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Hedging in Islamic Finance

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. State of Risk. Markets are becoming more volatile

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Hedging in Islamic Finance

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  1. HedginginIslamic Finance Sami Al-Suwailem Safar 1427 - March 2006

  2. Objectives • Explore dimensions of risk • Develop criteria for acceptable risks • Outline strategy for product design • Derive Islamic instruments for hedging Hedging 2

  3. State of Risk • Markets are becoming more volatile • Economic instabilities are rising • Solutions? Hedging 3

  4. Dow Jones Hedging 4

  5. Commodities Hedging 5

  6. Currencies: USD Hedging 6

  7. Rising Instabilities Hedging 7

  8. 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

  9. Derivatives • Exponential growth • Controversial impact • Questionable validity Hedging 9

  10. Size of Derivatives Hedging 10

  11. Structure of Derivatives • Zero-sum games • Separate risk from ownership • Allow hedging only through speculation • Dominated by speculators • Threaten system stability Hedging 11

  12. Market Distribution Hedging 12

  13. Risk Dilemma • Economic activities always involve risk • Excessive risk hurdles performance • Pure risk trading transforms into wagering Hedging 13

  14. 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

  15. 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

  16. The Challenge • How to have hedging without unproductive speculation? • How to distinguish legitimate risk taking from gambling? • Where to draw the line? Hedging 16

  17. 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

  18. 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

  19. 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

  20. (A, B) (– ، +) (+ ، –) Zero-sum Games Hedging 20

  21. (A, B) (– , –) (+ , +) Positive Games Hedging 21

  22. (A, B) (– ، +) (+ ، +) Mixed Games Hedging 22

  23. Product Design • Mixed games allow risk transfer with win-win outcome • Combine best of both worlds Hedging 23

  24. Islamic Product Development • Strategies for product development • Imitation dilutes values • Islamic finance becomes a follower Hedging 24

  25. Hedging Instruments Hedging 25

  26. Natural Hedge • Align costs and revenues • Shift some operations to the same region • Borrow in the same currency Hedging 26

  27. Cooperative Hedge • Non-profit arrangements • No legal guarantee • Risk is shared by members • Suite all kinds of risks Hedging 27

  28. 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

  29. 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

  30. Parallel Murabaha • Replaces currency forwards • Integrates currency hedge with goods traded • Murabaha can be for financing or for hedging • Integrates risk transfer with value-creation Hedging 30

  31. Conclusion • Strategies for product development • Vision for the value of the industry • Capitalize on Islamic principles Hedging 31

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