with the rapid development of Islamic finance and the complexity
of navigating a global economic landscape has given birth to a good deal of Sharia-compliant
hedging instruments. The objectives of this paper are thus: firstly, to lay out
the concept of risk and hedging in Islamic finance; secondly, to identify the
types of hedging instruments available.
Concept of Risk in Islam
Islamic finance, the word mukhatarah
is commonly used to refer to risk. The word mukhatarah itself is derived from the
Arabic root word ‘khatar’, which can
have several meanings such as ‘exposure and fear or destruct’ or ‘an exalted
position’ (Dusuki, 2012). According
to the Islamic Corporation for the Development of the Private
Sector (ICD) (2016)
there are several technical meanings
of mukhatarah or risk in Islam as
defined by Islamic scholars—two of them as pertaining to finance are gharar (uncertainty) and maysir (gambling). Although several scholars took risk to mean gharar and maysir exclusively, not all risks are prohibited in Islam (Oubdi & Raghibi, 2017).
Some risks are unavoidable, even necessary, and are a natural part of trade and
to Islamic scholar Ibn Taimiyyah, there is no Sharia
evidence to support the assumption that all forms of risk are forbidden, and
that “…in fact, Allah and His Messenger do not prohibit all types of risks, or
all activities which are doubtful in terms of whether it is profitable or unprofitable
or safe (neither profitable nor unprofitable)….Instead, the type of risk which
is prohibited concerns the consumption of property in an unjust or wrongful
manner. The main reason for prohibition from the Sharia viewpoint is mainly due
to the unjust consumption of property even without the element of risk. Risk alone
does not constitute prohibition….” There is also the view offered by Ibrahim & Suwailem (2015) that risk is acceptable for as long as the risk follows economic
activities and generate returns, rather than risk that is unprofitable and
detrimental to economic activities.
According to Dusuki (2012) risk in general can be divided into three types, namely:
Permissible risk is risk that arises out of real economic
activities that are done in the effort to obtain profit or to generate returns.
In other words, without taking this risk, the return is nonexistent because the
return earned is a result of the risk taken. Permissible risk is inevitable and
must be borne as part of Sharia contracts and transactions. This is based on
the Islamic legal maxim ‘al-ghurm bi
al-ghunm’ which states that ‘entitlement to profit is co-occur with
responsibility for possible loss and defects’ (Ahmad, Afifi, & Halim, 2014).
Non-permissible risk includes all kinds of risk that arises from
the wrongful consumption of property. This risk is related to excessive gharar or elements of maysir and is forbidden under Sharia
guidelines. Examples of transactions involving excessive gharar are sales or
purchases of items that are not in existence, owned, quantified, specified in
terms of quality or determined in terms of time for payment.
Tolerable risk is a kind of risk that can either be avoided or
absorbed by businesses. There may be times when it becomes necessary for
businesses to protect against this type of risk. In order to manage or minimize
tolerable risk, businesses need to use tools and instruments that are
Sharia-compliant. Usually, hedging instruments in the Islamic finance industry
are designed with this particular type of risk in mind (Mohamad & Tabatabaei, 2008).
Hedging in Islamic Finance
Hedging can be described as an act of protecting an asset
or investment from the uncertainties of the market. Hedging can also be
described as a position established in one market in the context of one’s
commercial activity, in an attempt to offset exposure to the price risk of an
equal but opposite obligation or position in another market (Zahan & Kenett, 2012). Summed up, hedging is a form of managing and minimizing risk.
Islam, it is encouraged for the Muslim Ummah to manage risk. This is based on
the concept of maqasid al-sharia. Maqasid al-sharia underlines the need
for the preservation of religion, body, mind, posterity, and wealth (Ahmad & Yacob, 2012). A frequently cited hadith pertaining to the preservation of
wealth states that: “In Islam, harm should neither be initiated nor reciprocated,”
(Imam Nawawi in Sidiqqi (2009)). Islamic legal scholars have derived a number of consequential
legal maxims from this hadith, such as:
Al-darar yuzal, meaning, “Harm
must be eliminated.”
Al-darar yuzal bi qadril-imkan, meaning, “Harm must be eliminated as much as possible.”
Daf’ul-madarrah muqaddamun ‘ala jalbil-manfa’ah, meaning, “Repelling harm takes priority over seeking benefit.”
These maxims support
initiatives to manage risk and avoid potential loss (Dusuki & Smolo, 2009).
Islamic scholars agree on the permissibility of hedging as a risk management
tool (Baldwin, 2014). One of the sources
regarding the permissibility of hedging in Islam comes from a hadith that
illustrates the importance of reducing risk. An Arab Bedouin asked Prophet Muhammad (PBUH),
“Shall I leave my camel untied and seek Allah’s protection on it, or should I
tie it?” The Prophet replied, “Tie your camel and then depend upon Allah,” (Imam
Al Tirmizi and Al-Baihaqi in Razif, Mohamad, & Rahman (2012)). This hadith implied that Prophet Muhammad (PBUH) instructs
Muslims to make an effort in mitigating risks and avoiding losses before
leaving things entirely to Allah.
Another source of permissibility often quoted by Islamic jurists
is a passage from the Qur’an, specifically verses 47-49 from Surah Yusuf where
Prophet Yusuf (AH) declares:
“You will plant for seven years
consecutively; and what you harvest leave in its spikes, except a little from
which you will eat. Then will come after that seven difficult (years) which
will consume what you saved for them, except a little from which you will
store. Then will come after that a year in which the people will be given rain
and in which they will press (olives and grapes).” This passage shows that
Prophet Yusuf instructs his followers to take strategic steps in reducing the expected
risk of famine to their community, by storing their harvest during abundant
times to prepare for the oncoming severe drought. This illustrates the idea of
the future as being uncertain, and that it is wise to protect against the
uncertainty of the future by managing and minimizing the risk that may come. The
verses provide an example of risk management being permissible under Islam.
the concept of hedging is not in conflict with Islam and the use of hedging
instruments is permitted as long as it is in line with Sharia principles. The
existence of hedging based on Sharia also falls under the category of maslahah (public interest). With the existence
of Sharia-compliant hedging instruments, the Islamic financial industry will
have a wider opportunity to conduct financial transactions while still
conforming to religious principles. Islamic
hedging should be used solely for hedging transactions that relate to real
economic activities and not for speculative purposes.
conventional financial institutions have a wide array of choices when it comes
to hedging products, its Islamic finance counterparts have a rather limited
selection of hedging instruments. This is because of the strict Sharia
requirement imposed to ensure that Islamic hedging contracts are free from
elements of riba, gharar, and maysir. So far there are several hedging
instruments available, namely:
Foreign Exchange Forward
In conventional finance, foreign exchange forward
(FX forward) is used mainly to manage and hedge against risk caused by the
fluctuation of foreign currency exchange rate (Swartz, 2013).
Two parties agree to conduct a sale or purchase of product or service in the
future at a fixed price agreed upon today. Both payment and delivery of goods
or service happen at a set future date.
Islamic Foreign Exchange forwards is the Islamic
alternative for the conventional FX forward. In the Islamic version, the
concept of wa’ad (Undertaking) and tawarruq are utilized in order to replicate
the effect of conventional FX forward. The application of wa’ad comes at
dealing date where the customer only commits to wa’ad with the bank to exchange
a certain amount of money at a certain date. This promise is not binding;
therefore, the contract of tawarruq is applied in order to ensure commitment of
both parties. The delivery is conducted at the date agreed upon initially with
the exchange rate fixed at the dealing date.
Profit Rate Swap
According to Mohamad et al., (2014),
Islamic Profit Rate Swap is defined as an agreement to exchange profit rates
between a fixed rate party and a floating rate party or vice versa. This type
of instrument is applied through the implementation of a series of primary
contracts to trade certain assets, and each party’s payment is calculated using
different pricing formula. The objective of IPRS is to match funding rates with
return rates (from investment), and it is to assist banks and corporate
companies in managing their profit rate risk (Mohamad et al., 2014).
Islamic Profit Rate Swaps use a wa’ad structure
leading to murabaha sale. A wa’ad is an undertaking or promise by one party
(the buyer of the assets) to the other party (the seller of the assets) that,
if required by the seller (usually called exercise of the undertaking or
wa’ad), the buyer will fulfil its promise, in this case, to enter into a
murabaha contract. It means the buyer will buy using murabaha contract from the
seller an agreed quantity of agreed Shariah compliant assets at an agreed price
on a relevant exercising date.
Murabahah is known as a sale arrangement where a
financier purchases goods from a supplier (at the cost price) and then sells
them to a counterpart at a deferred price that is marked-up to include the
financier’s profit margin (Uberoi & Evans, 2008).
This profit margin is deemed justified since the financier takes little to the
goods, albeit possibly only briefly, and hence accepts the commercial risk of
their own (Daud, Mohammad, Jusoh, & Ismail, 2017).
It is important to note that Islamic scholars forbid
the use of profit rate swaps unless the business is very obviously facing a
genuine hardship (Zahan & Kenett, 2012).
Cross Currency Swap
Islamic cross currency swap (ICRCS) is Sharia
compliant derivative arrangement that uses wa’ad leading to reciprocal murabaha
transactions (similar in some respects to the structure used for a profit rate
swap, as discussed previously). In addition to the transaction of assets, there
is a component of spot FX contract, applying the Shariah concept of Sarf (FX) (Dusuki, 2009).
This derivative contains wa’ad of two sales
structure illustrated as follows: Bank A gives a wa’ad to Bank B in relation to
each payment date under which Bank B may exercise Bank A’s wa’ad, requiring
Bank A to buy from Bank B, in cash in one of the two specified currencies (which
may be different for different payment dates), Sharia compliant assets in
respect of that payment date. Simultaneously, under different documentation,
Bank B gives a wa’ad to Bank A (in relation to payment dates which will
generally be the same as the payment date under this leg) under which Bank A
may exercise Bank B’s wa ‘ad, requiring Bank B to buy from Bank A, in cash (in
the other of the two specified currencies for the payment date under the second
leg), different Shari ‘ah compliant assets in respect of that payment date.
Hence, this two-leg structure generates two sales per payment date, one by Bank
A to Bank B and the other by Bank B to Bank A.
in Islamic Hedging
in the existence of Islamic hedging instruments are listed below.
in Sharia opinions and interpretations
Islamic scholars generally agree on the permissibility of using hedging
instruments, many differ in terms of opinions pertaining the structure,
concept, and process flow of the instruments (Islamic Corporation for the Development of the Private
Sector (ICD), 2016).
Practitioners also differ as to whether standardization of Islamic hedging
instruments will benefit businesses and consumers. On one hand, a unified,
standardized, and comprehensive hedging guidelines will strengthen the Islamic
finance industry and streamline practices. On the other hand, standardization
may favor a particular interpretation of the Qur’an and/or Hadith potentially
to the exclusion of other interpretations.
of public awareness on hedging instruments
is a lack of public awareness when it comes to Islamic hedging instruments. Conventional
hedging products are more familiar to the public due to the fact that conventional
hedging products have existed for far longer. There is also a perception from
many Muslim clients that Sharia hedging instruments are fundamentally not that
different from their conventional counterparts—that they are just conventional
hedging products re-packaged and marketed as Sharia-compliant ones (Baldwin, 2014).
There is a need for Islamic financial institutions to further educate the
public on the nature of Islamic risk management and hedging specifically.
selection of hedging alternatives
their conventional counterparts, the Islamic financial industry has a
comparatively limited offer of hedging instruments for their clients. This is
due to the fact that firstly, any hedging products developed by Islamic
financial institutions must strictly adhere to Sharia guidance; and secondly,
because there is a tendency on the part of Islamic institutions to look to
conventional hedging models as examples. So far, Islamic financial products
have essentially been limited to classical modes that developed centuries ago
or similar ones adapted to modern conditions to mimic the effects of
conventional hedging products (Al-Taani, 2013).
this end, there are calls within the Islamic finance industry to stop relying
on existing conventional instruments as a model (Oubdi & Raghibi, 2017).
Islamic scholars and financial practitioners
are now facing
the challenge of producing hedging instruments
which provide clients with the
benefits of conventional products
while also respecting the core tenets of Sharia, based
entirely on a risk sharing model.
As Islamic finance is enjoying a rapid rise in the global
business landscape and more and more Islamic business are conducting
cross-border activities, it is important for Islamic financial instittutions to
provide their clients with an effective and diverse range of risk management