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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 l.jpg

HedginginIslamic Finance

Sami Al-Suwailem

Safar 1427 - March 2006


Objectives l.jpg
Objectives

  • Explore dimensions of risk

  • Develop criteria for acceptable risks

  • Outline strategy for product design

  • Derive Islamic instruments for hedging

Hedging 2


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State of Risk

  • Markets are becoming more volatile

  • Economic instabilities are rising

  • Solutions?

Hedging 3


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Dow Jones

Hedging 4


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Commodities

Hedging 5


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Currencies: USD

Hedging 6



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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


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Derivatives

  • Exponential growth

  • Controversial impact

  • Questionable validity

Hedging 9



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Structure of Derivatives

  • Zero-sum games

  • Separate risk from ownership

  • Allow hedging only through speculation

  • Dominated by speculators

  • Threaten system stability

Hedging 11



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Risk Dilemma

  • Economic activities always involve risk

  • Excessive risk hurdles performance

  • Pure risk trading transforms into wagering

Hedging 13


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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


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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


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The Challenge

  • How to have hedging without unproductive speculation?

  • How to distinguish legitimate risk taking from gambling?

  • Where to draw the line?

Hedging 16


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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


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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


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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 l.jpg

(A, B)

(– ، +)

(+ ، –)

Zero-sum Games

Hedging 20


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(A, B)

(– , –)

(+ , +)

Positive Games

Hedging 21


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(A, B)

(– ، +)

(+ ، +)

Mixed Games

Hedging 22


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Product Design

  • Mixed games allow risk transfer with win-win outcome

  • Combine best of both worlds

Hedging 23


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Islamic Product Development

  • Strategies for product development

  • Imitation dilutes values

  • Islamic finance becomes a follower

Hedging 24



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Natural Hedge

  • Align costs and revenues

  • Shift some operations to the same region

  • Borrow in the same currency

Hedging 26


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Cooperative Hedge

  • Non-profit arrangements

  • No legal guarantee

  • Risk is shared by members

  • Suite all kinds of risks

Hedging 27


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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


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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


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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


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Conclusion

  • Strategies for product development

  • Vision for the value of the industry

  • Capitalize on Islamic principles

Hedging 31