The Islamic Hedging Management: Paving the Way for Innovation in Currency Options

Nadhirah Nordin,Hydzulkifli Hashim Omar,Asmak Ab Rahman

doi:10.32890/ijms.21.1.2014.10403

Abstract

Islamic hedging is one of the most important tools for risk management. Currency options contracts are commonly regarded as one of the useful tools of risk management and frequently used to reduce risk associated with the movement in price and currency risk. This article attempts to review the suitability of the Islamic currency options in one of the Islamic banks in Malaysia as a hedging mechanism and highlights Shariah issues pertaining to the structures. Currency options are prohibited in Islamic finance due to the issue of riba and to the violation of the bay al-sarf rule which requires currency trading to be done on “spot” basis only. Options contract is also rejected by some scholars because of premium payment or chargeable fees to the right. In view of the overwhelming importance of currency risk management in the volatile market, the application of Shariah principles in currency market faces a great challenge to Islamic scholars today. Based on the observation of the bank’s official information disclosed to the public and the interview conducted, the finding of this research indicates that the bank permitted currency options based on the principle of tawwaruq (commodity murabahah) or bay al-inah and wa’ad (unilateral promise) which are strictly used for hedging purposes. Tawwaruq and wa’ad principles have given Islamic financial institutions the opportunity to structure Shariah compliant financial products and meet the objective of increasing trading volume and liquidity in order to reduce transaction cost and risk. Keywords: Islamic hedging, options, currency trading, tawarruq, wa’ad.

Highlights

Hedging is an important risk management tool in financial markets
On the date of signing the option contract, the customer and the bank will carry out the first tawarruq transaction to gain profit of sales revenue that is equal to the premium value as in the transaction of a conventional option contract
Islamic FX options which is based on tawarruq, bay al-inah, wa’ad and bay al-sarf is seen as a significant alternative in Islamic finance to assist in more efficient and competitive risk management

Summary

Introduction

Hedging is an important risk management tool in financial markets. Hedging is a strategic measure of investors to reduce certain risks through certain financial tools. It decreases loss-risk of an investment or diminution in the value of an asset (Carter, 2003). Without having a proper risk management mechanism and hedging tools, even when a company makes profit, it could be making losses due to currency and exchange-rate risk, which can rise or fall within a short period of time (Chance, 2008). Fluctuations in the foreign exchange rate can have significant impacts on business decisions and outcomes. To avoid changes in the foreign-exchange rate within the three month period, both parties will enter the derivative market to determine the future rate of exchange in the specified period of time (Guan, 2002)

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