Transcript Shariah Compliant Parameters Reconsidered MFA Annual

Islamic Capital Markets
IB1006 CIFP1
PreExamination Session
12th April 2009
Maytower Hotel and Apartment, KL
Prof. Saiful Azhar Rosly, Ph.D
International Center for Education in Islamic Finance
(INCEIF)
[email protected]
Final Examination (80%)
• Part 1 : MCQ
20 questions
• Part 2: Short-Essays
5 questions
5x4=
• Part 3:
Long Essays 3/5 = 3 x 20 =
20 marks
20 marks
60 marks
Pre-exam sessions
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Definition capital market
Demand and Supply of capital
CAPM
Stocks
Unit trust
Sukuk
REITS
Derivatives
Global Financial Turmoil
1. Excess Recycled
Money (US72t)
and Asset Bubbles
2. Subprime Loans
4. NPL and Burst of
the Bubble
5 Bank
Foreclosures
6 Credit Crunch
US Recession
8 Drop in US
imports = drop in
Asian export
7 Fall in US
business and
consumer
spending
Yield in mortage >
t-bills
3 Securitization
Islamic Banking Challanges
Products & Product Development
(credit risk, rate of return risk,
displaced commercial risk, Shariah
risk))
Moral Hazard & Lack of Regulation
(Operational risk)
Bank Capital
Risk Management
Global economy
(market risk)
Subprime Crises: Lessons for Islamic
Finance
Loan
Origination
Asset-Based –
reduces speed of
financing
Reduces subprime
BBA
Securitization
Shariah prohibits
securitization of
murabaha
receivables
Less sale of BBA
mortgages
PSIA
Investment account
holders can
scrutinize mortgage
financing
Capital
Adequacy
Islamic Financial Market
Islamic Financial
Market
Direct Financial
Indirect Financial
market
Market
(Capital Market)
Sukuk
Equity
65%
85%
SC Screening
SC Screening
Bank
Takaful
13%
5%
Unit Trust
Mutual Funds
7%
Venture
Capital
5 Basic Shariah Principles in Financial Transactions
#1
Prohibition of Riba
#2
Application of Al-Bay
#3
Avoidance of Gharar
#4
Prohibition of Gambling(Maisir)
#5
Prohibition to engage in the
production of prohibited commodities
Islamic Bonds
Islamic
Bonds
BAIDS
MuNIfs
Asset-Backed
Securities
Sukuk Ijarah
Sukuk
Musharakah
Hybrid
Sukuks
"Sukuk Issuance Expected To
Exceed $20bn In 2008".
$25 billion is reasonable in the
current market environment.
Standard & Poor's
Securities Commission 2008
Sukuk Facts
Malaysia pioneered the
development of the global sukuk
market with the launch of the
first sovereign 5 year global
sukuk in 2002.
In 2007, 76% of bonds approved
by the Securities Commission
were sukuk.
Role of Sukuk in Economic
Development
Purpose of
Sukuk
Issuances
Project
Financing
Refinancing
Working
capital
Corporate Finance –
Demand for Capital
Capital
Structure
Debt
Sukuk
Equity
Cost of Capital
Cost of
capital
Cost of
Debt
Cost of
Sukuk
Cost of
Equity
Capital Structure
Capital
Structure
I
• Debt
• Equity
Capital
Structure
II
• Debt
• Sukuk
• Equity
Sukuk – Moving Forward
Strong base of
domestic investors
to anchor the
distribution of a
major sukuk issue
Sukuk pricing for
Malaysianoriginated issues are
highly competitive
An established
regulatory
framework which
meets both Shariah
and legal
requirements.
Shariah Compliance: Consistency is Critical
‘AQAD
Principles
LEGAL/CONTRACT
DOCUMENTATION
Protection of Rights
MAQASID
Benefits vs disbenefits
FINANCIAL
REPORTING
AAOIFI/IFSB/IFRS
Shariah Compliant Parameters
• Aqad-based – Contract-based
• Maqasid al-Shariah (purpose of the Law) –
impact on society
• Financial Reporting – actual strength and
performance of companies
• Legal documentation – identification and
recognition of rights and obligations of
contracting parties.
Approved Islamic Finance Products
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BBA Home Financing
Bay Inah Home Financing
Bay Inah Personal Financing/Overdraft/credit card
Tawaruk munazam personal financing
Commodity murabaha
Ijarah thumma al-bay
Bai-bithaman Ajil Islamic Debt Securities (BAIDS)
Discounted Bay al-dayn MuNif
Sukuk Ijarah
Sukuk Musharakah
Challenging issues in AQAD-based Islamic
Finance Products
• Benchmaking profit rate against interest rate (LIBOR,KLIBOR).
• Profit Equalization Reserve (PER) – displaced commercial risk
• Sale with condition to buyback at predetermined price
between two and three parties.
• Profit generated over installment payments – time value of
money
• Penalties on delayed payments
• Benchmaking sukuk rates against LIBOR
• Musharakah with Purchase undertakings – fixed profit to
one party only.
• Ijarah Sukuk - Sale with repurchase agreement at par value
and not mark-to market
• Ijarah Sukuk – Ownership of asset by SPV
• Profit-rate swaps – speculation or gambling?
#1 AQAD Method
Aqad
Agents of
Contract
Objective
of Contract
Subject
Matter
Offer &
Acceptance
Sale (Al-Bay’)
Buyer & Seller
Transfer of
Ownership from
Buyer to Seller
Property
Price set on the
spot
Contract of Sale
•
Example: Murabaha/BBA Sale
1. Buyer and Seller
eg. Seller owns asset/subject matter before making
sale
2. Subject matter
eg. Mal mutaqawim – property with usurfruct
3. Price
eg. Set on the spot
4. Offer & Acceptance
eg. Verbal or in writing
Method #2: Maqasid alShariah/Objective of Shariah
To protect the interest of the public (society)- maslahah alammah by:
1. removing the harm ( ibqa)
2. securing of benefits (tahsil)
#2 Maqasid Method
Maqasid
Shariah
Removing
the Harm
Securing
of Benefit
Objective of Shariah
Islamic financial products as defined by AQAD
methodology, should contain more benefits
(masalih) and less or no harm (madarah).
“ in gambling (maisir) and liqour (qimar), there
are some sins and some profits. But the sins
are greater than the profits” (Al-Baqarah:
168).
“ in Gambling (maisir) and Liqour (qimar),
there are some sins and some profits. But
the sins are greater than the profits” (AlBaqarah: 168).
Mudarat
Manfaat
Sins
Profits
Mudarat
Riba
Manfaat
Mudarat
Manfaat
Mudarat?
Financing
BBA
Manfaat?
Mudarat?
Manfaat?
Mudarat >
Manfaat
HARAM
Mudarat <
Manfaat
HALAL
Downside (Madarrah) of CreditFinancing
MACRO
MICRO
Economic Bubbles
Bankruptcy
Subprime Loans
Foreclosure
Financial Turmoil
Unemployment
The upside (Manfaat) of CreditFinancing
MACRO
MICRO
Allocation of Capital
Wealth creation
Economic Growth
Rich becoming richer
Leisure, luxury and lifestyle
Maqasid
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1.
2.
3.
4.
To analyse(theoretical) and measure(
empirical) impacts of financial
intermediation based on aqad-based Shariah
compliant products.
Efficiency studies
Profitability studies
Studies on Consumer welfare and protection
Studies on Financial stability
Maqasid – protecting public interest.
• Aqad-based products (ABP) SHOULD contain more benefits and less
harm.
• What if, it was proven than they (ABP) contain more harm than good?
eg. Abandon projects – customer cannot make recourse against bank
as selling party?
Defaulted BBA customer are required to make settlement based on the
selling price.
Sale with no transfer of ownership.
Giving away clean inah personal financing at high profit rates– a way
towards subprime inah?
Conflict between Aqad and Maqasid?
Method #3: Financial Reporting
• Proper recording of transactions to evident TRUE SALE.
• BBA – bank must put BBA asset on balance sheet prior to
sale. I week, 1 month it depends.
• Once sold, it is recorded as BBA receivables.
• AITAB assets should be on banking book as leasing assets
but now treated as “financing and advances”.
• External auditors (PWC, KPMG etc.) are not required by
the authority to conduct Shariah audit. And they may not
be not capable to do so.
Conflict between AQAD and financial reporting?
Islamic Bank Average Balance Sheet
Assets
Liabilities
Murabaha/BBA
Wadiah Dhamanah deposits
AITAB
Profit Sharing Investment Acct
Islamic Securities/Sukuk
Capital
1st October 2008
Assets
Liabilities
FIXED ASSET
1. BBA asset
15 October 2008
Assets
Liabilities
CURRENT ASSET
2. BBA Receivables
1. 1/9/2008 Bank purchases Property from Vendor
for $200,000
1. 15/9/2008 Bank Sells Property to Customer for
$280,000
‘Do not Sell what you don not Own”
Hadith (Sahih Bukhari)
High Court Judge Datuk Abdul Wahab Patail says that the
sale element in BBA sale is not a bona fide sale
BBA Legal Documentation
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4.
Sale and Purchase Agreement (SPA)
Property Purchase Agreement (PPA)
Property Sale Agreement (PSA)
Deeds of assignment/Charge
1. No transfer of title from Customer to Bank
2. Bank do not have
legal + beneficial ownership
of property to make a valid sale
Basel II and IFSB
• High risk-weights for Musharakah Financing to
imply that bank bears business risk and the
general investment account holders (GIA) do
not.
• Recent PSIA guidelines will test risk appetite of
depositors.
Method #4: Legal Documentation
• BBA should be documented as a true sale and not as a
loan. (Dato’ Nik vs. BIMB)
• Ijarah should be documented as operating lease and not
a loan (Tinta Press vs. BIMB)
• Islamic bank has not practice fairness compared with
conventional bank (Affin bank vs Zulkifli).
Conflict between AQAD and documentation of AQAD?
‘Do not Sell what you don not Own”
Hadith (Sahih Bukhari)
High Court Judge Datuk Abdul Wahab Patail says that the
sale element in BBA sale is not a bona fide sale
BBA Legal Documentation
1.
2.
3.
4.
Sale and Purchase Agreement (SPA)
Property Purchase Agreement (PPA)
Property Sale Agreement (PSA)
Deeds of assignment/Charge
1. No transfer of title from Customer to Bank
2. Bank do not have
legal + beneficial ownership
of property to make a valid sale
Shariah Compliance: Consistency is Critical
‘AQAD
Principles
LEGAL/CONTRACT
DOCUMENTATION
Protection of Rights
MAQASID
Benefits vs disbenefits
FINANCIAL
REPORTING
AAOIFI/IFSB/IFRS
Islamic Finance
Risk
Core
Activities
Return
Shariah
Islamic Way of Life in Business
No Risk
No Return
Islamic Way of Life in Business
Taking Risk
Making
Returns
Against Islamic Norms
Taking No Risk
Making Returns
with certainty
(by contract)
Islamic Bonds and Sukuk
ABC Balance Sheet
Current Asset
Cash
Account receivable
Marketable securities
Inventory
Fixed Asset
Total Asset
$8,000
$120,000
$20,000
$110,000
$250,000
$508,000
Current Liabilities
$108,000
Long-term liabilities
Owner’s Equity
Total liabilities and Owner’s
equity
$190,000
$210,000
$508,000
Financial Screening
• Capital structure
(Long-term debt/ total asset) < 33%
• Interest-bearing asset
(Account receivables/total asset) < 45%
• Interest income
(interest from FD and securities/total operating
income) < 5%
Islamic Securitization in Malaysia
BAIDS
i-ABS
Sukuk Ijarah
Fictitious
Sale
True
True
Sale
Sale
Fictitious
buy-back
no buyback
Buy-Back
True sale criteria
• Transfer of equity ownership to SPV and then
pass on to Investors.
• Creditors running after Originator hold no
claims on the Underlying Asset.
• Legal ownership : control over company
• Beneficial ownership: right to sell/dispose of
underlying assets.
Sukuk-Definition
Investment Sukuk are certificates of equal value
representing undivided shares in ownership of
tangible assets, usufruct and services or (in
the ownership of) the assets of particular
projects
Accounting and Auditing Organization for Islamic Financial
Institutions (AAOIFI)
Sukuks & Common Stocks
Common Stocks
Sukuks
Investment Sukuk are certificates of equal
value representing undivided shares in
ownership of tangible assets, usufruct and
services or (in the ownership of) the assets of
particular projects
“No guaranteed Income and Capital Preservation”
“Al-Kharaj bil Daman” “Al-Ghorm bil Ghonm”
Two Prominent Sukuk Structures
1. Sukuk Al-Ijarah
a.
b.
c.
d.
Guarantees
Sale and Repurchase agreement
Pricing of Sukuk
Ownership of asset – latest!!!
2. Sukuk Al-Musharakah
a. Purchase undertakings
Sukuk Al-Ijarah
a. Guarantees – Sale and Repurchase
Agreement
c. Pricing of Sukuk
d. Ownership of asset – latest!!!
(9) Payment
(8)Sale of asset
(5) Lease to Originator
(6) Rental payments
(1) Sells physical asset
ORIGINATOR
(4) Payments
from
cash
proceeds
Sukuk Al-Ijarah
SPECIAL
PURPOSE
VEHICLE
(3) Payments
(2) Issues
Sukuks
(7)
Payments
of
dividends
INVESTORS
(10)
Redem
ption
of IABS
Pressing Issue : Ownership of
Underlying Asset
Who Own Underlying Assets?
More than 80% of current Sukuks do not comply with
the Ownership Requirement.
Special Purpose
Vehicle
Owner?
Issues Sukuks
Payments
Investors
Owner??
AAOIFI June 2007 1st Statement
1. Sukuk, to be tradable, must be owned by Sukuk
holders, with all
rights and obligations of ownership, in real assets,
whether tangible,
usufructs or services, capable of being owned and sold
legally as well
as in accordance with the rules of Shari'ah, in accordance
with Articles
(2)1 and (5/1/2)2 of the AAOIFI Shari'ah Standard (17) on
Investment
1 2.
2nd Statement
The Manager (SPV) issuing Sukuk must certify
the transfer of ownership of such assets in its
(Sukuk) books, and must not keep them as his
own assets.
Sukuk Ijarah
• SPV holds legal and beneficial ownership
• Legal ownership – title of asset ownership
registered under buyer’s name.
• Beneficial ownership – right of disposal/right
to sell the assets by owner.
Interest-bearing Loan
• Decoupling of legal ownership from beneficial
ownership.
• Borrower holds legal ownership of the
property.
• Bank puts a charge on the property and holds
beneficial right.
Interest-Bearing Loans
• Decoupling legal ownership from beneficial ownership.
• Borrower holds legal ownership of the property.
• Bank puts a charge on the property and holds beneficial right.
Legal + Beneficial
Ownership
Legal
Ownership
(Customer)
Beneficial
Ownership
(Bank)
Sale on Cash Basis
• Buyer hold complete ownership
Legal
Ownership
(Customer)
Beneficial
Ownership
(Bank)
Complete
Ownership
Milkiyah Mutlakah
Sale on credit basis – Murabahah/BBA
• Decoupling legal ownership from beneficial ownership.
• Buyer holds legal ownership of the property.
• Bank puts a charge on the property and holds beneficial right.
Legal + Beneficial
Ownership
Legal
Ownership
(Customer)
Beneficial
Ownership
(Bank)
Guarantees
Profit + Principle
1. Sukuk Al-Ijarah
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Guarantee on Sukuk Issues
Originator establishes SPV that will issue the Sukuk.
Originator provide a guarantee against any shortfalls.
Fiqh academy resolution 30(3/4) – third independent party
(ie independent to the contract) to guarantee at no
consideration (ie free of charge).
• AAOIFI Shariah Standard no.17 – “the prospectus must not
include any statement to the effect that the issuer of the
certificates accepts the liability to compensate the owner of
the certificate up to the nominal value of the certificates in
situations other than torts and negligence not that the
guarantee a fixed percentage of profit.
Guarantee the Principle
• Third party guarantee
1. Government
a. private sukuk – not permissible
b. government sukuk - permissible
1. Private company
No text prohibiting a guarantee from a third
party.
Guarantees - Examples
1. Islamic Development Bank Sukuk
• Trust certificates issued by Solidarity Trust
Services Limited (SPV)
• Originator – IDB
2. Malaysia
• Trust certificates issued by SPV Malaysian
Global Sukuk
• Originator – Ministry of Finance
Guarantees of Principle by Sale and BuyBack Structure
• Bay al-Wafa
• Allowed by minority but rejected by the
majority and Islamic Fiqh Academy resolutions
passed in 1992.
• Sale and leaseback is bay al-inah – Rejected
by Islamic Fiqh Academy.
Sale with Repurchase Agreement
(3) At maturity Sells x
SPV
(1) Sells x
Originator
(4) Payments $600m
(2) Payments $600m
Investors
$600m
Payments
For
Redemptions
Of Sukuk
Musharakah Sukuk
Musharakah al-Aqd – profit sharing
Musharakah al-milk – not for
business
Musharakah sukuk (MS)
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SPV enters into Musharakah agreement with Originator.
SPV represents SukukHolders through issuances of MS.
SPV contributes $X cash
Originator contributed $land,equipment,building,vehicles
Proceed of MS will be used by SPV as its capital contribution $X.
Profit distributed according to respective capital contribution.
Originator will undertake management role as Manager under
separate agreement.
• Profit that exceeded certain % belongs to the Manager
• The Originator gives an irrevocable undertaking to purchase the
units of the SPV in the Musharakah face value at pre-agreed price
(and not at market price). -Purchase Undertaking Contract
Musharakah Sukuk
Middle-East - GCC
RAKIA Sukuk
Extract of Termsheet:
– Issuer: RAKIA Sukuk Company Limited
– Issue purpose: The proceeds to be used in part to
purchase the Project Land and in part for the
completion of the Works
– Issue size: US$325 million
– Maturity: 5 years
– Profit: 3 month LIBOR + 150 bps
– Guarantor: Government of Ras Al Khaimah
RAKIA Sukuk
The development will consist of four islands of varied sizes in addition to a peninsula together measuring
2.30 million square metres. The development will extend four kilometres linearly into the sea and
approximately three kilometres along the coast of Ras Al Kh aimah. The ‘‘Peninsula’’ and ‘‘Island 1’’ are
intended to form the hospitality gateway to the development, covering an area of 0.26 million square metres
and 0.12 million square metres respect ivel y. ‘‘Island 2’’ is envisioned as being residential in nature. The
total area of ‘‘Island 2’’ will be 0 .50 million square metres. ‘‘Island 3’’ is intended to contain sports and
commercial facilities covering an area of 0.35 mil lion square metres. ‘Island 4’’ has been designated for
hotel and resort developments covering an area of 1.07 million square metr es.
RAKIA Sukuk
Purchas
e
Price for
Project
Land
Sale
of
Project
Land
Issuer
(SPV)
Sukuk Issue
Sukuk Proceeds
Investors
Purchase
Undertaking
Manager of Sukuk
Assets
RAKIA
RAKIA Sukuk
Ongoing
Maturity or
Dissolution
Sukuk Assets
Incom
e
Incom
e
Liquidity
Payments
Exercise
Price
Issuer
(SPV)
RAKIA
RAKIA
Incentive
Fees
Periodic
Distribution
Sukuk
Redemption
Investors
Purchase Undertaking
• The Originator gives an irrevocable undertaking
to purchase the units of the SPV in the
Musharakah face value at pre-agreed price (and
not at market price). -Purchase Undertaking
Contract
• Through the Purchase Undertaking Contract,
Partner A effectively guarantee capital of Partner
B.
• In a Musharakah contract a Partner A cannot
guarantee the capital of Partner B
Musharakah Sukuk
• Sukuk al-Musharakah issued in 2005 by Dubai
Metals & Commodities Company (DMCC)
Authority
• Proceeds of sukuk were used to build Almas
Tower and the Au Tower and the AG Tower in
the DMCC Free Trade Zones.
Musharakah sukuk
• Sukuk al-Musharakah issued by Wings FZCO on
behalf of Emirates Airlines in 2005 $824million.
• Landmark musharakah sukuk – Dubai ports,
Customs and Free Zone Corporation (PCFC) for
$2.8 billion
• Subscribers
1. 70% banks
2. 7% high net worth individuals
3. 13% fund managers
Malaysian Musharakah Sukuk
Khazanah Exchangeble Sukuk
KL Sentral Sukuk
Khazanah Exchangeable Sukuk
Investors
Sukuk Proceed
Sukuk
Cash Payment
Purchase Right Deed
Cherating Capital
(Issuer)
Khazanah Nasional
(Obligor)
Purchase Undertaking
Deed
Sale Price (Nomina)
Sale of Equity Pool
Sale Price (Nominal)
Plus Expressway
Berhad
Cempaka Capital
(SPV)
Sale of Equity Pool
KL Sentral
Sukuk
Islamic Capital Market: Derivatives
from Islamic Perspective
• Hedging – buy or sell futures contracts in
order to reduce losses from price movements.
• Speculation – buy and sell futures contracts in
in order to make big gains.
• Hedging is part of risk management.
Risk-Taking and Risk Management
• Risk is potential loss
• Risk-taking – Taking risk with an expectation to make
gains.
• Risk-taking is one aspect of risk-aversion
• Risk-aversion – will take no risk unless rewarded
• Risk-neutral – take more risk without any expectation
to make more or less gains
• Risk-loving – more risk with less expectation to make
more gains.
• Risk-avoidance - Expectation to make gains without
taking any risk - HARAM
Risk Management
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Once you have chosen to take the RISK, you must be ready to face losses as well as
making gains.
Price risk : Potential loss from changes in price due to market volatilities i.e.
changes in demand and supply.
Changes in price will affect revenues.
How to take on price risk?
Transfer the risk?
To Whom?
Who is willing to carry your risk?
Is it for free? Or at a price?
Does Shariah allow risk transfer?
Why transfer risk? why not carry it yourself since you have chosen to take the risk
and make money out of it.
Since you have chosen to take risk, you must face the consequences!
Derivatives – transferring price risk to another party.
Derivatives and ‘Aqad
• Buyer and Seller
• Objective
• Subject matter
1.price
2.possession
3.mal mutaqawim
• Offer and Acceptance
Shariah Issues
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Gambling
Gharar
Al-Mal
Manfaat & Mudarat
Sell futures contract – short selling.
Currency futures – treated as commodities
Arbun
Trading of arbun?
Option
Trading of option
Value of call option gets higher as market price falls lower than
strike price
Shariah issues
• Arbun: Down payment; non-refundable deposit
paid by a buyer retaining a right to confirm or
cancel a sales contract.
• Bay’ Istijrar – a contract between a supplier and a
client whereby the supplier supplies a particular
item on an ongoing basis on a agreed mode of
payment until they terminate the contract. It is
also applied between a wholesaler and a retailer
for the supply of a number of agreed items.
• Khiyar al-Shart- option to cancel contract under
specified condition
Salam Contract
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Price set on the spot
Future delivery
Financing and not hedging
Can we transfer price risk at a price?
Futures
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In finance, a futures contract is a standardized contract, traded on a futures exchange, to buy or sell
a standardized quantity of a specified commodity of standardized quality (which, in many cases,
may be such non-traditional "commodities" as foreign currencies, commercial or government paper
[e.g., bonds], or "baskets" of corporate equity ["stock indices"] or other financial instruments) at a
certain date in the future, at a price (the futures price) determined by the instantaneous
equilibrium between the forces of supply and demand among competing buy and sell orders on the
exchange at the time of the purchase or sale of the contract. The future date is called the delivery
date or final settlement date. The official price of the futures contract at the end of a day's trading
session on the exchange is called the settlement price for that day of business on the exchange.
A futures contract gives the holder the obligation to make or take delivery under the terms of the
contract, whereas an option grants the buyer the right, but not the obligation, to establish a
position previously held by the seller of the option. In other words, the owner of an options
contract may exercise the contract, but both parties of a "futures contract" must fulfill the contract
on the settlement date. The seller delivers the underlying asset to the buyer, or, if it is a cashsettled futures contract, then cash is transferred from the futures trader who sustained a loss to the
one who made a profit. To exit the commitment prior to the settlement date, the holder of a
futures position has to offset his/her position by either selling a long position or buying back
(covering) a short position, effectively closing out the futures position and its contract obligations.
Futures contracts, or simply futures, (but not future or future contract) are exchange traded
derivatives. The exchange's clearinghouse acts as counterparty on all contracts, sets margin
requirements, and crucially also provides a mechanism for settlement.[1]
Futures
• Obligation to buy or sell
commodities/financial assets.
• Buy futures (long futures)
• Sell futures (short futures)
• Strike price – contract price is set on the spot
– known price
• Market price – unknown price
• Delivery - Future
Hedging
• Futures:
• Hedges are created by combining a long and
short position in the same asset to reduce or
eliminate price fluctuation risk.
• Short position: sell futures
• Long position: buy futures
Example 1 : Perfect Hedge
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5.
Jim, a Kansas wheat farmer, ex[pects to harvest 40,000 metric ton of wheat in
early August. In June 15, the price of wheat is $3.50 per bushel. Jim is concerned
that the price of the wheat will fall below $3.50 before his August delivery date. A
friend told Jim that he should HEDGE his position by selling August wheat futures.
By selling wheat futures, Jim can lock in the August price of $3.45 per bushel. Jim
took his friend’s advice and sold eight 5,000 bushels of August wheat futures.
When August came, the price of wheat had fallen to $3.00 per bushel. However,
Jim hedge covered his losses because what he lost on the cash crop was offset by
his gain on the futures contract minus a small transaction charge.
He value of the hedge position was calculated as follows:
Revenue from the sales of physical wheat: $3.00 x 40,000 = $120,000.
Sale of 8 wheat futures contract = 8 x $3.45 x 5,000 = $138,000.
Purchase of 8 wheat futures contract = 8 x $3.00 x 5,000 = $120,000.
Gain on futures contract = $18,000 ($138,000 - $120,000)
Jim net cash flow for August was $138,000 ($120,000 + $18,000), which is $3.45
per bushel of wheat.
Example 2
•
Frank, the farmer expects to harvest 50,000 bushels of soybeans in September. On
April 1, the September futures contract for soybeans is $7.00 per bushel.
1. If Frank would like to lock in the $7.00 per bushel soybeans price, what should he
do?
ANSWER: Since Frank is concerned with a falling price, he should enter into a selling
hedge. Frank should sell 10 (50,000/5,000) September contracts for $7.00 per
bushel.
2. If soybeans price increases to $8.00 per bushel, show Frank’s position at harvest
time:
ANSWER:
1. Revenue from the harvest of soybeans = $8.00 x 50,000 = $400,000.
2. Sale of 10 soybeans futures contract = 10 x 50,000 x $7.00 = $350,000.
3. Purchase of 10 soybeans futures contract = 10 x 50,000 x $8.00 = $400,000
4. Frank made $50,000 in the cash market but lost $50,000 in the futures market.
5. He is better of if he had not taken the hedge. But he did not know in advance
(except Allah swt) what would happen to the soybeans in September.
Speculation with commodities
• With hedging, an investor is trying to minimize
price risk.
• However, with speculation, the investor is
willing to assume price fluctuation risk in
order to have a chance to make a large gain.
• Gains and losses can be magnified by using
margin (i.e leverage).
Example: Speculation
• Marcus believes that the price of corn will go from its
current June price of $3.00 per bushel to$4.00 per
bushel in the next 3 months.
• September corn futures are currently selling for $3.25
per bushel and Marcus bullishly purchases 10 contracts
on margin.
• The initial margin requirement is 15% and commission
rates for a round trip are $40 per contract. Marcus was
optimistic.
• 3 months later corn futures prices fell to $2.75 per
bushel and Marcus reversed out of his position and
made a loss of $25,400.
Calculations I - LOSS
• Purchased 10 September corn futures for $3.25
per bushel = $3.25 x 10 x5,000 = $162,500.
• Margin deposit of 15% = $24,375 (.15 x
$162,0000cost]
• Sold 10 September corn futures for $2.75 per
bushel = 10 x $2.75 x 5,000 = $137,500 revenue.
• Gross profit ($137,500 - $162,500) = -$25,000
loss
• Minus round trip commission ($40 x 10) = -$400
• Net loss = $25,400.
Calculation II - GAIN
• If the corn price had increased to $3.90 per
bushel over the 3 month period.
• Sold 10 September corn futures for $3.90 = 10
x 5,000 x $3.90 = $195,000 revenue
• Gross profit ($195,000 - $162,500) = $32,500
• Minus round-trip commission = -$400
• Net profit = $32,100.
Stock futures contract
• Stock futures are futures contract on market
indexes.
• 1 contract = $250
• S & P500 future index value = 1200
• S&P500 Index =1000
• sell 20 futures contract = (20 x 1200 x $250)
Example - Stock futures
• Barry Shorter is managing 1 $60 million common stock portfolio for
the Jones Investment company.
• Barry is concerned that the market is going to fall over the next 3
months and as a result of the market decline, he expects the
common stock portfolio that he is managing to fall in value.
• Barry notes that the 3-months S&P futures index value is currently
at 1200.
• QUESTION: What should Barry do hedge his positions?
• ANSWER: Barry should short hedge (sell futures) to protect the
falling value of his stock portfolio. He should sell enough S&P500
futures contracts to cover his common stock portfolio. One contract
is equal to $300,000 ($250 x 1200). Since he has a $60 million
portfolio, he needs 200 S&P500 futures contract.
($60m/$300,000).
Stock futures
• If the common stock portfolio falls in value to $48 million
over the next 3 months, what would be the ending value of
Barry’s position if he was fully hedged? Assume that the
S&P500 simultaneously falls to 960.
• ANSWER:
• Barry should sell 200 June S&P futures contract for $60m.
• Three months later he should buy 200 June S&P500 for
$48million ($250 x 960 x 200) to reverse his position.
• His stock portfolio declined in value by $12m over the 3
month period.
• However, he made $12 million on the stock futures ($60m $48m). Therefore he fully hedge his position and has an
overall loss of zero on his hedge position.
Options
• An option is an agreement that gives the
holder the right (but not the obligation) to buy
or sell specified securities at a given price
(called an exercise price or striking price)
during a specified period of time.
• Call option – the right to buy a designated
security, say 100 shares of common stock.
• Put option – the right to sell the security.
Example I
• Jerry paid a premium of $4 per share for one 6-month call
option contract (total of $400 for 100 shares) of the
Mahony Corporations.
• At the time of the purchase, Mahony stock was selling for
$56 per share and the exercise price of the call option was
$55.
• Question 1: Determine Jerry’s profit or loss if the price of
Mahony’s stock is $54 when the option is exercised?
• Answer 1: Cost of call = $4 premium x 100 = $400
• Ending value = (-$400 cost) + 0 gain = $400 loss.
• The option was worthless because the stock’s price is less
than the exercise price at maturity.
Example 1
• Question 2: What is Jerry’s profit or loss if the
price of Mahony’s stock is $62 when the
option is exercised?
• Answer 2:
• Cost of call of option = $400
• Ending value = -$400 + ($62 -55)100 = -$400
+$700 = $300 gain.
Options values or premiums are a function
of 5 variables
1. the underlying asset value
2. the risk-free rate
3. the standard deviation of the return of the
asset
4. the option’s time to maturity
5. the option’s exercise price.
Rules on Call option.
• When Pm > Ps, exercise call option
• When Pm < Ps, option has no value
Put Options
• John Poston is bearish on the stock of the Goji Corporation. Thus,
John purchases 4 put options contracts on Goji stock for a premium
of $3.
• The option’s striking price is $40 and it has a maturity of 3 months.
Goji has a current market price of $39.
• If John is correct and Goji’s price falls to $30, how much profit will
he earn over the 3-month period.
• Answer: Cost of Put = $3 per share x 100 shares x 4 contracts =
$1,200.
• Put’s intrinsic value = Striking price – ending price = $40 - $30 = $10
per share.
• Total valaue at maturity $10 per share x 100 shares x 4 contract =
$4,000.
• Net gain = $4,000 - $1,200 = $2,800.
Khiyar al-Shart – option of conditions – Option to cancel the
contract due to gharar in subject matter
• Khiyar al-ayb – option from defect
• Khiyar al-ruyat – option of inspection
• Khiyar al-tayeen - option of determination
matter
• Khiyar al-majlis – option of meeting
Foreign Currency futures
• Sandra Fleets believes that the British pound sterling is going to fall
in value relative to the dollar.
• Sandra plans to act on her belief by selling four 3-month futures
contract now and then reversing out of her position in 3 months.
• Each British pound sterling futures contracts comes in unit of
62,500 pound.
• Since the current price for the pound sterling futures contract is
$1.50 per pound, the contract she sells are worth $375,000 ($1.50 x
4 x62,500).
• In 3 months, the pound fell to $1.40 and Sandra reversed her
position by purchasing four British pound futures contract for
$350,000 ($1.40 x 62,500).
• She made a gross profit of $25,000 ($375,000- $350,000).
Conclusion
• Compliance Issue must move beyond AQAD
methodology.
• Sale without Ownership transfer
• Sale with Ownership transfer to the Wrong
Party.
• Sukuk Ijarah: Capital Protection via Sale and
Repurchase Agreement.
• Sukuk Musharakah: Capital Protection via
Purchase Undertaking
Thank You
Wassalam
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