Financial Engineering in Islamic Finance the Way Forward: A Case for Shariah Compliant Derivatives

Copyright © 2015 by Hussain Kureshi, Septia Irani Mukhsia and Mohsin Hayat.

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CONTENTS

Dedication

Epigraph

Foreword

Preface

Acknowledgements

Introduction

Chapter 1 Bai Istijrar

Chapter 2 Products With No Names

Chapter 3 Islamic Contracts Of Swaps Or Mubadlah

Chapter 4 Islamic Profit Rate Swaps

Chapter 5 Islamic Foreign Exchange Swaps

Chapter 6 Wa’d Based Contracts

Chapter 7 Credit Default Swap / Credit Linked Notes

Chapter 8 Structured Products

Chapter 9 Equity Linked Structured Deposit

Chapter 10 Islamic Sukuk Linked Deposits

Chapter 11 Islamic Repurchase Agreements

Chapter 12 Indices

Chapter 13 Options

Chapter 14 Types Of Options

Chapter 15 Futures And Forwards

Chapter 16 Real Asset Vs Synthetic Asset

Chapter 17 Stripping And Securitization

Chapter 18 Commodities

Chapter 19 Hedging The Price Of Gold Using Ijara

Chapter 20 Risk Reversal Strategies

Chapter 21 Reverse Salaam

Chapter 22 Financial Rights Or Haqq Malli

Conclusion

About The Authors

LIST OF FIGURES

Figure 1.1 Bai Istijrar Workings

Figure 2.1 Sales Contracts

Figure 2.2 Liability Contracts

Figure 3.1 Interest Rate Swaps – Increasing Rates.

Figure 3.2 Interest Rate Swaps - Decreasing Rates.

Figure 3.3 FCY interest payment swaps

Figure 3.4 US $ strengthens wrt Yen

Figure 3.5 US $ weakens to the Yen

Figure 3.6 Interest Rates Increase in US

Figure 3.7 Interest Rates Increase in Japan

Figure 4.1 IPRS Mechanism

Figure 4.2 IPRS for hedging

Figure 5.1 Islamic Foreign Exchange Swap: Tawarruq 1

Figure 5.2 Islamic Foreign Exchange Swap: Tawarruq 2

Figure 5.3 FX Forward Sale using bai muajjal.

Figure 5.5 Forward Currency Sale using tawarruq

Figure 6.1 Wa’d based forward sale.

Figure 6.2 Wa’d with margin.

Figure 6.3 Wa’d with hawalah

Figure 7.1 A Simple System of Risk

Figure 7.2 Details of Credit Financing Within The System

Figure 7.3 Details of Sources of Funding

Figure 7.4 Expected Losses

Figure 7.5 Probability of Default

Figure 7.6 Selling the Risk

Figure 7.7 Transferring the Risk

Figure 7.8 Credit Linked Note Illustration

Figure 8.1 Balance Sheet

Figure 8.2 Structured Products

Figure 8.3 Structured Product ABC

Figure 8.4 ABC Exposure

Figure 8.5 ABC Exposure with Ratings

Figure 8.6 Structured Product DEF

Figure 8.7 DEF Exposure

Figure 8.8 Structured Product GHI

Figure 8.9 GHI Exposure

Figure 8.10 Structured Product JKL

Figure 9.1 Balance Sheet

Figure 11.1 Repo Transaction Process Flow

Figure 11.2 Repo Illustrated

Figure 11.3 Reverse Repo

Figure 11.4 Final Leg of the Transaction

Figure 11.5 Repo with a Haircut

Figure 11.6 90 Days Prices for shares

Figure 11.7 Chart for IBM prices.

Figure 11.8 1st 3 Days if Trading

Figure 11.9 Assets Funded by Repo

Figure 12.1 Movements in Values of Portfolio

Figure 12.2 Returns from 0 to 90 Days

Figure 12.3 Running Portfolio Values

Figure 12.4 Counterparty’s Return

Figure 12.5 Closer Look at Counterparty’s Returns

Figure 12.6 Fund Manager’s Returns

Figure 13.1 Call Options Scenario

Figure 13.2 Possible Prices for Wheat

Figure 13.3 and Figure 13.4 Payouts with Scenarios 1,2 & 3.

Figure 13.5 Movements A and B in Wheat Prices

Figure 13.6 Movements in Prices of Wheat and Wheat Call Options

Figure 13.7 Put Options Scenario

Figure 13.8 Movements in Prices of Wheat and Wheat Put Options Prices

Figure 13.9 Wheat Prices Over 12 Months

Figure 13.20 Link to Underlying

Figure 13.21 Lots of Wheat in Inventory

Figure 14.1 Call Options Trades

Figure 14.2 Put Option Trades

Figure 14.3 Trade for Increasing Prices

Figure 14.4 Trade for Decreasing Prices

Figure 14.5 No profits for either side.

Figure 14.6 Non- Exercisable Up and In Option – Barrier Not Hit

Figure 14.7 Exercisable Up and In Option – Barrier Hit

Figure 14.8 Exercisable Up and Out Option

Figure 14.9 Non-Exercisable Up and Out Option

Figure 14.10 Knock In and Knock Out Options

Figure 14.11 One Touch Option

Figure 14.12 Double Touch Option

Figure 14.13 No Double Touch Option

Figure 14.14 Strip Options

Figure 15.1 Market Scenario

Figure 15.2 Long and Short Positions

Figure 15.3 Contango Prices

Figure 15.4 Backwardation Prices

Figure 15.5 Contango and Backwardation

Figure 15.6 Contango and Backwardation Continued

Figure 16.1 Financial Instruments

Figure 16.2 A Real Transaction of Trade

Figure 16.3 Returns from the Trade

Figure 16.4 Trade Transaction for Intermediaries

Figure 16.5 Returns Comparisons

Figure 16.6 Synthetic Trade

Figure 16.7 Returns on Synthetic Trades

Figure 16.8 Changes in Ratings

Figure 17.1 Cash Flows of a 3 Year Car Loan

Figure 17.2 Figures for another 3 year car loan

Figure 18.1 Sale of Copper

Figure 18.2 Margin Sale between Brokers

Figure 19.1 Step 0 of trade

Figure 19.2 Step 1 of trade

Figure 19.3 Step 3 of Trade

Figure 19.4 Step 3 of Trade

Figure 19.5 Step 4 of Trade

Figure 19.6 Step 5 of Trade

Figure 19.7 Step 6 of Trade

Figure 19.8 Price of Gold in Future

Figure 20.1 Reverse Salaam Contract Initiation

Figure 20.2 Reverse Salaam Contract Conclusion

DEDICATION

Dedicated to the multitude of talented individuals within the Muslim world who have not found a voice. This book is dedicated to the possibilities of self actualization that many within the Muslim world are not yet able to experience.

EPIGRAPH

If one can live with imperfections, we realize we live in a perfect world.

Luqman Zuhdi – Islamic Banker.

FOREWORD

I know Hussein because we grew up together in the same town and knew the same people; but we never ‘hung-out’ with each other. Today I am proudly contributing to Hussein’s book which brings us together as more than friends- we are contemporaries in creating Islamic financial history. An author of Islamic finance, at this nascent juncture, is no less than a pioneer. The ideas and thought that a writer evokes without abundant references certainly is worthy of acclaim. This book is a masterpiece of originality and academic stimulation and an essential tool for augmenting Islamic financial insight. Hussein has made a courageous effort in taking on the challenge to discuss and vividly illustrate the ever-complex subject of derivatives and that, too, from the Islamic perspective. I have yet to come across a more exhaustive narration of the principles and dynamics of Islamic derivatives. I feel honored to introduce this book to the financial world. I think Hussein and I will now be spending a lot of time together.

Bilal Rasul

Head of Department/ Registrar (Modarabas), Specialized Companies Division Securities & Exchange Commission of Pakistan

PREFACE

Islamic banking to date has come a long way to engineer financial products that facilitate trade, which we feel is the main goal of financial intermediation. Financial intermediation cannot be an end in itself, it must serve to fulfil the needs of trade and commerce. It is when financial products move away from any real function, and returns on financial products are no longer linked to returns on actual economic activity, do we witness a world of synthetic banking, bubbles and crises.

Yet products like derivatives, trading techniques like short selling, margin purchases and contracts where the consideration or price is fluid, can and do mirror real trade transactions and therefore need to be explored by the shariah community and the community of Islamic bankers. Another area of deficit is the domain of agriculture financing, which requires the focus of Islamic banks, and this is not possible without the development of commodity exchanges, the presence of speculators and futures trading. Unless farmers are not able to lock in the prices for their goods, banks will be reluctant to finance them. The participants or counterparties to such transactions are not always end users / buyers, but often enough include an array of market makers, speculators, brokers and traders that have no interest in actually taking delivery of any goods, but resell their purchases to other buyers before taking delivery and earning spreads between buying and selling prices thereof.

The commodities industry in the developed world is ripe with exchanges, futures contracts and speculators, and they play an important role in determining the actual price of things from coffee beans to grain to crude palm oil. Restricting the behaviour of speculators so that prices are not artificially increased is the role of regulators or the muhtasib, in the context of the Muslim world, and they should execute this role with diligence and regard for public interest. Much of the Muslim world lives in an environment where one or two agricultural goods are subsidized, be it rice, wheat, or grains. These subsidies are extended to a rural poor, and financed by tax revenues from the urban middle class, the rich or the IMF. Ironically many leaders harp about the choking hold of the IMF and the World Bank, and launch political campaign based upon pointing fingers at cruel lenders, but do not realize (or disclose) that these loans are being used to fund subsidies on electricity tariffs, or flour or wheat prices or purchases of crude oil. Subsidies do not offer a long term solution in as much as exorbitant borrowing is for funding public expenditure.

Nevertheless, this book looks at some structures that allow a seller and a buyer to hedge their prices and looks at the critical problem of hedging and why it has become necessary in today’s world of commerce and trade. We shall draw heavily upon references to our first work title, Contracts and Deals in Islamic Finance as many of the basic contracts in Islamic Finance are covered in this piece. We shall also explore certain tradition contracts of bai, that have some features of derivatives such as options in them and also look at certain conventional trades that can be easily replicated by the Islamic financial services industry provided the necessary market framework and infrastructure is made available.

Finance is not the domain of bankers anymore but pertains to the everyday life of ordinary citizens whose deposits, pension contributions, tax payments, insurance premiums are channelled through various institutions and used to finance assets, projects, governments and companies that affect our everyday lives.

Financial intermediation has made us all part and parcel of a system whether we want to or not, and I believe that 21st century citizens are if nothing else homi economicus and they must realize their role in the global marketplace.

ACKNOWLEDGEMENTS

Hussain Kureshi’s Acknowledgements

It is part of the traditions of Islam to acknowledge one’s teachers. To honour this tradition I have to recognize the team at International Centre for Education in Islamic Finance in Kuala Lumpur, Malaysia. Professor Yusuf Saleem for encouraging me to write my first paper on salaam, which was published in the ISRA Journal of 2014. Professor Ezamshah for his eloquent explanation of risk and how to price risk. Professor Rosly who painstakingly answered every question I had. Professor Azam who is as elegant as he is knowledgeable. Professor Razak for dropping the one pearl of wisdom that the rate of zakat should be the minimum profit rate applied to a credit financing contract. Professor Pisal for his humorous anecdotes, and last but not least, Professor Yusuf. I must also thank Ghaith Mahaini for urging me to write in the first place.

Finally I must acknowledge the warmth and hospitality of the peoples of Malaysia that gave me and my family a home and an environment conducive for me to finish my program.

A warm acknowledgment to the support of my mother, Mrs. Bilquise Azam Kureshi who patiently mentored me through the challenges of going back to school at the age of 42. Finally I must acknowledge team oomi zoomi, which consists of Inaya, Azam and Sophiya who were forced to be separated from their homeland and loving grandparents, Mamajaani, Mamo and Dado, to keep me company while I finished my studies and the book. Finally, I cannot thank Hannah my wife enough for putting up with missing out on her career and my mood swings. I am indebted to you for that.

Moraad Chodhry, who is possibly the most prolific writers on banking and finance, to him I owe a word of thanks for the encouragement. Sydney Felicio and Jade Bailey at Penguin, thank you for patiently taking all my calls, and then again where will you find a writer who submits material weeks before deadlines.

Septya’s Acknowledgements

In the name of God, the most Merciful, the most Beneficent.

I would like to extend my utmost gratitude to my father, Andi Mukhsia, who created our surnames as a mark of the beginning of a new legacy; and my mother, Endang Ratnawati, who has been my best personal critique and friend throughout my whole life. Without them I would not be where I am right now and I am forever grateful for their support and patience towards my every single antics and whim. I would like to also give my words of acknowledgements for Andre and Sheila, my dearest younger siblings who in their own ways always remind me to relax a little bit more and enjoy what life will bring to my plate.

I am indebted to all my lecturers in INCEIF for opening my eyes towards Islamic Banking and Finance. This is for Dr Sheikh Hamzah, Dr Eskandar, Dr Magda, Prof Zainal, Dr Yusuf Saleem, Dr Pisal, Madam Kartini, Prof Syed, and Prof Saiful, who were always ready with answers and enthusiasm in guiding us with their teachings. Not to forget, is my acknowledgements to my classmates and friends in INCEIF. My special thanks to Hidayah, Amalina, Anis Farhana, Muhammad Aminuddin, Hazazi, Asyhar, Shahrul Izzat, Najib Rosli, Aslam Iqbal, Muhammad Zulfadhlee, Ghaniat, Alladeenn, Salman, Imran, Ahmad Safiq, and many more I could not fit into this short passage, for always reminding and correcting my wrongs and keeping me entertained throughout my whole course in INCEIF.

I would like to extend yet another big acknowledgement towards Hussain Kureshi on the opportunity for being a part of this team since his first book together with Mohsin Hayat, Contracts and Deals in Islamic Finance. I would not be here writing this page without his push and encouragement on contribution for this book. I wish to also dedicate my endless thanks towards Arfah, Ericka Leigh, Iqbal Karmana, Adinda Medina, Bismo Sulharyadi, and Nimas Sitorini for always being there, putting up with my stubbornness and constant criticism, and just simply being my friends over all these years.

Last but not least, I would like to acknowledge my best friend and partner in crime Adam for being the greatest support from day one, listening to all my ramblings and what not with a smile, giving me the pat on my back for every smallest things I do, and providing me the shoulder to lean on to whenever I need it for. And above all, I am eternally grateful to my Creator to have blessed me with such beautiful and contended life, filled with all the people whom I love and find joy from; a life which I would not trade for anything or anyone else in this whole world.

Mohsin Hayat Acknowledgements

I acknowledge my family, which has always been supportive of my projects. Even though my two boys Zidaan and Araz would rather play with me, they understand the value of work. I also acknowledge my colleague and office manager, Nasir Rabbani, who for many years has organized, documented, researched, MS Excel-ed, and made available anything and everything upon request. His work has always been invaluable.

My thoughts and ideas have evolved through people I’ve met along the way; ranging from colleagues, friends, restaurant owners, entrepreneurs, emerging market CEOs, financiers, investors from New York, Hong Kong, Kuala Lumpur, Islamabad, Karachi, London, Singapore—people such as Glen Taylor, Yee Hui Wong, Punit Khanna, Kaman Leung, Iqbal Latif, and many more.

And at last but not the least, I acknowledge my coauthor, who did the heavy lifting for this project. Hussain is passionate, thoughtful, and driven by what he believes.

INTRODUCTION

How do we convert real hard assets into financial products? Banks by definition do not trade in real hard assets, they trade in financial products that are linked to real assets. Normal bank loans are linked to either one of the two, future income streams of a borrower, or future revenue generated from an asset that is financed. Bank loans are therefore linked directly to a stream of income, which may be linked to an intangible asset like a borrower’s skill, or may be linked to a tangible asset, like a factory machine, which produces goods and services. Bank loans are rarely disbursed merely on the value of the collateral provided by a borrower. The same holds for Islamic Banking, which to date is still a credit sale based financing system as is much of the global banking system.

How can financial products, or paper products be engineered such that the parties to the product benefit in a manner that mirrors the behaviour of a real good or product or asset. For instance, banks are not in the business of buying inventories of aluminium at a cost price and then selling it onward for a profit to a 3rd party. But banks are in the business of trading in aluminium futures contracts which allows them (the banks) to benefit from movements in the real prices of the real asset.

What if a product was devised between Bank A and Party B, where B agrees (for a consideration of $.10 paid by the bank), to pay the bank $2, if the price of copper goes up by 5% within a specific time frame, in a specific market, such as the London Mercantile Exchange. If this product looks rather vague, have a closer look at investing in commodities indexes. Needless to say, B charges a fee for this contract or promise. If the price of copper does go up by 5%, B pays the Bank $2, if the price of copper does not go up by 5%, B retains the $.10 fees. These products closely resemble the end result of options trades, and cash settled futures transactions. There is no desire, will, or intent to hold any