Hedging in Islamic Finance Sami Al-Suwailem Safar March 2006 Sami Al-Suwailem Safar March 2006

Hedging2 ObjectivesObjectives  Explore dimensions of risk  Develop criteria for acceptable risks  Outline strategy for product design  Derive Islamic instruments for hedging  Explore dimensions of risk  Develop criteria for acceptable risks  Outline strategy for product design  Derive Islamic instruments for hedging

Hedging3 State of Risk  Markets are becoming more volatile  Economic instabilities are rising  Solutions?  Markets are becoming more volatile  Economic instabilities are rising  Solutions?

Hedging4 Dow Jones

Hedging5 CommoditiesCommodities

Hedging6 Currencies: USD

Hedging7 Rising Instabilities meanmedianmeanmedian DJ S&P FTSE Commodities USD

Hedging8 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 Financial volatility is transmuted into volatility of real output. 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 Financial volatility is transmuted into volatility of real output.

Hedging9 DerivativesDerivatives  Exponential growth  Controversial impact  Questionable validity  Exponential growth  Controversial impact  Questionable validity

Hedging10 Size of Derivatives

Hedging11 Structure of Derivatives  Zero-sum games  Separate risk from ownership  Allow hedging only through speculation  Dominated by speculators  Threaten system stability  Zero-sum games  Separate risk from ownership  Allow hedging only through speculation  Dominated by speculators  Threaten system stability

Hedging12 Market Distribution

Hedging13 Risk Dilemma  Economic activities always involve risk  Excessive risk hurdles performance  Pure risk trading transforms into wagering  Economic activities always involve risk  Excessive risk hurdles performance  Pure risk trading transforms into wagering

Hedging14 Unresolved Issues Ken Arrow (2003): Derivatives can be used to reduce risk but people gamble on them. Speculators are adding to the swings rather than reducing them. Ken Arrow (2003): Derivatives can be used to reduce risk but people gamble on them. Speculators are adding to the swings rather than reducing them.

Hedging15 Unresolved Issues… Kreitner (2000): No analytical formula could distinguish gambling from risk allocation. The question of gambling was eventually swallowed and internalized, as if the problem were solved. The contract law stopped worrying and learned to love risk. Kreitner (2000): No analytical formula could distinguish gambling from risk allocation. The question of gambling was eventually swallowed and internalized, as if the problem were solved. The contract law stopped worrying and learned to love risk.

Hedging16 The Challenge  How to have hedging without unproductive speculation?  How to distinguish legitimate risk taking from gambling?  Where to draw the line?  How to have hedging without unproductive speculation?  How to distinguish legitimate risk taking from gambling?  Where to draw the line?

Hedging17 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  Acceptable risk (ex ante): Minor, likelihood of success is high Inevitable, inseparable from real activities  Payoff structure (ex post): Non-zero-sum-game

Hedging18 Statistical Measure  Expected utility is a statistical mean  Allows for gambling  Statistical median: Excludes low probability events Immune to outliers Consistent with Islamic concept of gharar  Expected utility is a statistical mean  Allows for gambling  Statistical median: Excludes low probability events Immune to outliers Consistent with Islamic concept of gharar

Hedging19 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  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

Hedging20 Zero-sum Games (+ ، – )( – ، +) (A, B)

Hedging21 Positive Games (+, +) ( –, – ) (A, B)

Hedging22 Mixed Games (+ ، +)(– ، +) (A, B)

Hedging23 Product Design  Mixed games allow risk transfer with win-win outcome  Combine best of both worlds  Mixed games allow risk transfer with win-win outcome  Combine best of both worlds

Hedging24 Islamic Product Development  Strategies for product development  Imitation dilutes values  Islamic finance becomes a follower  Strategies for product development  Imitation dilutes values  Islamic finance becomes a follower

Hedging25 Hedging Instruments InstrumentRisks Hedged Asset-Liability alignmentGeneral Delta-hedgingGeneral Mutual hedgingGeneral Bilateral mutual adjustmentRate of return Conditional mudharabahCapital, misreporting Combining musharakah and deferred sale Capital, rate of return Third party hedgingCapital, rate of return Diversified deferred priceCapital, rate of return, liquidity Value-based hybrid salamCapital, rate of return, liquidity

Hedging26 Natural Hedge  Align costs and revenues  Shift some operations to the same region  Borrow in the same currency  Align costs and revenues  Shift some operations to the same region  Borrow in the same currency

Hedging27 Cooperative Hedge  Non-profit arrangements  No legal guarantee  Risk is shared by members  Suite all kinds of risks  Non-profit arrangements  No legal guarantee  Risk is shared by members  Suite all kinds of risks

Hedging28 Bilateral Adjustment  Murabaha cannot have a changing rate  Adjust 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  Murabaha cannot have a changing rate  Adjust 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

Hedging29 Diversified Deferred Price  Also for murabaha  Have 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  Also for murabaha  Have 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

Hedging30 Parallel Murabaha  Replaces currency forwards  Integrates currency hedge with goods traded  Murabaha can be for financing or for hedging  Integrates risk transfer with value- creation  Replaces currency forwards  Integrates currency hedge with goods traded  Murabaha can be for financing or for hedging  Integrates risk transfer with value- creation

Hedging31 ConclusionConclusion  Strategies for product development  Vision for the value of the industry  Capitalize on Islamic principles  Strategies for product development  Vision for the value of the industry  Capitalize on Islamic principles