Hedging(Dr. AlSuwailem)

7/27/2019 Hedging(Dr. AlSuwailem)

1/31

Hedging

in

Islamic Finance

Sami Al-SuwailemSafar 1427 - March 2006


2/31

Hedging 2

Objectives

Explore dimensions of risk

Develop criteria for acceptable risks

Outline strategy for product design

Derive Islamic instruments for hedging


3/31

Hedging 3

State of Risk

Markets are becoming more volatile

Economic instabilities are rising

Solutions?


4/31

Hedging 4

Dow Jones

0

50

100

150

200

250

300

02/01/1990 02/01/1993 02/01/1996 02/01/1999 02/01/2002 02/01/2005


5/31

Hedging 5

Commodities

0

20

40

60

80

100

120

140

160

Dece

mber-91

July-93 January-

95

July-96 January-

98

July-99 January-

01

July-02 January-

04

July-05


6/31

Hedging 6

Currencies: USD

0

20

40

60

80

100

120

140

160

180

29/12/1989 29/12/1992 29/12/1995 29/12/1998 29/12/2001 29/12/2004


7/31

Hedging 7

Rising Instabilities

1990-1994 2000-2004

mean median mean median

DJ 38.6 27 159.4 199

S&P 500 52.1 36 156 176

FTSE 53.9 57 158.9 174

Commodities 57 52 123 124

USD 106.5 100.5 134.4 138


8/31

Hedging 8

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.


9/31

Hedging 9

Derivatives

Exponential growth

Controversial impact

Questionable validity


10/31

Hedging 10

0

50,000

100,000

150,000

200,000

250,000

300,000

350,000

Jun-98 Dec.

1998

Jun-99 Dec.

1999

Jun-00 Dec.

2000

Jun-01 Dec.

2001

Jun-02 Dec.

2002

Jun-03 Dec.

2003

Jun-04 Dec.

2004

Jun-05

OTC OE

Size of Derivatives


11/31

Hedging 11

Structure of Derivatives

Zero-sum games

Separate risk from ownership

Allow hedging only through speculation

Dominated by speculators

Threaten system stability


12/31


13/31

Hedging 13

Risk Dilemma

Economic activities always involve risk

Excessive risk hurdles performance

Pure risk trading transforms into

wagering


14/31

Hedging14

Unresolved Issues

Ken Arrow (2003): Derivatives can be used to reduce risk but

people gamble on them.

Speculators are adding to the swings ratherthan reducing them.


15/31

Hedging15

Unresolved Issues

Kreitner (2000): No analytical formula could distinguish

gambling from risk allocation.

The question of gambling was eventuallyswallowed and internalized, as if the

problem were solved.

The contract law stopped worrying and

learned to love risk.


16/31

Hedging16

The Challenge

How to have hedging withoutunproductive speculation?

How to distinguish legitimate risk

taking from gambling?Where to draw the line?


17/31

Hedging17

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


18/31

Hedging18

Statistical Measure

Expected utility is a statistical mean

Allows for gambling

Statistical median:

Excludes low probability events

Immune to outliers

Consistent with Islamic concept ofgharar


19/31

Hedging19

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


20/31

Hedging20

Zero-sum Games

(+ )( +)

(A, B)


21/31

Hedging21

Positive Games

(+ , +)( ,)

(A, B)


22/31

Hedging22

Mixed Games

(+ +)( +)

(A, B)


23/31

Hedging23

Product Design

Mixed games allow risk transfer withwin-win outcome

Combine best of both worlds


24/31

Hedging24

Islamic Product Development

Strategies for product development

Imitation dilutes values

Islamic finance becomes a follower


25/31

Hedging25

Hedging Instruments

Instrument Risks HedgedAsset-Liability alignment General

Delta-hedging General

Mutual hedging General

Bilateral mutual adjustment Rate of return

Conditional mudharabah Capital, misreporting

Combining musharakah and

deferred sale

Capital, rate of return

Third party hedging Capital, rate of return

Diversified deferred price Capital, rate of return, liquidity

Value-based hybridsalam Capital, rate of return, liquidity


26/31

Hedging26

Natural Hedge

Align costs and revenuesShift some operations to the same

region

Borrow in the same currency


27/31

Hedging27

Cooperative Hedge

Non-profit arrangementsNo legal guarantee

Risk is shared by members

Suite all kinds of risks


28/31

Hedging28

Bilateral Adjustment

Murabaha cannot have a changing rateAdjust 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


29/31

Hedging 29

Diversified Deferred Price

Also formurabahaHave 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


30/31

Hedging 30

Parallel Murabaha

Replaces currency forwardsIntegrates currency hedge with goods

traded

Murabaha can be for financing or forhedging

Integrates risk transfer with value-

creation


31/31

Hedging 31

Conclusion

Strategies for product developmentVision for the value of the industry

Capitalize on Islamic principles

Documents

Hedging(Dr. AlSuwailem)