Hedging in Islamic Finance: Sami Al-Suwailem

Hedging in Islamic Finance
Sami Al-Suwailem
Safar 1427 - March 2006
Objectives
Explore dimensions of risk
Develop criteria for acceptable risks

Outline strategy for product design Derive Islamic instruments for hedging
Hedging
State of Risk
Markets are becoming more volatile
Economic instabilities are rising

Solutions?
Hedging
300
Dow Jones
250
200
150
100
50
0 02/01/1990
02/01/1993
02/01/1996
02/01/1999
02/01/2002
02/01/2005
Hedging
Commodities
160 140 120
100
80
60
40
20
0 Dece mber-91
July-93
January95
July-96
January98
July-99
January01
July-02
January04
July-05
Hedging
Currencies: USD
180 160 140 120 100 80 60 40 20 0 29/12/1989
29/12/1992
29/12/1995
29/12/1998
29/12/2001
29/12/2004
Hedging
Rising Instabilities
1990-1994
mean DJ S&P 500 38.6 52.1 53.9 57 106.5 median 27 36 57 52 100.5
2000-2004
mean 159.4 156 158.9 123 134.4 median 199 176 174 124 138
FTSE
Commodities
USD
Hedging
Experts Views
Bernstein (1996):
Volatilities seems to be proliferating rather than
diminishing.
Krugman (1999):
The world economy has turned out to be a much
dangerous place than we imagined.
Tumpel-Gugerell (2003):
Volatility of leading stock markets has doubled
since 1997. Financial volatility is transmuted into volatility of real output.

Hedging 8
Derivatives
Exponential growth
Controversial impact
Questionable validity
Hedging
Size of Derivatives
350,000 300,000 250,000 200,000 150,000 100,000 50,000 0
Jun-98 Dec. 1998 Jun-99 Dec. 1999 Jun-00 Dec. 2000 Jun-01 Dec. 2001 OE Jun-02 Dec. 2002 Jun-03 Dec. 2003 Jun-04 Dec. 2004 Jun-05
OTC
Hedging
10
Structure of Derivatives
Zero-sum games
Separate risk from ownership

Allow hedging only through speculation Dominated by speculators Threaten system stability
Hedging
11
Market Distribution
Speculation: 97.30%
Hedging: 2.70%
Hedging
12
Risk Dilemma
Economic activities always involve risk
Excessive risk hurdles performance

Pure risk trading transforms into
wagering
Hedging
13
Unresolved Issues
Ken Arrow (2003):
Derivatives can be used to reduce risk but
people gamble on them. Speculators are adding to the swings rather than reducing them.
Hedging
14
Unresolved Issues
Kreitner (2000):
No analytical formula could distinguish
gambling from risk allocation. The question of gambling was eventually swallowed and internalized, as if the problem were solved. The contract law stopped worrying and learned to love risk.
Hedging
15
The Challenge
How to have hedging without
unproductive speculation? How to distinguish legitimate risk taking from gambling? Where to draw the line?
Hedging
16
Islamic Framework
Acceptable risk (ex ante):
Minor, likelihood of success is high
Inevitable, inseparable from real activities
Payoff structure (ex post):

Non-zero-sum-game
Hedging
17
Statistical Measure
Expected utility is a statistical mean
Allows for gambling

Statistical median:
Excludes low probability events Immune to outliers Consistent with Islamic concept of gharar
Hedging
18
Payoff Structure
Zero-sum games: conflict of interest
Positive sum games: cooperative

Non-zero-sum games: mixed Mixed games are acceptable if the
positive outcome is dominant
Hedging
19
Zero-sum Games
(A, B)
( +)
(+ )
Hedging
20
Positive Games
(A, B)
( , )
(+ , +)
Hedging
21
Mixed Games
(A, B)
( +)
(+ +)
Hedging
22
Product Design
Mixed games allow risk transfer with
win-win outcome Combine best of both worlds
Hedging
23
Islamic Product Development

Strategies for product development
Imitation dilutes values

Islamic finance becomes a follower
Hedging
24
Hedging Instruments
Instrument
Asset-Liability alignment Delta-hedging Mutual hedging Bilateral mutual adjustment Conditional mudharabah
Risks Hedged
General General General Rate of return Capital, misreporting
Combining musharakah and deferred sale

Third party hedging Diversified deferred price Value-based hybrid salam
Hedging
Capital, rate of return

Capital, rate of return Capital, rate of return, liquidity Capital, rate of return, liquidity
25
Natural Hedge
Align costs and revenues
Shift some operations to the same
region Borrow in the same currency
Hedging
26
Cooperative Hedge
Non-profit arrangements
No legal guarantee
Risk is shared by members Suite all kinds of risks
Hedging
27
Bilateral Adjustment
Murabaha cannot have a changing rate
Adjust installment but keep total debt
fixed
If market rate is up: increase installment,
reduce balance If market rate is down: reduce installment, increase balance Done with mutual agreement
Hedging
28
Diversified Deferred Price

Also for murabaha
Have the price in two components:

Principal: in money Markup: in liquid assets
Allow return to adjust to market

If markup is large, total price becomes
tradable
Hedging
29
Parallel Murabaha
Replaces currency forwards
Integrates currency hedge with goods
traded Murabaha can be for financing or for hedging Integrates risk transfer with valuecreation
Hedging
30
Conclusion
Strategies for product development
Vision for the value of the industry

Capitalize on Islamic principles
Hedging
31

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Hedging in Islamic Finance

Develop criteria for acceptable risks

Economic instabilities are rising

dangerous place than we imagined.

since 1997. Financial volatility is transmuted into volatility of real output.

Separate risk from ownership

Excessive risk hurdles performance

Payoff structure (ex post):

Allows for gambling

Positive sum games: cooperative

positive outcome is dominant

win-win outcome Combine best of both worlds

Islamic Product Development

Imitation dilutes values

Combining musharakah and deferred sale

Capital, rate of return

Shift some operations to the same

region Borrow in the same currency

Adjust installment but keep total debt

Diversified Deferred Price

Have the price in two components:

Allow return to adjust to market

Integrates currency hedge with goods

Vision for the value of the industry

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