APPLICATION OF OPTIONS IN ISLAMIC FINANCE # Imran Iqbal * Dr. Sherin Kunhibava ** Assoc. Prof. Dr. Asyraf Wajdi Dusuki *** ABSTRACT

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2 APPLICATION OF OPTIONS IN ISLAMIC FINANCE # Imran Iqbal * Dr. Sherin Kunhibava ** Assoc. Prof. Dr. Asyraf Wajdi Dusuki *** ABSTRACT The objective of this research is to provide a clearer understanding of the options contract in Islamic finance. Option contracts provide economic benefits of hedging and flexibility of use; however, they are also used for speculative purposes that contravene the SharÊÑah. Options are also objected to because of the payment of a premium, and conditional options are not allowed in currency exchanges. Islamic options have been engineered, and some Islamic banks do use them for hedging purposes. This paper begins with an explanation and description of options in conventional finance, including the benefits, and moves on to explain the SharÊÑah view on conventional options. The paper then moves on to describe Islamic options that exist within Islamic finance itself ÑurbËn (earnest money), hémish jiddiyyah (security deposit), and khiyér al-sharï (stipulated option) and thereafter explains Islamic options created by Islamic banks to hedge against risk, focussing specifically on currency risk, ÎukËk (Islamic bonds) and commodity hedging. The paper concludes by discussing which types of options may be deemed to be acceptable from a SharÊÑah point of view. Keywords: Options, speculation, hedging, gharar, wañd # The opinions stated in this paper are of the authors' alone and do not represent the views of the organizations they work for. * Imran Iqbal is the Head of Islamic Banking for Saudi Hollandi Bank. He can be contacted at im_iq@yahoo. co.uk or iiqbal@shb.com.sa. ** Sherin Kunhibava Phd. is a Consultant at Wisdom Management Consultancy Sdn. Bhd. and can be contacted at sherinkunhibava@yahoo.com or drsherin@wisdommc.com. *** Assoc. Prof. Dr. Asyraf Wajdi Dusuki is the Head of Research Affairs at the International SharÊÑah Research Academy for Islamic Finance (ISRA). He can be contacted at asyraf@isra.my.

3 2 ISRA RESEARCH PAPER (NO. 46/2012) Imran Iqbal, Sherin Kunhibava & Asyraf Wajdi Dusuki 1. INTRODUCTION A derivative is a financial instrument whose value depends on the value of other, more basic variables (Hull, 2005). Derivative is therefore a generic term for instruments that derive their value from elsewhere. The main types of derivatives are forwards, futures, options and swaps. This paper will be focussing on the option contract. Options are widely used in the conventional financial market and have as their underlying a number of assets such as rates, currencies, equities, commodities and indexes (Bacha, 2001). 1 Although option contracts are widely used in the conventional market, their use in Islamic finance is less prevalent. This is partly due to a lack of understanding of the instrument and its uses/benefits. It is also partly due to concerns that allowing options opens up the possibility of misuse. The majority of Islamic finance scholars have ruled that the conventional version of the option contract is impermissible. However, Islamic businesses face the same financial risks 2 as their conventional counterparts and similar instruments are needed to manage these risks. Hence, various Islamic options have been engineered to hedge against these risks using underlying Islamic instruments to replicate the conventional instruments. Islamic commercial law also contains certain known permissible options. The aim of this paper is to discuss various SharÊÑah issues relating to options and to increase the understanding about these instruments. This paper begins with an explanation and description of options in conventional finance, including the benefits, and moves on to explain the SharÊÑah view on conventional options. The paper then moves on to describe Islamic options that exist within Islamic finance itself ÑurbËn (earnest money), hémish jiddiyyah (security deposit), and khiyér al-sharï (stipulated option) and thereafter explains Islamic options created by Islamic banks to hedge against risk, focussing specifically on currency risk, ÎukËk (Islamic bonds) and commodity hedging. The paper concludes by discussing which types of options may be deemed to be acceptable from a SharÊÑah point of view. 1 These underlying assets can be categorised as physicals and financials. Where the underlying commodity is delivered on the maturity of the derivative, it is known as a commodity derivative. Where the settlement at maturity is by cash, it is known as a financial derivative. Examples of the underlying of financial derivatives are currencies, stock indexes, interest rates, and stocks. Cash settlements take place in financial derivatives because the underlying asset is either not tangible or it is very difficult to make physical delivery.

4 APPLICATION OF OPTIONS IN ISLAMIC FINANCE 3 2. UNDERSTANDING OPTIONS An option is a contract that gives the buyer the right, but not the obligation, to sell or buy a specific quantity of a given asset at a specified price at a specific date in the future. For this right, the buyer pays a price, known as a premium, to the seller of the option. The seller of the option is also known as the option writer, and the buyer of the option is also known as the owner. The price in the contract is known as the exercise price or strike price, and the date in the option contract is known as the exercise date or maturity. 2.1 Types of Options Two basic types of options exist, a call option and a put option. A call option gives the buyer the right to buy the underlying asset by a certain date for a certain price. A put option on the other hand gives the buyer the right to sell the underlying asset by a certain date for a certain price. There are thus four possible participants in an option contract: buyers of calls, sellers of calls, buyers of puts and sellers of puts. Often buyers are referred to as having long positions; sellers are referred to as having short positions (Hull, 2005). Let s look at the potential profit and loss of each participant of the option contract (Bacha, 2001) Long Call (Right to Buy) Let s say an investor wants to buy shares in a mining company (BARU) and believes that its shares will increase in price. The investor has two choices: either pay the full price and buy the shares, or pay a fraction of the price (i.e., the premium) and buy call options. The latter is known as a Long Call position. Both choices give the same result if prices rise, i.e., they make a profit from the investment. However, if prices fall and the investor has bought the shares, he will continue to lose money until the price reaches zero, whereas with the option his loss is limited to the premium only. Let us assume that the investor buys a call option on BARU shares at an exercise price of $4.00 with a premium to be paid of 10 cents per share.

5 4 ISRA RESEARCH PAPER (NO. 46/2012) Imran Iqbal, Sherin Kunhibava & Asyraf Wajdi Dusuki The diagram of the potential profit and loss is as follows: This is known as a payoff diagram. If on the exercise date the price of the share is $4.50, the investor will exercise his right and buy the shares at a price of $4.00. He can immediately sell it in the market at $4.50, thus making a profit of 40 cents after taking account of his cost of 10 cents for the premium he has paid already. Now let s consider if the price has fallen to $3.50 on the exercise date. In this case the investor will let the option expire as there is no need to buy a share for $4.00 when he can get it in the market for cheaper. The only loss to the investor is the 10 cents premium Short Call (Obligation to Sell) The seller (or writer) of the call option above is said to have a short call position, i.e., he is obliged to sell the underlying shares at the exercise price. In this situation the payoff is the reverse of the long call. As can be seen from the diagram, as the price increases, the seller s potential loss increases. When the price falls, the seller is giving protection to the buyer, in return for which he receives the premium.

6 APPLICATION OF OPTIONS IN ISLAMIC FINANCE Long Put (Right to Sell) Let us explain a Long Put position or right to sell with a different example. Assume an investor owns DIGI shares. The investor has heard of a possible merger between DIGI and CELCOM and is concerned about the drop in the price of DIGI shares. He does not want to sell, but at the same time, he does not want to bear losses if the share price plunges. So the investor buys a put option contract whereby he has the right to sell his shares at an exercise price of $23, say, and let us assume the premium the investor has to pay is $0.50 per share. In that way he ensures that his losses are contained. The diagram of the potential profit and loss is as follows: If the DIGI share price falls to say $21, then the investor would want to exercise his right to sell at $23, thus making a profit of $1.50 after taking account of the premium paid. However if the price of DIGI shares rises to say $24, then the investor will let the option expire and his loss is limited to the amount of premium. Taking a long put position limits the loss of the investor to the premium paid. At the price of $22.50 there is neither loss nor profit, and the put breaks even Short Put (Obligation to Buy) The seller of the put option above is considered to have a short put position whereby he has an obligation to buy the underlying shares at the exercise price. Once again, the payoff profile for the short put is the reverse of the long put as shown in the diagram below:

7 6 ISRA RESEARCH PAPER (NO. 46/2012) Imran Iqbal, Sherin Kunhibava & Asyraf Wajdi Dusuki These are the basic forms of options and can be applied to any underlying, i.e., the same concepts can be applied to currencies, rates or commodities Combinations It should be noted that more than one option can be combined to create a payoff profile that suits the individual needs of the customer. For example, if a long call is added to a short put, it results in what is termed a synthetic forward position. This is the equivalent of owning the underlying, i.e., if the price goes up it makes a profit and if the price goes down it loses money. This technique is used by Islamic Banks to create Islamic forwards with SharÊÑah-compliant instruments. The premium is not always paid (or received) in options. In the synthetic forward example above, the customer buys a call option where he pays a premium and simultaneously sells a put option where he will receive a premium. The two options can be priced in such a way that the two premiums cancel each other out. This is called a zero cost option and no money is exchanged at inception. This is preferred by some customers as they can get protection against adverse price movements without having to pay any cash up-front Stand-alone vs. Embedded Options The options described above are termed stand-alone options as they are bought and sold separately. There are also a whole series of options called embedded options where the optionality is not separate but included as part of another product. The most common type of embedded option is the cancellation option. Some products have a

8 APPLICATION OF OPTIONS IN ISLAMIC FINANCE 7 built-in cancellation feature whereby the buyer (or the seller) has the right to terminate the transaction. If the cancellation happens with mutual agreement at the current market price, there is no value to the option. However, if the right to cancel is given to only one party and there are no further obligations when terminated, then the cancellation option has a value or price. The cost or premium of this option is not usually separately identified. Instead, it is typically included as part of the price of the original product. Another example of an embedded option is the right to extend a product; for example, if the customer is given the option to increase the size of a transaction. 2.2 Features of Options Options vary as to when the right can be exercised. In European options, the right to buy or sell can only be exercised at maturity. The maturity date and the exercise date must be the same. For American options the right to buy or sell can be exercised at maturity or any time before. Here the exercise date need not be the same as the maturity date. A Bermudan option is an option that can be exercised at specific dates between issue date and maturity date. However, not all options are exercisable by one or the other party. Sometimes the option may be automatic, i.e., if a specific event occurs, the trade is concluded. An example of this may be a credit option in a loan. In this case if a default or down-grade in the credit rating of a company occurs, the loan will be considered called and all amounts owed will become due immediately. Options can be contracted over-the-counter or traded on an exchange. Over-the-counter (OTC) options are customised agreements negotiated by the parties to the contract. For example, a commercial bank might write a custom-tailored currency option for its customer. In the OTC contract, the terms of the contract, i.e., the amount of the underlying asset, the strike price and the exercise date are negotiated by the parties in private. Exchange-traded options on the other hand are contracts like futures, i.e., they are standardised and traded on organised exchanges. The exchange-traded option specifies a uniform underlying instrument, one of a limited number of maturity prices, and one of a limited number of exercise dates (Edwards & Ma, 1992). The advantage of exchange-traded options is that their performance is guaranteed by a clearing corporation that becomes the seller to each option contract. This eliminates

9 8 ISRA RESEARCH PAPER (NO. 46/2012) Imran Iqbal, Sherin Kunhibava & Asyraf Wajdi Dusuki default risk that might exist in OTC option contracts. Of course, the advantage of OTC options is that they can be customised according to the needs of the customers (Kamali, 2000). As can be seen above, options are widely used in the conventional financial market and can take various forms. As the optionality can be embedded in other transactions, it is not always clear that an option exists. 2.3 Uses and Benefits of Options Although options, and in fact all derivatives, can be used for risk management or hedging purposes, they are also used for arbitrage and/or speculation. Hedging means to reduce one s exposure to risk, arbitrage is the process of taking advantage of price differences between markets, and speculation is the practice of making investments or going into business that involves risk. Thus speculators expose themselves to risk and hope to profit from doing so. It is the excessive speculation and its potentially harmful effects that have led to a negative impression of options. (This will be discussed in greater detail below.) Despite this, there are a number of benefits in using options. Firstly, it is a risk management tool and provides the holder protection against adverse price movements for a minimal cost. This we have seen in the above example (Section 2.1.3) of the investor who owns DIGI shares; by buying a put option, the investor hedges his risk by limiting his possible losses to amount of premium he pays. Secondly, options are more flexible than forwards. In a forward, the customer locks into a forward rate irrespective of how prices change. Hence, if the price moves against him, the customer makes a profit on the forward to offset the loss on the underlying position he is hedging. However, if the price moves in his favour, the customer will make a profit on his underlying position, but this will be offset by the loss he makes on the forward, thus always resulting in the same overall end result. On the other hand, with an option the customer can get the same protection if prices move against him, but he is not obligated to exercise if prices move in his favour. This means that the customer is able to benefit on the underlying position without having his profits reduced by the hedging instrument except for a small deduction due to the premium. This flexibility of options can also be advantageous in providing hedging for situations where the outcome is not certain. An example of this is tendering. Let us assume

10 APPLICATION OF OPTIONS IN ISLAMIC FINANCE 9 a Malaysian private equity firm is bidding for acquisition of a company in Russia. Bidding is by closed tender, and the outcome of the bid will only be known in three months. The Malaysian company is unsure whether it will obtain the tender. At the same time the Malaysian company is concerned about the movement of the exchange rate of ringgit to ruble. If the company enters into a forward contract to buy rubles for ringgits at an exchange rate of 1:9.8, it would be locked in the contract and would be unable to back out of the exchange if the bid was unsuccessful. On the other hand, if the Malaysian company entered into an option contact to buy (long call) it would have to pay a premium for the right to buy rubles at the rate of 1:9.8 but would be able to let the option lapse if the bid was unsuccessful. This example shows that, while options are not a necessity, there is definitely a need for them. An option reduces exposure to unforeseeable circumstances and risks. Another benefit of options is that they can be used to reduce the cost of hedging. Let us assume a customer has taken out floating-rate financing with the interest-rate based on Libor. As interest rates rise, the customer ends up paying more on the loan. He is able to get protection from rising interest rates by doing an interest rate swap that will effectively fix the overall net payment. If the swap is too expensive for the customer, he is able to reduce his cost (i.e., the fixed rate) by giving up some of the protection at very high rates by using an embedded option. As different customers face various risks and have different requirements, it is beneficial to have more than one instrument to hedge these risks. Options give customers the ability to hedge according to their particular circumstances. Having seen that options do meet certain needs and that they provide certain advantages, the question arises as to why a significant number of contemporary SharÊÑah scholars have ruled them impermissible. This is discussed next. 3. A FIQH DISCUSSION OF WHY CONVENTIONAL OPTIONS ARE NOT PERMISSIBLE IN ISLAMIC FINANCE There are a number of reasons why options are unacceptable in the SharÊÑah. The reasons for the objections are not universal; in other words; there is no consensus regarding the specific objections to options. In this paper three main objections to options are identified and discussed below:

11 10 ISRA RESEARCH PAPER (NO. 46/2012) Imran Iqbal, Sherin Kunhibava & Asyraf Wajdi Dusuki the nature and use of options are such that they amount to gambling; options are often used for excessive speculation the premium paid for the right to buy or sell an option contract is impermissible. 3.1 Gambling (Maysir) and Excessive Uncertainty (Gharar) The first SharÊÑah objection to conventional options is that they involve gambling. Whenever the buyer exercises the option contract because it is favourable to him it will result in a corresponding loss to the seller. The gain of one party is equal to the loss of the other part. In economics this is known as a zero-sum game. Obaidullah (Obaidullah, 1998, p. 84) asserts that in options the buyer and seller have diametrically opposite expectations. Depending on the actual outcome, one of them will win at the expense of the other. The gains are therefore in the nature of maysir, and maysir cannot occur without the existence of gharar, being a subset of that larger category. De Lorenzo takes a similar stance (DeLorenzo, n.d.), i.e., options, being intangibles, are part of zero-sum markets where gains take place only with corresponding losses. De Lorenzo opines that this sort of economic activity is clearly forbidden in SharÊÑah. He adds that although proponents of options markets may argue that these activities perform the function of stabilising prices and regulating risk, as far as the SharÊÑah is concerned, these markets produce nothing of value. He concludes that options and futures amount to bets on the direction the market is moving in. Obviously, the ethics of this market are unacceptable. El-Gamal stresses that financial options are pure gharar (El-Gamal, 1999). He goes on to explain that this does not mean that they will necessarily be considered invalid forever; i.e., if jurists find the benefit for allowing them to be overwhelming, then they may be endorsed. As an example, El-Gamal explains that the salam contract contains gharar since the object of sale does not exist at the time of the contract; however, the SharÊÑah has permitted it due to the need for this contract to improve economic efficiency (Al-Amine, 2008, p ).

12 APPLICATION OF OPTIONS IN ISLAMIC FINANCE The Negative Effects of Speculation Scholars argue that derivatives such as option contracts are often used to speculate, i.e., not to protect the value of the underlying assets but to gain from the increase in value of the underlying asset. Apropos of this, much of the post-mortem literature on the financial crisis has identified derivatives as playing a key causative role. It has been claimed that derivatives contributed to the financialization of the economy whereby the financial sector came to dominate the whole economy and forced the real sector to change the way it did its business just to meet the requirements of the financial market. Elgari states: The real sector shrank in terms of growth rate and profit and contribution to the total income of the economy. In the United States, for example, the size of the derivative market reached $56 trillion when the GDP itself was a mere $14 trillion. GDP as percentage of financial turnover was 79.6% in In 2000 it was 1.9%. As derivatives are no longer tools for risk management but for pure speculation, they can grow indefinitely and cause havoc to the stability of the whole economy (Elgari, 2009, p. 4). Obaidullah (Obaidullah, 1998) explains that the ability to speculate on the future direction of the price of the underlying asset due to the random fluctuation in prices causes the gains and losses to the parties to be random too, resulting in the options contract being nothing more than a game of chance. As can be seen, this argument against derivatives is usually explained together with gambling. Another term which is also confused, or used interchangeably, with speculation is investment. It is thus appropriate to define the terms speculation, investment and gambling to understand the differences. Speculation is defined as: discussion about a possible future event. Broadly, in finance, it is the practice of making investments or going into business that involves risk. The term is sometimes used with pejorative undertones to apply to investment for short-term gain. In certain markets, such as commodities and financial futures, speculation is clearly distinguished from transactions undertaken in the normal course of trading (physical buying or selling) or

13 12 ISRA RESEARCH PAPER (NO. 46/2012) Imran Iqbal, Sherin Kunhibava & Asyraf Wajdi Dusuki hedging (where the specific purpose is to minimise overall gains and losses arising from price movements) (Dictionary of International Insurance and Finance Terms, 2001, p ). Thus, speculation is described as investment for short-term gains of a risky nature. Investment, on the other hand, is defined by the Dictionary of International Insurance and Finance Terms (Dictionary, 2001, p. 194) as: 1. expenditure on real or financial assets rather than the funding of consumption. In this sense, investment consists of the purchase of any asset which is expected to increase in value. 2. To an economist, it covers spending that results in economic growth. Comparing the definitions of speculation and investment, it can be deduced that investment is supposed to describe more stable or less risky operations, with longterm rewards, that involve economic growth, whereas speculation denotes shorter term investments and quick gains. Speculators are often accused of recklessly betting on the rise of certain stocks or other underlying assets, a process involving excessive risk and gambling (Tickell, 2000). The Dictionary of International Insurance and Finance Terms (Dictionary, 2001) says about gambling that the term is applied figuratively to the commitment of money on any venture with a high degree of risk. Gambling on a stock market is similar to speculation in that it is shorter-term, riskier and less serious-minded than investment. Thus gambling is described to be similar to speculation because of the short-term gain and riskier deals or positions taken. Investment, on the other hand, is seen as something where more effort is taken to research the possibility of profits. Investment is also closely associated with economic growth and development and not just transfer of wealth from one party to another. Gambling and speculation on the other hand are described as short-term and riskier (Al-Suwailem, 2006). However, a blanket ruling cannot be issued that all speculation is un-islamic (Khan, 1988) (Khan, 1988), unlike gambling, which is clearly ÍarÉm. This is because an element of speculation is present in all forms of business, including muìérabah and mushérakah (Kamali, 1999). In fact, one of the English translations of muìérabah is speculation (H. Wehr, 1980: 540). The concern is when speculation turns into a zerosum game that resembles maysir (Obaidullah, 2002). What this means is that when

14 APPLICATION OF OPTIONS IN ISLAMIC FINANCE 13 speculation is used to create wealth, as in making an investment like muìérabah or mushérakah, it would be acceptable, but when speculation is used only to transfer wealth (El Diwany, 2003) 2 from one party to another, it would amount to a zero-sum game, like gambling (El Diwany, 2003). However, there are proponents of options who believe that because of their usefulness they should not be dismissed because of the elements of gambling and speculation (Smolarski, Schapek & Tahir, 2006, p ). These proponents claim that the presence of speculators in the market enhances liquidity and provides hedgers with parties they can pass their risk on to (Kamali, 1999) (Smolarski, Schapek & Tahir, 2006). In other words, without speculators, hedging would be very difficult or even impossible (Al-Amine, 2008, p.114). A more general argument by analogy is that derivatives are only tools; fiqh rulings are based on how a tool is used, e.g., a knife can be used as a weapon or as cutlery (Mirakhor, 2009). 3.3 Can a Fee Be Charged for the Right Given in an Option? Payment of a premium is required in an option contract for the right given to buy (or sell) the underlying asset at a predetermined exercise price. Contemporary Muslim jurists are divided as to whether it is lawful to charge a fee for this right. According to Usmani (Usmani, 1996, p.10), an option is a promise, and such a promise is itself permissible and normally binding on the promisor ; however, the fee charged for the promise in an option transaction makes options invalid in the SharÊÑah. This ruling, he opines, applies to all kinds of options, both call and put options. This view is based on the fact that options are rights, not tangible assets, and therefore cannot be the subject matter of a sale and purchase. The Islamic Fiqh Academy of the Organisation of Islamic Cooperation (OIC) stated in its Resolution No. 63/1/7: 2 In Islam, wealth creation is important rather than wealth transfer because wealth decays and new wealth must be created to replace the old wealth (El Diwany, 2003). If only wealth transfer was to take place, the stock of wealth would not be enough and would eventually be held by a few fortunate human beings. Wealth creation is therefore necessary for the equal distribution of wealth and more fundamentally for the survival of mankind.

15 14 ISRA RESEARCH PAPER (NO. 46/2012) Imran Iqbal, Sherin Kunhibava & Asyraf Wajdi Dusuki II - OPTION SALE a) Form of Contract The purpose of option contracts is to permit withdrawal of a commitment to sell or buy something specific and described at a definite price during a given period or at a given time either directly or through an organization which guarantees the rights of the two parties. b) The Shariah Ruling on It Option contracts, as currently applied in the world financial markets, are a new type of contract that does not come under any of the Shariah nominate contracts. Since the object of the contract is neither a sum of money nor a utility nor a financial right which may be waived, then the contract is not permissible in the Shariah. As these contracts are prohibited in themselves, trading them is also prohibited (OIC Fiqh Academy, 2001). This decision of the OIC Fiqh Academy was confirmed by the European Council for Fatwa and Research. 3 The same stance was taken by De Lorenzo (De Lorenzo, n.d.), who opined that the sale of options is prohibited because it involves the sale to another party of nothing more than a right to buy. There are, however, other scholars who disagree with the abovementioned views. Kamali has presented strong arguments for the permissibility of compensation in an option contract (Kamali, 1997, p.27). He begins by affirms that the concept of options is valid under SharÊÑah under the concept of al-khiyérét, which are traceable in the Sunnah and were further developed through ijtihéd in the juristic writings of the ulama (scholars learned in Islamic law). On the issue of an option being a mere right and therefore ineligible for sale or purchase, Kamali groups the rights given under an option under intangibles such as service and usufruct (manfañah). While the anafês have 3 European Council for Fatwa and Research, Final Statement of the Twelfth Ordinary 6-10 of Dhul-QiÑdah, 1423 Ah, 31 December of January 2004, (accessed May 11, 2007 from

16 APPLICATION OF OPTIONS IN ISLAMIC FINANCE 15 excluded usufruct from the definition of property, the other major juristic schools have included it (Al-Zuhayli, 2003, 4:398). Kamali (1997) continues his argument on whether compensation is allowed under the SharÊÑah by stating that the typical khiyér (option) that the Sunnah validates is the option of stipulation (khiyér al-sharï) which grants to the buyer the option, within a time frame, to either ratify the contract or to revoke it. Under such options, Kamali maintains that the Sunnah entitles the parties the freedom to insert stipulations that meet their legitimate needs and what may be of benefit to them. Nevertheless, the liberty that is granted here is subject to the general condition that contractual stipulations may not overrule the clear injunctions of SharÊÑah on ÍalÉl and ÍarÉm. Provided that this limitation is observed, in principle, there is no restriction on the nature and type of stipulation that the parties may wish to insert into a contract (Kamali, 1997, p.29). Based on this argument of freedom to contract, Kamali opines that the freedom to insert stipulations in contracts includes the request for monetary compensation. Thereby Kamali concludes that the imposition of a fee for the right granted by options is valid under the SharÊÑah. This view of Kamali was followed by Al-Amine (Al-Amine, 2008), who after extensive discussion of the right in an option and its value as property (mél), and the sale of rights, came to the conclusion that there is nothing in Islamic law which prevents the exchange of such a right for money (Al-Amine, 2008, p.305). This opinion of Kamali and Al-Amine that a fee may be granted in an option contract is a minority view. There are, however, scholars who approve the use of ÑurbËn, and hémish jiddiyyah, which have a fee component to them. Elgari (Elgari, 1993) opines that legitimate options in Islam are affiliated to sale contracts (and to other contracts which accept the option principle) (Elgari, 1993, p.13). Therefore an option as traded in the stock exchange independently and having an existence of its own cannot have a price on its own. Islamic law recognizes trading of intangibles such as service and usufruct (manfañah); however, a right given under an option may not be the same thing as usufruct. The rights under an option do not have

17 16 ISRA RESEARCH PAPER (NO. 46/2012) Imran Iqbal, Sherin Kunhibava & Asyraf Wajdi Dusuki a tangible or material quality. They are similar to pre-emptive rights such as the right of custody and guardianship, which are allowed in the SharÊÑah but are not allowed to be sold as an independent agreement against monetary compensation (Elgari, 1993). Thus Elgari makes a distinction between options which are traded on their own (earlier described as stand-alone options in this paper) and options which are affiliated or embedded in other contracts. Elgari (Elgari, 2009) then explains the Islamic option, which he identifies as being the ÑurbËn contract, which he believes is exactly like a call option. The scholar states that the down payment in ÑurbËn can be retained by the seller, thus working as a fee for the option. The scholar then lays down two important features or conditions that must be satisfied. The first is that the option cannot be separated from the sale of the underlying asset. This stipulation prevents the growth of derivatives beyond the actual needs of real transactions. Secondly, ÑurbËn should not be entered into unless the seller actually owns the underlying asset and continues ownership for the whole duration of the option. This is to prevent the ÑurbËn being traded separately. The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI, 2008) in Standard 1, Trading in Currencies, has pointed out the impermissibility of options in the SharÊÑah (AAOIFI, 2008, p.373) 4 but has instead approved the use of ÑurbËn: 5 /2 Options 5/2/1 A contract by means of which a right is bestowed but not an obligation for the purchase or sale of an identified item (like shares, commodities, currencies, indexes or debts) at a determined price and for a determined period. There is no obligation in this contract except on the person selling this right. 5/2/2 The Shariah rule for options Options contracts indicated above are not permitted, neither with respect to their formation nor trading. 4 In Appendix B for SharÊÑah Standard No. 20 on Sale of Commodities in Organised Markets, Point 12, AAOIFI has stated that the basis for the impermissibility of options is that the subject-matter of the contract is not wealth that can be deemed suitable for compensation in the SharÊÑah.

18 APPLICATION OF OPTIONS IN ISLAMIC FINANCE 17 5/2/3 Shariah substitutes for options 5/2/3/1 The conclusion of a contract pertaining to ascertained assets is permitted according to the SharÊÑah, along with the payment of part of the price as earnest money (urbun) with the stipulation that the buyer has the right to revoke the contract within a specified period in lieu of the entitlement of the seller to the amount of earnest money in case the buyer exercises his right of revocation. It is not permitted to trade the right established with respect to the earnest money. This distinction brings us back to the difference between stand-alone options and embedded options and the payment of a fee. While Usmani, the OIC Fiqh Academy, De Lorenzo and Kamali have not made a distinction between an option that is traded independently and an embedded option, Elgari s distinction would seem to be in line with the approval of ÑurbËn by AAOIFI. The authors of this paper support the view that when an option is stand-alone and can be traded independently, the premium paid for it is impermissible; however, when the option is embedded in a larger transaction, is similar to ÑurbËn, and a fee is paid on it, this would be permissible. At this point, it is worth noting the research and findings of amméd (Hammad, n.d.) who after extensive discussion on financial compensation for an undertaking to sell currencies at a future date, provides SharÊÑah parameters for contracts of exchange with an undertaking. He states on pp : It has become obvious by the end of this study that it is permissible to exchange money for any undertaking to either do or avoid some act, by contractual or non-contractual disposal, by an exchange contract or a benevolent or other contract provided the following five conditions are realized: (1) It must accomplish an intended benefit for the obligee. (2) The benefit must be valid from a SharÊÑah perspective. (3) It must be valuable (be assigned a monetary value in custom). (4) It must be a pledge that is possible to honour. (5) There should be a need for it.

19 18 ISRA RESEARCH PAPER (NO. 46/2012) Imran Iqbal, Sherin Kunhibava & Asyraf Wajdi Dusuki amméd s research is focussed on undertaking to sell currencies at a future date; however, his research findings could be used in a wider context for all types of contracts that have as their underlying other commodities. amméd does not explicitly state whether these SharÊÑah parameters apply to a stand-alone or embedded option, or both. Can the learned scholar s statement, It is permissible to exchange money for any undertaking to either do or avoid some act by contractual or non-contractual disposal, be taken to include stand-alone options? The sweeping nature of this statement makes that the probable conclusion. It is the opinion of the authors that the SharÊÑah parameters are meant for both stand-alone and embedded options and that amméd has approved the payment of fees for both standalone and embedded options. 4. OPTION CONCEPTS IN FIQH In this section, Islamic options are explained, starting with the nominate contracts of Islamic finance itself: ÑurbËn, hémish jiddiyyah, and khiyér al-sharï. Then we will move on to Islamic options created by Islamic banks to hedge against currency risk: Islamic FX products and structures with embedded options. 4.1 KhiyÉr In the SharÊÑah, there are a number of options that provide one or both parties the choice to carry on with the contract or to terminate it, based either on a stipulated condition (khiyér al-sharï), inspection (khiyér al-ru yah), discovery of a defect (khiyér al-ñayb) or the selection option (khiyér al-ta yin) which gives one of the parties the right to choose one of two objects of sale. In fact, al-zuhayli (Al-Zuhayli, 2003, p ) has documented seventeen options approved by the anafês, two types by the MÉlikÊs, sixteen by the ShÉfiÑÊs, and eight by the anbalês. Of these, only khiyér al-sharï (option of stipulation) is explained in this paper. The reason for choosing it is that it is the first Islamic alternative to conventional options to have been advanced by SharÊÑah scholars such as Sulaiman (Sulaiman, 1982), Kamali (Kamali, 1997), Obaidullah (Obaidullah, 1998), and Al-Amine (Al-Amine, 2008). The word khiyér means choice or option. KhiyÉr al-sharï (option of stipulation) is in essence an option within a certain period after the conclusion of a bargain during which

20 APPLICATION OF OPTIONS IN ISLAMIC FINANCE 19 either of the parties may cancel it. This implies that the parties get some time to assess the benefits of the contract. The validity of khiyér al-shart is proven by an authentic ÍadÊth: أ ن ر ج ل ذ ك ر ل لن ب ص ل ى اهلل ع ل ي ه و س ل م أ ن ه ي د ع ف الب ي وع ف ق ال :»إ ذ ا ب اي ع ت ف ق ل ال خ ل ب ة «A man ( ibbén ibn Munqidh) complained to the Prophet (peace be upon him) that he was a victim of frequent cheating in sales. The Prophet advised him, When you conclude a sale, say, There must be no fraud (ØaÍÊÍ al-bukhérê, 1422: 3:65). Al-BayhaqÊ, in his version of the above-mentioned ÍadÊth, reported the following addition to it:»ث أ ن ت ب ال ي ار ف ك ل س ل ع ة اب ت ع ته ا ث ل ث ل ي ال ف إ ن ر ض يت ف أ م س ك و إ ن س خ ط ت ف ار د د» Then you may reserve for yourself an option lasting for three nights. If you are pleased, keep it; and if you are displeased, return it (Al-BayhaqÊ, 1344: 5:273). This is further supported by a ÍadÊth of ÑAbd Allah ibn ÑUmar that the Prophet (peace be upon him said):»امل ت ب اي ع ان ك ل و اح د م ن ه م ا ب ال ي ار ع ل ى ص اح ب ه م ا ل ي ت ف ر ق ا إ ال ب ي ع ال ي ار «The parties to a contract of sale have a right of option as long as they have not separated except in a sale that is subject to option (ØaÍÊÍ al-bukhérê, 1422: 3:64). This option of stipulation has also been documented in the Mejelle (The Mejelle English Translation, n.d.) in Chapter VI Section I article : It is permitted to make a condition in a sale, given to the seller or the buyer, or both together, an option, within a fixed time to make valid the sale by assenting to it, or, to annul it.

21 20 ISRA RESEARCH PAPER (NO. 46/2012) Imran Iqbal, Sherin Kunhibava & Asyraf Wajdi Dusuki If the party, who has been given the option by the term giving the option, in the time of the option, that is to say, within the time that he has the option, wishes, he annuls the contract, and, if he wishes, it is allowed. 4.2 ÑUrbËn ÑUrbËn refers to a sale in which the buyer deposits earnest 5 money with the seller as partial payment of the price in advance but agrees that he will forfeit the deposit money if he fails to ratify the contract, in which case the seller can keep it (Kamali, 2000). ÑUrbËn differs from the conventional option contract in that the partial payment paid is considered as earnest money; as such, if the buyer does not revoke the contract and continues, the earnest money would form part of the purchase price. However, if the contract is revoked within the specified time, the partial payment will be forfeited to the seller. Thus the partial payment is not a fee or premium, as in an option contract, but more of a deposit. As can be seen, ÑurbËn is similar to a call option, except that in the call option the down payment is not subtracted from the contract price. The legality of ÑurbËn is still unsettled. The anbalê School considers ÑurbËn a legal contract, but the other schools object to it and consider it an invalid contract; firstly, because it is considered to akin to misappropriating the property of others; and secondly, it involves an unknown option or condition, which amounts to gharar (Al- Amine, 2000). However a number of contemporary scholars have proposed its use as an Islamic derivative, for example Al-Amine (Al-Amine, 2000), Kamali (Kamali, 1997) and Elgari (Elgari, 1993) (Elgari, 2009). As stated above, Elgari approves the use of an option if it is in the form of ÑurbËn and down payment is provided. AAOIFI also recognizes the need for SharÊÑah-compliant substitutes for conventional options and permits partial payment through ÑurbËn, as stated in Standard No.1 on Trading in Currencies (see above). 5 Earnest is a term used to indicate a serious state of intent, and the term earnest money was used in the past for a down payment for the purchase of real estate to indicate the seriousness of intent (Al- Amine, 2008).

22 APPLICATION OF OPTIONS IN ISLAMIC FINANCE HÉmish Jiddiyyah There is another partial payment, known as hémish jiddiyyah or security deposit, permissible in the SharÊÑah. This security deposit is exclusively used in murébaíah for a purchase orderer. SharÊÑah Standard 8 of the AAOIFI Standards explains it as follows: 2/5/3 It is permissible for an institution, in the case of a binding promise by the customer, to take a sum of money as hamish jiddiyyah (i.e., a security deposit). This is to be paid by the customer at the request of the institution, both as an indication of the financial capacity of the customer and to ensure the compensation of any damage to the institution arising from a breach by the customer of his binding promise. Having taken this hamish jiddiyyah, the institution need not demand compensation for damage as this may be charged against the hamish jiddiyyah. The hamish jiddiyyah is considered not as urbon, i.e., earnest money. The amount of money deposited by the customer as security for his commitment can be either held as trust in the custody of the institution, in which case the latter cannot invest it, or it may be held, if the customer permits the institution to invest it, as an investment trust on the basis of Mudaraba between the customer and the institution. HÉmish jiddiyyah is also a partial payment, but unlike ÑurbËn, the security deposit cannot be taken by the seller in the event the sale does not take place unless the seller has suffered a loss. And in case the seller has suffered a loss, he can take only the amount that compensates his loss. It should be noted that if the loss suffered is greater than the security deposit paid, the seller can claim the extra amount from the buyer. In ÑurbËn, the seller is entitled to all of the earnest money, whether or not losses are suffered (AAOIFI, 2008). 6 Further, in a hémish jiddiyyah, when the customer has fulfilled his promise and executed the contract of murébaíah for the purchase orderer, the institution must refund the hémish jiddiyyah to the customer. The institution is not to use the hémish jiddiyyah unless there is a breach of promise as stated above. In the case of ÑurbËn, it is permissible for the institution to take the ÑurbËn after concluding the murébaíah sale with the customer because it is part of the price. Finally, hémish 6 AAOIFI has, however, stated in its SharÊÑah Standard 8, para 2/5/6, that it is preferable that the institution return to the customer the amount that remains after deducting the actual damage incurred from the ÑurbËn as a result of the breach.

23 22 ISRA RESEARCH PAPER (NO. 46/2012) Imran Iqbal, Sherin Kunhibava & Asyraf Wajdi Dusuki jiddiyyah can only be used in a murébaíah for a purchase orderer whereas ÑurbËn is used in a sale WaÑd WaÑd is a promise or undertaking. It is not an option per se; however, as will be seen below, many Islamic FX option products use the wañd as the main instrument to make the structure an option. This is why it is explained in this paper. The OIC Islamic Fiqh Academy has ruled that a promise may be binding in its Resolution No (2/5 & 3/5): According to the Shariah, a promise (made unilaterally by the purchase orderer or the seller), is morally binding on the promisor, unless there is a valid excuse. It is, however, legally binding if made conditional upon the fulfilment of an obligation, and the promisee has already incurred expenses on the basis of such a promise. The binding nature of the promise means that it should be either fulfilled or compensation be paid for damages caused due to the unjustifiable breach of the promise. Thus the OIC Fiqh Academy has stipulated the following requirements for a wañd to be binding: (6) It must be unilateral. (7) It must have caused the promisee to have incurred some costs/liabilities. (8) If the promise is to purchase something, then the actual sale must take place at the appointed time by the exchange of offer and acceptance. A mere promise should not be considered a concluded sale. (9) If the promisor reneges, the court may force him to either purchase the commodity or pay actual damages to the seller. The actual damages will include the actual losses suffered by the promise and will not include the opportunity lost (Dar, 2005). The AAOIFI Standard SharÊÑah Standard 1: Trading in Currencies, para 2/9, and the SharÊÑah Advisory Council of the Central Bank of Malaysia, in its 49th meeting held 7 Imam MÉlik has, however, given a more general definition of ÑurbËn that includes rent or leasing (Al-Amine, 2008, p. 237).

24 APPLICATION OF OPTIONS IN ISLAMIC FINANCE 23 on 28th April, 2005, allowed wañd to be given in a currency exchange. This opinion is also held by the OIC Islamic Fiqh Academy in Resolution No. 63/1/7 of 1992 of its seventh session, which recommended the use of wañd as one of the SharÊÑah-approved instruments to create SharÊÑah-approved alternatives to currency trading. However, bilateral promises are not allowed. Here a distinction has to be made between wañd (a unilateral promise by one party), wañdan (two independent unilateral promises given by two parties to each other but dependent on two different conditions), and muwéñadah (a bilateral promise, i.e., each of two parties issues a promise, dependent on the other promise, to the other party). The first two promises are permissible; however, a bilateral promise would seem to be prohibited in a sale (bayñ). 8 According to Hasan (2008), for wañdén to be allowed, the conditions for the exercise of each promise should be different and each promise should have different economic effects. 5. OPTION STRUCTURES IN ISLAMIC BANKING In this section, current practises related to option structures in Islamic banking and finance are discussed. The discussion starts with option structures engineered for risk management purposes in currency exchanges; secondly, option structures in ÎukËk are explained; then option structures in structured products; and finally, options in dual currency murébaíah are described. 5.1 FX Option The use of option structures engineered for risk management in currency exchange is not universal, i.e., not all banks use these structures. The banks that do use these structures do so upon the approval of their SharÊÑah Advisory Boards. Two structures have been developed using wañd. In both structures a fee is paid, one through the mechanism of a commodity murébaíah and the other with direct payment of fees WaÑd with Commodity MurÉbaÍah The FX wañd is a structure very similar to the conventional option. It uses a wañd that is binding on one party. On the start date of the transaction, the bank will undertake 8 The basis for not allowing a bilateral binding promise is because it amounts to a contract prior to acquisition of the item to be sold (AAOIFI, 2008, 130).