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Islamic Finance and Foreign Exchange Risk

Management

LECTURE 13

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ROLE OF THE FINANCIAL SYSTEM

• Financial intermediation: Channeling funds from savers to users.

• Other services: e.g. payment services, fund management, etc.

• Array of assets and liabilities, each with different liquidity, maturity, risk and reward.

• Providing incentives for efficient resource allocation (i.e. technical and allocative efficiency)

Note: all these functions are universal in nature.

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SHARI’AH OBJECTIVES• Boils down to 2 overarching points/criteria : 1. The achievement of Maslahah (benefit to the

community at large) arising from the outcome of the transaction.

2. Realisation of “balance” in the terms of the contract.

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PARAMETERS OF MASLAHAH

According to the International Fiqh Academy, Maslahah should be:

* genuine and not imaginary* holistic and not partial* general/public, and not special/private (e.g.

hoarding vs. ownership right)* should not run counter to a superior Maslahah* in harmony with Maqasid al-Shari’ah (Shari’ah

Objectives)

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BALANCE IN THE TERMS OF CONTRACTS

Balance or equivalence in the rights and obligations of contracting parties

• Prohibiting contracts which comport injustice in one form or another.

• Preventing greed that results in unjust behaviour and unfair transactions.

• Ensuring mutual consent based on informed decisions (devoid of coercion, fraud, mischief, etc.).

• Ensuring transparency in all transactions.

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SHARI’AH MU’AMALAT RULINGS

Summed up into 2 main guidelines

* The Principle of Permissibility (outside a negative list of prohibitions)

* The Principle of Mutual Consent (pre-requisite for the validity of a contract)

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FEATURES OF ISLAMIC FINANCE

• At a primary level all financial instruments and transactions must be free of at least the following five items (prohibitions):(i) Riba (usury),(ii) Rishwah (corruption),(iii) Maysir (gambling),(iv) Gharar (ambiguity) and(v) Jahl (ignorance).

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PROHIBITION OF RIBA

• Riba = Increment or Increase (usury = interest)• No matter how small or large• Regardless of whether the loan is for

consumption or investment• Be it short-term or long-term in nature• Regardless of price levels – indexation is

disallowed

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REMOVING RIBA FROM FINANCIAL TRANSACTIONS

• Ensuring that financial transaction is related to real sector activity.

• Disallowing debt trade and speculative transactions not based on real production or exchange.

• Preventing debt discounting and rescheduling for increment (non-value-adding)

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ISLAMIC INGREDIENTS • Riba is prohibited; trade (Tijara) is allowed.• Aside from the fact that the underlying asset must be halal, at

least two conditions have to be met,(i) the underlying asset or commodity must

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

in its final form.• Stringent conditions for the validity of a sale would obviously

render the trading of derivatives impossible.• However, the Shari’ah provides exceptions to these conditions

to enable deferred sale where needed.

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CORE PRINCIPLES OF ISLAMIC FINANCE

• Goods & commodities can be sold at a profit• Money is not a commodity and therefore it

cannot be sold or loaned for profit• Money can be invested in real economic activities:

e.g. buying and leasing of assets, investing in stocks, expansion of businesses, etc.

• Profits from real economic activities will be shared between the Bank and the Customers.

• Interest/usury is unlawful

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CONVENTIONAL VS. ISLAMIC BANKING

Conventional Banking• Customer deposits are

loans to Bank• Bank loans money to

Customer for, say, buying property

• Borrower pays interests and principal to Bank

• Bank pays interest and principal to Depositors

Islamic Banking*Customer deposits represent

investment of capital*Bank buys a property and

leases it to Customer*Customer pays lease rentals

and purchase price for the property over time to Bank

*Bank makes capital repayment with profits to Depositors

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FUND MOBILISATION MODES IN ISLAMIC FINANCE

• Qard (Bank acting as borrower; principal guaranteed; no return)• Wadiah (Bank acting as trustee; principal guaranteed; no

return)• Wakalah (Bank acting as Investment Agent; neither the capital

nor profit is guaranteed; return of capital only if Bank is negligent or in default of its investment obligations; all profits to be distributed to investors after deducting Bank’s fixed and variable fees)

• Mudarabah (Bank acting as Fund Manager; capital repayment and profit not guaranteed as in the case of Wakalah; profits to be shared between the Bank and Depositors)

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THEORY VS. PRACTICE• Islamic Banking is different from Conventional Banking in

principle, but in practice….?• Regulatory Issue: Almost all CBs require Islamic Banks to treat Mudarabah and

Wakalah investment accounts as on-balance-sheet liabilities similar to conventional deposits. Why? [Mitigating risks?]

• Institutional Issue: Nearly all Islamic Finance products are credit or debt-

oriented products and have similar pricing to comparable conventional financial products. Why? [Law of One Price?]

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ISLAMIC DEPOSITS: RISKS & MITIGANTS

• Qard and Wadiah accounts are on-balance-sheet liabilities of the Bank

• Mudarabah and Wakalah accounts, in theory, are off-balance-sheet (similar to Asset Under Management) so that investors/depositors will be exposed to losses incurred by Bank

• To mitigate the risks, (i) CB requires IBs to treat Mudarabah and Wakalah accounts similar to conventional current or savings deposit accounts, i.e. on-balance-sheet liabilities, (ii) CB applies the same capital reserve provisions of conventional accounts to Mudarabah and Wakalah as well, and (iii) IBs allocate a certain % of Mudarabah profit into a reserve account (Profit Equalisation Reserve) for the purpose of stabilising periodic profit pay-outs and covering any interim losses suffered by Mudarabah investments

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MURABAHA & TAWARRUQ FINANCING

• Murabaha (BBA) Financing Step 1: Bank makes a spot purchase of goods from Supplier Step 2: Bank sells the goods (on deferred terms) to Customer at cost

plus profit

• Tawarruq Financing Step 1: Bank buys commodity on a spot basis from Broker A at cost Step 2: On the same day Bank sells the commodity to the Customer

at a cost-plus-profit basis on deferred terms Step 3: On the same day, Customer will sell the commodity to Broker

B on a spot basis at cost• Note : Broker A and Broker B are not related.

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IJARA FINANCING: DIRECT LEASE Steps:1. Customer (as Agent of Financier) buys assets (e.g. land,

building, machinery, equipment, ship, aircraft) from Supplier2. Bank pays the purchase price to the Customer (as Agent) who

passes it on to Supplier3. Bank leases the asset to Customer for agreed tenor4. Customer will pay lease rentals (comprising principal

amortisation and lease returns) to Bank5. At maturity of the lease, Bank will sell the asset to Customer

at a pre-agreed price.

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IJARA: SALE & LEASE-BACKSteps:1. Customer sells – instead of mortgaging - asset (e.g. land,

building, machinery, equipment, ship, aircraft)to Financier (Bank)

2. Bank pays the purchase price (facility amount) to Customer3. Bank then leases back the asset to Customer for agreed

tenor4. Customer will pay to Bank the lease rentals (comprising

principal amortisation and lease returns)5. At maturity of the lease, Bank will sell the asset back to

Customer at a pre-agreed price

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DIMINISHING MUSHARAKAH HOME FINANCE

• Steps:1. Customer selects the House @ say RM 1 mil.2. Customer signs S&P Agreement and pays RM 100,000 deposit to Vendor3. Customer applies for DMF from Bank for RM 900,000 payable in 20 years4. Customer signs financing documents with Bank 5. Customer has 10% share in the House (i.e. deposit paid to Vendor).6. Bank pays RM 900,000 to Vendor (Bank’s share is 90%)7. Customer, as registered owner, charges the House to Bank 8. Bank leases its 90% stake to Customer for, say, 20 years9. Customer will purchase a portion of Bank’s 90% share on monthly basis

(Customer’s share will increase as Bank’s share decreases) until it is fully paid for.

* Note that monthly installment comprises rental (interest equivalent) and house share purchase (principal equivalent).

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SUKUK AL-IJARASPC (Firm) wants to buy assets from Corporate (Developer/Lessee) at $500

million and lease it for 5 yearsSteps:1. SPC buys assets from Corporate at, say, $500 m.2. SPC leases the asset back to Corporate for, say, 5 years (lease rentals

payable 6-monthly in arrears benchmarked on LIBOR6 + spread).3. SPC issues $500 mil Sukuk at par value.4. Investors subscribe to the Sukuk as primary subscribers.5. SPC will collect lease rentals and distribute pro rata to Sukuk holders.6. Sukuk can be listed, rated, cleared through Euroclear/ Clearstream and

traded in secondary market.* Bahrain, Malaysia, Qatar, Pakistan and Indonesia Sukuk issues are

structured based on this concept.

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SUKUK AL-MUSHARAKAH• Similar to Sukuk al-Ijara except that Corporate and SPC enter into a Musharakah

arrangement. • Corporate transfers usufruct rights over land and other physical assets to the

Musharakah.• The Musharakah appoints Corporate (Developer) as an agent to develop the land (or

other physical assets) with cash injections, and leases the assets to Corporate for, say, 5 years (Lease rentals payable by Corporate is benchmarked on LIBOR plus credit spread).

• SPC raises fund by issuing a Sukuk, and the Musharakah leases the project to Developer for, say, 5 years (Lease rentals are benchmarked on LIBOR plus credit spread).

* The net profit (from rentals) of the Musharakah is shared between SPC and Corporate in the ratio of 99:1. SPC will distribute periodic profit (99% of total) to Investors (Sukuk holders). Corporate irrevocably undertakes to buy the 99% Musharakh shares at the end of 5 year period – which means that SPC will no longer have any share in the Musharakah.

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LAWFUL TO BENCHMARK ON LIBOR?One view: LIBOR is interest rate.Another view: LIBOR is a premium for AA-rated

credit risk.Law of One Price states:“In an efficient market, two products bearing the

same risk will inevitably assume the same pricing”. In other words, for two products to have the same pricing, they must also share the same risk profile.

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SHORT-SELLING UNLAWFUL?• Hadith: A merchant named Hakim ibn Hizam reported, “I asked the Prophet:

O Messenger of Allah! A man comes to me and asks me to sell him what is not with me, so I sell him and then buy the goods for him in the market. And the Prophet (pbuh) said: sell not what is not with you.”

Short Selling:• Seller does not own the shares• Seller borrows shares and pays interest on margin account (riba)• Seller may be forced to close the short position by short covering (gharar)Are Forwards, Futures & Options tainted by gharar and therefore unlawful?Classical View: Yes, it is unlawfulModern View (minority): No, it isn’tConsideration: existence of subject mater vs. availability of subject matter; if they are used for hedging, commercial speculation and not for gambling

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SPECULATION, A FORM OF MAYSIR?

• Maysir (Gambling) entails: - two or more players - each plays with the sole purpose of winning at the expense of the other(s) - gain of one is the loss of the other(s): a zero-sum gameThe Qur’an on liquor and gambling, Say: “In them is a great sin, and (some)

benefit for men but the sin of them is greater than their benefit.” (Al-Baqarah verse 219)

In gambling, unnecessary risk is created, whereas speculation is about taking on existing risk.

Are Forwards, Options and other Derivatives a form of Maysir?Classical View: Yes, it is. Modern View (minority): No it isn’t, if they are used for hedging,

commercial speculation and not for gambling.

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UNLAWFUL INVESTMENTS

Business Activities• Conventional financial institutions• Conventional insurance COs.• Alcoholic beverages• Gaming and gambling• Non-Halal Food• Hot entertainment• Pornography• Arms and weapons• Tobacco-related products• Any black listed activities (e.g.

drugs, money laundering, corruption, human trafficking)

Rationale. Interest-based• Uncertainty (Gharar)• Prohibited• Prohibited• Prohibited• Immoral/negative values • Immoral/negative values• Destructive to society• Harmful to life• Harmful to society at large

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ISLAMIC FINANCE PRODUCTS PROFILE(Predominantly Credit/Debt Oriented)

Conventional Products• Home Loan Fixed Rate• Home Loan Floating Rate• Auto Loan • Personal Loan• Short-term Facility• Long Term Facility• Bond

Islamic Products• Murabaha Home Facility• Ijara Home Facility• Murabaha Car Facility• Tawarruq Personal Facility• Murabaha Facility• Ijara Facility• Sukuk

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DELICATE BALANCING EXERCISE

• Key challenge is to delicately balance the demands of the market forces with the dictates of Shari’ah to build market share.

• Conventional banks wrestle with credit risk, while Islamic banks have to deal with both asset price risk and commercial risk.

• Co-existence of Conventional and Islamic finance makes it doubly difficult for the latter: It’s like trying to play Soccer in a Rugby Field!

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RISKS PECULIAR TO ISLAMIC FINANCE

• Rate Mismatch Risk: fixed rate assets are largely long-dated against floating rate liabilities – since Islamic Rate hedging tools are not widely available and hence higher exposure to rate mismatch risks

• Liquidity Risk: IBs have limited supply of liquid assets compared to Conventional Banks and therefore face higher liquidity risk

• Shari’ah Non-compliance Risk: the danger of a product being declared “not in compliance” based on new information or new fatwa (if the transaction fails to meet Shari’ah requirements, IB has to donate the profit to charity)

• Legal Risk: Civil Court may declare (a) Shari’ah compliant product as a void contract (High Court judgment overturned by Court of Appeal) or (b) terms of the Shari’ah-compliant product as unenforceable.

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EVOLUTION OF ISLAMIC FINANCE* Stage I: Differentiation: - Conforming to conventional risk and return profile with

Shari’ah compliance, to gain market share. *Stage II: Distinction: - Improving the market share through new products that

distinctly differ from conventional offering.*Stage III: Innovation: Developing a new banking framework based on R & D efforts

to meet the higher Islamic ideals with greater emphasis on the musharakah mode of operation.

Note: Islamic Finance is stuck in the first stage.

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TROUBLING QUESTIONS

• Disconnect between theory and practice? e.g. Murabaha, Mudarabah, Ijara classical versus

modern• Riba admitted through the back door? e.g. Benchmarking on interest rate• Risk averting, risk shifting and risk transferring? e.g. Very

little risk-sharing• Why Musharakah is not the main driver? e.g. DD versus SS. Dual banking system

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FOREX RISK MANAGEMENT IN ISLAMIC FINANCE

• The basic philosophy is to use “On Balance Sheet” techniques.

• “On Balance Sheet” techniques avoid derivatives which are “Off Balance Sheet”, but require changes in the way one does business.

• A simple “On Balance Sheet” technique would mean pricing our exports only in ringgit.

• Or more generally, transacting only in home currency.

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FOREX RISK MANAGEMENT IN ISLAMIC FINANCE (CONT’D)

• While such a technique can mitigate exchange rate risk, it invariably retards one’s competitiveness.

• By doing business only in our HC, we are effectively transferring the exchange rate risk to the counterparty.

• Unless one has some “monopolistic” power, it may not be possible to stick to only HC.

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EVALAUATING HEDGING TECHNIQUES

Common conventional techniques:o Currency Forwardso Currency Futureso Currency Options o Exposure Netting o Pricing Strategyo CRSA (currency risk sharing arrangement)o Money Market Hedgeo Currency Swaps o Currency Collars

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SHARI’AH & HEDGING TECHNIQUES

Of the common techniques, some such as:• CRSA• Exposure Netting • Pricing Strategy deemed acceptable from a Shari’ah viewpoint. But these may not be sufficient. Further more,

each of the above techniques has its own inadequacies.

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SHARI’AH VIEWS ON TRADING OF CURRENCIES

• Legal definition of the currency exchange (Sarf) contract is: the exchange of one monetary form for another in the same or different genera, i.e. gold for gold, silver for silver, gold for silver, silver for gold etc. whether it is in the form of jewelry or minted coins. Such trading is permitted since the Prophet (pbuh) permitted such exchange.

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SOME BASIC CONDITIONSFor the currency exchange contract: 1) mutual receipt prior to the contracting

parties’ parting, 2) equality of quantities, if monies of the same

genus are traded, 3) inapplicability of additional conditions

(Sharat), 4) Non-deferment.

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BASIC CONDITIONS (CONT’D)

• Saying of the Prophet (pbuh): “Gold for gold, in equal amounts, hand–to-hand; and silver for silver, in equal amounts, hand-to-hand”, as well as his (pbuh) saying: “Do not trade one of them absent (thus, deferred) for the other immediately delivered”.

• Narrated by major narrators with the exception of Al-Bukhari on the authority of Ubadah Ibn Al-Samit: “Gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates, and salt for salt, in equal amounts, hand-to-hand; and if the genera differ (in an exchange), then trade as you wish provided it is hand-to-hand”, c.f. Al-Hafiz, Al-Zayla (1st edition, (hadith), vol.4, p.4)

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THE RATIONALE• As for Forward and Futures contracts, most Fuqaha are of the

opinion that these instruments are not Shari’ah compliant. The use of interest (cost of carry) in their pricing is an obvious problem.

• Despite the prohibition, many IFIs faced with FX risks do use currency forwards and futures for hedging purposes as required by regulators.

• In view of this reality, Chapra & Khan (2000) appeal to Fiqh scholars to review their position and allow the use of these contracts for hedging.

• Chapra & Khan (2000) point out “that hedging is not an income- earning activity. Since riba is a source of income and hedging does not generate income there is no question of involvement of riba. On the other hand, hedging actually reduces gharar (ambiguity). “

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THE PRACTICE

• Given the obvious need, the Majma’al-Fiqh made recommendations for forwards and futures to be transacted based on Islamic nominate contracts, such as Salam, Sarf, Wa’ad, to buy or sell at a future date, Istisna’.

• Perhaps on the basis of this, some structures of forward contracts can use Wa’ad and Muwa’adah to buy and sell at a specified future date as the basis to make forward contract Shari’ah compliant (Securities Commission 2009).

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THE PRACTICE (CONT’D)

• In all cases, the Shari’ah committees of the respective institutions, which have allowed the FX Swap, insist that it be used only for hedging.

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PRODUCT 1: FX SWAP CONTRACT– Shariah views on FX Swap contract٦

• Islamic foreign exchange swap (Islamic FX Swap) is a contract that is designed as a hedging mechanism to minimize market participants’ exposure to volatile and fluctuating market currency exchange rates. There are two structures under Islamic FX swap; Tawarruq contract and Wa’ad (promise/undertaking). The general Shari’ah parameters - that one must abide by when structuring Swap products - are as follows:

• Each contract in the Swap structure must be actual [not a fictitious contract (Suriyah)].• Each contract has its own effect (Atharuha). For example, a sales agreement gives the

effect of ownership. There should not be any encumbrance on ownership (Milkiah Tammah). It is up to the buyer whether he wants to sell it, keep it, or use it.

• Each contract in the structure must be independent and separated. • The contracts must not be conditional to one another.• For exchange contracts (Uqud Mu’awadhart), the pillars and condition of the contracts

must be complied with. The contract must be clear and a real transaction must occur, and must be proven.

• The sequence of each contract to be executed must be followed accordingly to ensure that all these contracts are independent and separate from one another (Mustaqillah).

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CONTRACTS BASED ON WA’AD

• Wa’ad is an Arabic word which literally means “a promise”. The value of the Wa’ad in Shari’ah is similar to the value of a social promise in the common law. The promise may have moral force, in that breaking it may provoke opprobrium (social blame) but it does not entail legal obligations or legal sanctions. Under the Civil Law, the Wa’ad can be binding or non-binding.

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THE WEIGHT OF WA’AD• The Fiqh Academy, has decided that the Wa’ad

is obligatory not only in the eyes of God but also in the Court of Law when:

• It is made in commercial transactions• It is a unilateral promise• It has caused the promise to incur liabilities.

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STRUCTURE OF FORWARD WA’AD (as per Malaysian IFI)

• The unilateral agreement involved two parties, where the first party promises to enter into a contract with the second party to buy/sell currency for settlement on a forward value date at the rate and amount agreed today. The first party who makes the promise is obliged to honor the agreement; however, the second party is not obliged to do the same. This product will involve Malaysian Ringgit and other major currencies like USD, JPY, and GBP etc. Tenor of the contract is less than 12 months.

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On 4 Jan 2010: Promise date

Customer promises (wa’ad) to make a contract to buy JPY300 million @ 3.588 in 90 days

CustomerIFI

On 2 April 2010: Contract Date

On 5 April 2010: Settlement Date (forward date)

Customer IFIIFICustomerIFI pays JPY 300 million

Customer gives MYR10,764,000

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OTHER SHARI’AH TOOLS FOR MANAGING CURRENCY RISKS

• Deuthsche Bank has developed a “Promissory Currency Sale Undertaking”. In this arrangement the ‘option’ buyer pays an upfront amount in exchange for a binding unilateral promise by the seller (bank) to sell a currency at a pre-determined price and agreed upon future date.

• This is a variant of Wa’ad-based contract, a unilateral promise.

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WA’AD & COMMODITY MURABAHA-BASED PRODUCT

• HSBC’s Malaysian subsidiary (HSBC Amanah) has recently announced the introduction of a “Dual Currency Structured Investment”. The product has two components, a Murabaha based on a commodity and a “unilateral promise to exchange currencies”.

• Investment in this structured product, enables one to earn a return from the Commodity Murabaha (ringgit-denominated) while also receiving a unilateral promise from HSBC to exchange a pre-determined amount of foreign currency (dollar-denominate) within a given time frame. The unilateral promise from the bank acts as a means for the customer to “lock-in” a foreign exchange rate.

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FEX Option-i

• Provides the holder with the right but not the obligation to buy (call) or sell (put) currency at an agreed strike exchange rate on a maturity date (exercise date).• Also the building block for 3 other

products (i.e. FX Calendar Plus-i, TARF-i & Zero Cost Collar-i)

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FX Calendar Plus-i

• Typically a zero-cost hedging strategy based on synthetic forward.

• Synthetic forward consists of either one of 2 strategies (i) buying a call and selling a put with similar strike rate and expiry date or (ii) selling a call and buying a put with similar strike rate and expiry date.

• Essentially, FX Calendar Plus-I is akin to a combination of a synthetic forward and a vanilla option on different dates.

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TARF-i (Target Accrual Redemption Forward-i)

• Typically a zero-cost hedging strategy based on synthetic forward.

• A synthetic forward consists of either one of 2 strategies: (i) buying a call and selling a put with similar strike rate and expiry date or (ii) selling a call and buying a put with similar strike rate and expiry date.

• TARF-I is akin to a series of synthetic forwards which will automatically expire when it reaches an agreed target.

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Zero Cost Collar-i

• Collar-I is typically a zero-cost hedging strategy based on one of 2 strategies: (i) buying a call and selling a put with different strike rate but similar expiry date or (ii) selling a call and buying a put with different strike rate but similar expiry date.

• The different strike rates in Collar-I will effectively form a ‘collar’ for the client

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SUMMARY & CONCLUSIONS

• Rules that govern Islamic banking and finance also apply equally to international finance in the Islamic paradigm.

• Nearly all conventional instruments used for reining in foreign exchange risks fail to meet key Islamic criteria relating to interest rate, ambiguity, speculation and lack of real sector link (esp. currency forwards, currency futures, money market hedging, currency swaps).

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SUMMARY & CONCLUSIONS (CONT’D)

• Need to craft Shari’ah compliant instruments for managing FX risks in international transactions – but these will have to be cost-effective.

• Liberal interpretations in grey areas may help buy time, but cannot be a long-term solution.

• Some hedging techniques that are clearly non- Shari’ah compliant may be treated as “necessary evil” under certain circumstances.

• Need to re-examine conventional instruments to ascertain if they do more good than harm holistically.

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2011 EXAMINATION QUESTION (7)

(a) Are there conflicts in foreign exchange transactions between market practices and the Shari’ah principles?

(4 marks)(b) Are there viable Islamic alternatives to

currency forwards?(6 marks)

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2011 EXAMINATION QUESTION (8)

• Examine the implications of the on-going quantitative easing in the US and fiscal tightening in the euro zone for USD and EUR currencies.

(10 marks)

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END OF LECTURE 13

“Injustice anywhere is a THREAT to justice everywhere”- Martin Luther King