Derivatives in Islamic Finance

Pages: 48 (12954 words) Published: February 5, 2012

ANDREAS A. JOBST (forthcoming in Islamic Economic Studies, Vol. 15, No. 1) Paper presented at the International Conference on Islamic Capital Markets held in Jakarta, Indonesia during August 27-29, 2007 jointly organized by Islamic Research and Training Institute (IRTI) of the Islamic Development Bank (IDB), Jeddah, Saudi Arabia, and Muamalat Institute, Jakarta, Indonesia.

ANDREAS A. JOBST# ABSTRACT Despite their importance for financial sector development, derivatives are few and far between in countries where the compatibility of capital market transactions with Islamic law requires the development of Shari[ah-compliant structures. Islamic finance is governed by the Shari[ah, which bans speculation, but stipulates that income must be derived as profits from shared business risk rather than interest or guaranteed return. This paper explains the fundamental legal principles of Islamic finance, which includes the presentation of a valuation model that helps illustrate the Shari[ah-compliant synthetication of conventional finance through an implicit derivative arrangement. Based on the current use of accepted risk transfer mechanisms in Islamic structured finance, the paper explore the validity of derivatives from an Islamic legal point of view and summarizes the key objections of Shari[ah scholars that challenge the permissibility of derivatives under Islamic law. In conclusion, the paper delivers suggestions for Shari[ah compliance of derivatives. Keywords: derivatives, securitization, structured finance, Islamic banking, Islamic finance, sovereign securitization, Shari[ah compliance, sukuk, mudarabah, ijarah, murabahah, riba, istisna[, gharar, maisir, maslahah. JEL Classification: D81, G15, M20.

# International Monetary Fund (IMF), Monetary and Capital Markets Department (MCM), 700 19th Street, NW, Washington, D.C. 20431, USA; e-mail: The views expressed in this paper are those of the author and should not be attributed to the International Monetary Fund, its Executive Board, or its management. Any errors and omissions are the sole responsibility of the author.


International Conference on Islamic Capital Markets

1. INTRODUCTION Financial globalization facilitates greater diversification of investment and enables risk to be transferred across national financial systems through derivatives. The resulting improvement in allocation of risks has made overall capital markets more efficient, while the availability of derivatives has increased liquidity in the underlying cash markets. Amid a compressed spread environment, lower risk premia have also encouraged investors to seek higher yields from emerging market assets as alternative investment. With increasingly market-determined emerging market interest rates and currencies, extension of emerging market yield curves, rapidly growing volume of international trade and capital flows, and increasing stock market activity, the local and foreign interest in emerging derivative markets is growing rapidly. The development of derivative markets in emerging markets plays a special role in this context as more institutional money is dedicated to emerging markets, which requires the availability of financial instruments to manage market, credit and interest rate risks in largely underdeveloped local capital markets. Derivatives in general are financial contracts whose inherent value derives from, and exists by reference to, a pre-determined payoff structure of securities, interest rates, commodities, credit risk, foreign exchange or any other tradable assets, indices thereof and/or baskets of any combination of the above with varied maturities. Derivatives assume economic gains from both risk shifting and efficient price discovery by providing hedging and low-cost arbitrage opportunities. While documentation standards and market practices that govern conventional derivative transactions in...

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International Conference on Islamic Capital Markets
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