Islamic Perspective on Financial Derivatives: Demand for Instruments of Risk Management in Various Businesses of Pakistan

Abstract

This study was undertaken with the aim of exploring the legitimacy or otherwise of financial derivatives according to the Islamic commercial law, and ascertaining the demand for instruments of risk management in various business and economic sectors of Pakistan. The study drew the conclusion that forward contracts and futures contracts are allowed to benefit from. However, only hedgers can take advantage of them. These instruments can never be used for purely speculative purposes where making or taking delivery is not intended. Although it is not necessary to pay the complete price to the seller at the time of the contract yet some other precautionary measures such as a bank guarantee or a fair amount of money to be given to the seller should be taken to ensure that pure speculation is scrupulously forestalled and the delivery would certainly be made. If a large amount of money is given to the seller at the time of the contract the proscription of bai al-kali bil-kali would no longer be applicable because bai al-kali bil-kali comes about where the settlement by both parties is deferred to a future date, but that is not the case here. This amount of money would later on be adjusted to the total price. Options trading is also permissible because it is simply an extension of the fundamental concept of freedom and legitimacy given by the Shari’ah in relation to commercial transactions. However, those types of financial derivatives which involve riba such as interest-rate futures, interest-rate options, interest-rate swaps and swaptions are ruled out altogether and can never be taken advantage of. Similarly, those derivatives which proceed on gambling, inordinate uncertainty, alcohol, pork and other inadmissible commodities are precluded into the bargain.

To carry out the empirical part of the research, 600 questionnaires were randomly given out to the organizations operating in two commercial and industrial cities of Pakistan, namely Lahore and Faisalabad. The goal of the survey was to ascertain the demand for instruments of risk management in various business and economic sectors. The research findings indicated that there is demand for collateral, futures contracts, guarantee, and hatt wa ta’ajjal for credit risk management. As regards market risk management, arbun sale, bai al-salam, forward contracts, futures contracts, istijrar, istisna, and khiyar al-shart are in demand. In relation to currency risk management, foreign currency forwards, foreign currency futures, and foreign currency options are in demand. To mitigate interest-rate risk, forward rate agreements, interest-rate futures, and interest-rate options are in demand. The research findings further represented that a large number of the respondents want to use these instruments, if available, for hedging purposes.

The researcher learnt while administering the questionnaires that the respondents who do not want to utilize the instruments or techniques of risk management are either unacquainted with their structure or, quite often, not aware of their adequate and proper use. It was therefore proposed that the Islamic as well as conventional financial institutions had better provide their clientele and other business entrepreneurs with the required risk management counselling. Another issue is germane to the Islamic legal implications of foreign currency options, forward rate agreements and interest rate swaps permitted by the State Bank of Pakistan. The illicit features of these instruments ipso facto make them impracticable for those people who are desirous of using only Shari’ah-compliant instruments. It was thus suggested that the State Bank of Pakistan should also introduce other Shari’ah-compliant instruments, that is to say istisna, salam, bai al-arbun, istijrar, forward contracts, futures contracts, options and Islamic swaps, and allow Islamic as well as conventional banks to employ them for risk management. It is scrupulously hoped that some, if not all, parts of this research would be of benefit to and applied by the Islamic as well as conventional financial institutions in Pakistan and elsewhere.