Derivatives in Islamic Finance: There isNo Right Way to Do the Wrong Thing—Opportunitiesfor Investors

Abstract

Derivatives are few and far between in countries where the compatibility of financial transactions with Islamic law requires the development of <i>shari’ah</i>-compliant structures. However, as Islamic finance continues to develop rapidly, the rising opportunity cost of limited <i>shari’ah</i>-compliant risk transfer mechanisms has raised questions about the scope of religious restrictions on the use of derivatives, and the scope for efficient risk management techniques for investors. Islamic finance is governed by the <i>shari’ah</i>, which bans speculation and gambling, and stipulates that income must be derived as profits from the shared generation of goods and services between counterparties rather than interest or a guaranteed return. The article explains the fundamental legal principles underpinning Islamic derivatives by reviewing accepted contracts and the scholastic debate surrounding existing financial innovation in this area, in order to generate an axiomatic perspective on a principle-based permissibility of derivatives under Islamic law. An overview of recent standardization efforts also is provided. <b>TOPICS:</b>Derivatives applications, ESG investing