Islamic forex hedging does not necessarily involve tangible assets and the exchange of commodities, as there are ways to execute forex options without an exchange of assets. However, the majority of hedging transactions do involve a combination of Murabahah/Musawwamah. This is because a financial right, such as an FX option or an FX forward, is not considered a valid asset to purchase in an Islamic transaction. Therefore, one has to circumvent these rules by conducting front end and/or back end synthetic Murabahah/Musawwamah trades. Hedging is certainly useful in financial risk management, since it allows financial institutions and their clients to protect themselves from volatility in currencies brought about by the floating currency regimes in most countries. With the Islamic world increasingly intertwined with the rest of the global economy, hedging will be a necessary mechanism for us to protect against potential downside risks associated with our investments and liabilities in other currencies and monetary jurisdictions. Hence, if a customer has an asset in a foreign currency, which she would like to liquidate in the future, she can hedge or opt for the currency rate at today’s rate rather than expose herself to lower valuations of that foreign currency. Alternatively, a customer may have liabilities in foreign currencies, but he does not want to take on the risk of high valuations for the foreign currency, which will require him to pay more in the end. With respect to the question of enhancing returns, we must be clear from the start that hedging in the way that it is allowed is merely a legal ruse/stratagem, which is exceptionally tolerated, to circumvent explicit prohibitions on the deferred settlement of currencies. Whether it is a profit rate swap, total returns swap, FX forward or FX options, these are all exceptions to the rule and not acceptable instruments per se, like Murabahah, Ijarah or any other nominate contract. The objective of the transaction therefore has to be a necessity (unlike Murabahah and Ijarah where the objective of the transaction does not necessarily have to follow from the original purpose the contract was designed for. For instance, Ijarah used for financial leasing or Murabahah for monetization). Most scholars only recognize necessity for risk management purposes or protecting against downside movements and therefore by extension cost reduction. It cannot and should not be used for enhancing returns, whether it is based on fundamental analysis or speculation, since this makes both the objective/intention and the mechanism of the transaction non-compliant. To do so would be opening the floodgates to all sorts of speculative positions on financial rights and derivatives.
DR SAYD FAROOK
The purpose of a foreign exchange hedge transaction is to reduce the risk of adverse price movements in the exchange rate of a currency by entering into an offsetting transaction. For example, I am based in the UK and know that I will be receiving GBP10,000 (US$17,000) in three months time. In this case, there are two main courses of action I can take. Either I wait until the three months have passed and see how many British pounds I will receive at that point in time; or I enter into a hedge transaction which could for example be a forward or an option contract. From a Shariah perspective, the challenges with hedge contracts are generally defined as follows: • The calculation of the future exchange rate includes an interest rate component. The first point can be mitigated by applying Shariah compliant transaction types to achieve a similar economic benefit. This includes, but is not restricted to, the use of tangible assets, the exchange of commodities or the use of promises. The second point is in a way more challenging, and will depend on the client’s intent. Some of the conventional hedging instruments have developed into speculative products, even though the original intent behind them was to reduce the currency exposure. In any case, there is strong demand for these instruments in the market since organizations typically require certainty of cash flows and do not include currency fluctuation when they manage their operations. When applying a forward contract, the exchange rate at the end of the transaction is known, and the parties to the transaction do not get the benefit of any potential favorable price movement. On the other hand, applying option type structures in a mitigation strategy may also allow taking advantage of any favorable price movement by not executing a bought option. Writing an option, however, has unlimited downside potential and would be more speculative in nature. Applied in the right way, hedges are an invaluable risk mitigation technique in financial management. DR NATALIE SCHOON Head of product management, Bank of London and the Middle East
Hedging can be useful as it reduces risk and therefore results in investors being willing to accept a lower return. This lowering of the cost of capital can benefit those seeking finance, whether Islamic or conventional, potentially making projects viable that may not get funded if there was no hedging. From a Shariah perspective hedging is permissible provided there is a real underlying commodity. Agreeing to purchase or sell oil or gas, for example, in three months time at a price agreed now is certainly permissible, providing the transaction is undertaken. Similarly, if an importer agrees to a fixed forward exchange rate for the purchase of Euros after three months with UAE dirham or Saudi riyals in order to make a payment, this reduces contractual uncertainty and encourages trade. Merely taking positions in currencies through buying or selling derivative contracts when the buyer or seller does not actually want the currency is however not permitted, as such use of derivatives contracts is usually speculative. PROFESSOR RODNEY WILSON Director of postgraduate studies, Durham University
To minimize risk hedging is one option used by institution. In most cases hedging cost lower returns. As long as the structure is Shariah compliant it can be used to enhance returns. OMAR KALAIR President and CEO, UM Financial
There is no doubt that hedging is a useful tool for risk management in financial transactions. As regards the Islamic forex hedging transactions, the scholars have allowed them as long as they are used for risk management and not for purely speculative purposes. The extent to which these tools/transactions can be used for return enhancement is determined by the real purpose behind using them. As long as hedging is used for risk management and not for pure speculation, the return enhancement is acceptable and indeed desired. PROFESSOR HUMAYON DAR CEO, BMB Islamic UK
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