Application of Options in Islamic Finance

# The opinions stated in this paper are of the authors' alone and do not represent the views of the organizations they work for.

* Imran Iqbal is the Head of Islamic Banking for Saudi Hollandi Bank. He can be contacted at [email protected] or [email protected].

** Sherin Kunhibava Phd. is a Consultant at Wisdom Management Consultancy Sdn. Bhd. and can be contacted at [email protected] or [email protected].

*** Assoc. Prof. Dr. Asyraf Wajdi Dusuki is the Head of Research Affairs at the International SharÊÑah Research Academy for Islamic Finance (ISRA). He can be contacted at [email protected].

APPLICATION OF OPTIONS IN ISLAMIC FINANCE#

Imran Iqbal*

Dr. Sherin Kunhibava**

Assoc. Prof. Dr. Asyraf Wajdi Dusuki***

ABSTRACT

The objective of this research is to provide a clearer understanding of the options

contract in Islamic finance. Option contracts provide economic benefits of hedging and

flexibility of use; however, they are also used for speculative purposes that contravene

the SharÊÑah. Options are also objected to because of the payment of a premium, and

conditional options are not allowed in currency exchanges. Islamic options have

been engineered, and some Islamic banks do use them for hedging purposes. This

paper begins with an explanation and description of options in conventional finance,

including the benefits, and moves on to explain the SharÊÑah view on conventional

options. The paper then moves on to describe Islamic options that exist within Islamic

finance itself—ÑurbËn (earnest money), hÉmish jiddiyyah (security deposit), and

khiyÉr al-sharÏ (stipulated option)—and thereafter explains Islamic options created

by Islamic banks to hedge against risk, focussing specifically on currency risk, ÎukËk

(Islamic bonds) and commodity hedging. The paper concludes by discussing which

types of options may be deemed to be acceptable from a SharÊÑah point of view.

Keywords: Options, speculation, hedging, gharar, waÑd

ISRA RESEARCH PAPER (NO. 46/2012)Imran Iqbal, Sherin Kunhibava & Asyraf Wajdi Dusuki

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1. INTRODUCTION

A derivative is a financial instrument whose value depends on the value of other, more

basic variables (Hull, 2005). ‘Derivative’ is therefore a generic term for instruments that

derive their value from elsewhere. The main types of derivatives are forwards, futures,

options and swaps. This paper will be focussing on the option contract. Options are

widely used in the conventional financial market and have as their underlying a number

of assets such as rates, currencies, equities, commodities and indexes (Bacha, 2001).1

Although option contracts are widely used in the conventional market, their use in

Islamic finance is less prevalent. This is partly due to a lack of understanding of the

instrument and its uses/benefits. It is also partly due to concerns that allowing options

opens up the possibility of misuse. The majority of Islamic finance scholars have ruled

that the conventional version of the option contract is impermissible. However, Islamic

businesses face the same financial risks2 as their conventional counterparts and similar

instruments are needed to manage these risks. Hence, various Islamic options have

been engineered to hedge against these risks using underlying Islamic instruments to

replicate the conventional instruments. Islamic commercial law also contains certain

known permissible options. The aim of this paper is to discuss various SharÊÑah issues

relating to options and to increase the understanding about these instruments.

This paper begins with an explanation and description of options in conventional finance,

including the benefits, and moves on to explain the SharÊÑah view on conventional

options. The paper then moves on to describe Islamic options that exist within Islamic

finance itself—ÑurbËn (earnest money), hÉmish jiddiyyah (security deposit), and khiyÉr

al-sharÏ (stipulated option)—and thereafter explains Islamic options created by Islamic

banks to hedge against risk, focussing specifically on currency risk, ÎukËk (Islamic

bonds) and commodity hedging. The paper concludes by discussing which types of

options may be deemed to be acceptable from a SharÊÑah point of view.

1 These underlying assets can be categorised as physicals and financials. Where the underlying commodity is delivered on the maturity of the derivative, it is known as a commodity derivative. Where the settlement at maturity is by cash, it is known as a financial derivative. Examples of the underlying of financial derivatives are currencies, stock indexes, interest rates, and stocks. Cash settlements take place in financial derivatives because the underlying asset is either not tangible or it is very difficult to make physical delivery.

APPLICATION OF OPTIONS IN ISLAMIC FINANCE 3

2. UNDERSTANDING OPTIONS

An option is a contract that gives the buyer the right, but not the obligation, to sell

or buy a specific quantity of a given asset at a specified price at a specific date in the

future. For this right, the buyer pays a price, known as a premium, to the seller of the

option.

The seller of the option is also known as the option writer, and the buyer of the option

is also known as the owner. The price in the contract is known as the exercise price or

strike price, and the date in the option contract is known as the exercise date or maturity.

2.1 Types of Options

Two basic types of options exist, a call option and a put option. A call option gives

the buyer the right to buy the underlying asset by a certain date for a certain price. A

put option on the other hand gives the buyer the right to sell the underlying asset by a

certain date for a certain price. There are thus four possible participants in an option

contract: buyers of calls, sellers of calls, buyers of puts and sellers of puts.

Often buyers are referred to as having long positions; sellers are referred to as having

short positions (Hull, 2005). Let’s look at the potential profit and loss of each participant

of the option contract (Bacha, 2001).

2.1.1 Long Call (Right to Buy)

Let’s say an investor wants to buy shares in a mining company (BARU) and believes

that its shares will increase in price. The investor has two choices: either pay the full

price and buy the shares, or pay a fraction of the price (i.e., the premium) and buy

call options. The latter is known as a Long Call position. Both choices give the same

result if prices rise, i.e., they make a profit from the investment. However, if prices

fall and the investor has bought the shares, he will continue to lose money until the

price reaches zero, whereas with the option his loss is limited to the premium only. Let

us assume that the investor buys a call option on BARU shares at an exercise price of

$4.00 with a premium to be paid of 10 cents per share.


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The diagram of the potential profit and loss is as follows:

This is known as a payoff diagram. If on the exercise date the price of the share is

$4.50, the investor will exercise his right and buy the shares at a price of $4.00. He can

immediately sell it in the market at $4.50, thus making a profit of 40 cents after taking

account of his cost of 10 cents for the premium he has paid already. Now let’s consider

if the price has fallen to $3.50 on the exercise date. In this case the investor will let

the option expire as there is no need to buy a share for $4.00 when he can get it in the

market for cheaper. The only loss to the investor is the 10 cents premium.

2.1.2 Short Call (Obligation to Sell)

The seller (or writer) of the call option above is said to have a short call position, i.e.,

he is obliged to sell the underlying shares at the exercise price.

In this situation the payoff is the reverse of the long call. As can be seen from the

diagram, as the price increases, the seller’s potential loss increases. When the price

falls, the seller is giving protection to the buyer, in return for which he receives the

premium.


2.1.3 Long Put (Right to Sell)

Let us explain a Long Put position or right to sell with a different example. Assume an

investor owns DIGI shares. The investor has heard of a possible merger between DIGI

and CELCOM and is concerned about the drop in the price of DIGI shares. He does

not want to sell, but at the same time, he does not want to bear losses if the share price

plunges. So the investor buys a put option contract whereby he has the right to sell

his shares at an exercise price of $23, say, and let us assume the premium the investor

has to pay is $0.50 per share. In that way he ensures that his losses are contained. The

diagram of the potential profit and loss is as follows:

If the DIGI share price falls to say $21, then the investor would want to exercise his

right to sell at $23, thus making a profit of $1.50 after taking account of the premium

paid. However if the price of DIGI shares rises to say $24, then the investor will let

the option expire and his loss is limited to the amount of premium. Taking a long put

position limits the loss of the investor to the premium paid. At the price of $22.50 there

is neither loss nor profit, and the put breaks even.

2.1.4. Short Put (Obligation to Buy)

The seller of the put option above is considered to have a short put position whereby

he has an obligation to buy the underlying shares at the exercise price. Once again, the

payoff profile for the short put is the reverse of the long put as shown in the diagram

below:


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These are the basic forms of options and can be applied to any underlying, i.e., the same

concepts can be applied to currencies, rates or commodities.

2.1.5 Combinations

It should be noted that more than one option can be combined to create a payoff profile

that suits the individual needs of the customer. For example, if a long call is added

to a short put, it results in what is termed a ‘synthetic forward’ position. This is the

equivalent of owning the underlying, i.e., if the price goes up it makes a profit and if

the price goes down it loses money. This technique is used by Islamic Banks to create

Islamic forwards with SharÊÑah-compliant instruments.

The premium is not always paid (or received) in options. In the synthetic forward

example above, the customer buys a call option where he pays a premium and

simultaneously sells a put option where he will receive a premium. The two options

can be priced in such a way that the two premiums cancel each other out. This is called

a “zero cost” option and no money is exchanged at inception. This is preferred by some

customers as they can get protection against adverse price movements without having

to pay any cash up-front.

2.1.6 Stand-alone vs. Embedded Options

The options described above are termed “stand-alone” options as they are bought and

sold separately. There are also a whole series of options called “embedded” options

where the optionality is not separate but included as part of another product. The most

common type of embedded option is the cancellation option. Some products have a


built-in cancellation feature whereby the buyer (or the seller) has the right to terminate

the transaction. If the cancellation happens with mutual agreement at the current market

price, there is no value to the option. However, if the right to cancel is given to only

one party and there are no further obligations when terminated, then the cancellation

option has a value or price. The cost or premium of this option is not usually separately

identified. Instead, it is typically included as part of the price of the original product.

Another example of an embedded option is the right to extend a product; for example,

if the customer is given the option to increase the size of a transaction.

2.2 Features of Options

Options vary as to when the right can be exercised. In European options, the right to

buy or sell can only be exercised at maturity. The maturity date and the exercise date

must be the same. For American options the right to buy or sell can be exercised at

maturity or any time before. Here the exercise date need not be the same as the maturity

date. A Bermudan option is an option that can be exercised at specific dates between

issue date and maturity date.

However, not all options are exercisable by one or the other party. Sometimes the

option may be automatic, i.e., if a specific event occurs, the trade is concluded. An

example of this may be a credit option in a loan. In this case if a default or down-grade

in the credit rating of a company occurs, the loan will be considered called and all

amounts owed will become due immediately.

Options can be contracted over-the-counter or traded on an exchange.

Over-the-counter (OTC) options are customised agreements negotiated by the parties to

the contract. For example, a commercial bank might write a custom-tailored currency

option for its customer. In the OTC contract, the terms of the contract, i.e., the amount

of the underlying asset, the strike price and the exercise date are negotiated by the

parties in private. Exchange-traded options on the other hand are contracts like futures,

i.e., they are standardised and traded on organised exchanges. The exchange-traded

option specifies a uniform underlying instrument, one of a limited number of maturity

prices, and one of a limited number of exercise dates (Edwards & Ma, 1992).

The advantage of exchange-traded options is that their performance is guaranteed by

a clearing corporation that becomes the seller to each option contract. This eliminates


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default risk that might exist in OTC option contracts. Of course, the advantage of OTC

options is that they can be customised according to the needs of the customers (Kamali,

2000).

As can be seen above, options are widely used in the conventional financial market and

can take various forms. As the optionality can be embedded in other transactions, it is

not always clear that an option exists.

2.3 Uses and Benefits of Options

Although options, and in fact all derivatives, can be used for risk management or

hedging purposes, they are also used for arbitrage and/or speculation. Hedging means

to reduce one’s exposure to risk, arbitrage is the process of taking advantage of price

differences between markets, and speculation is the practice of making investments or

going into business that involves risk.

Thus speculators expose themselves to risk and hope to profit from doing so. It is the

excessive speculation and its potentially harmful effects that have led to a negative

impression of options. (This will be discussed in greater detail below.)

Despite this, there are a number of benefits in using options. Firstly, it is a risk

management tool and provides the holder protection against adverse price movements

for a minimal cost. This we have seen in the above example (Section 2.1.3) of the

investor who owns DIGI shares; by buying a put option, the investor hedges his risk by

limiting his possible losses to amount of premium he pays.

Secondly, options are more flexible than forwards. In a forward, the customer locks

into a forward rate irrespective of how prices change. Hence, if the price moves against

him, the customer makes a profit on the forward to offset the loss on the underlying

position he is hedging. However, if the price moves in his favour, the customer will

make a profit on his underlying position, but this will be offset by the loss he makes

on the forward, thus always resulting in the same overall end result. On the other

hand, with an option the customer can get the same protection if prices move against

him, but he is not obligated to exercise if prices move in his favour. This means that

the customer is able to benefit on the underlying position without having his profits

reduced by the hedging instrument except for a small deduction due to the premium.

This flexibility of options can also be advantageous in providing hedging for situations

where the outcome is not certain. An example of this is tendering. Let us assume


a Malaysian private equity firm is bidding for acquisition of a company in Russia.

Bidding is by closed tender, and the outcome of the bid will only be known in three

months. The Malaysian company is unsure whether it will obtain the tender. At the

same time the Malaysian company is concerned about the movement of the exchange

rate of ringgit to ruble. If the company enters into a forward contract to buy rubles for

ringgits at an exchange rate of 1:9.8, it would be locked in the contract and would be

unable to back out of the exchange if the bid was unsuccessful. On the other hand, if

the Malaysian company entered into an option contact to buy (long call) it would have

to pay a premium for the right to buy rubles at the rate of 1:9.8 but would be able to let

the option lapse if the bid was unsuccessful. This example shows that, while options

are not a necessity, there is definitely a need for them. An option reduces exposure to

unforeseeable circumstances and risks.

Another benefit of options is that they can be used to reduce the cost of hedging. Let

us assume a customer has taken out floating-rate financing with the interest-rate based

on Libor. As interest rates rise, the customer ends up paying more on the loan. He is

able to get protection from rising interest rates by doing an interest rate swap that will

effectively fix the overall net payment. If the swap is too expensive for the customer,

he is able to reduce his cost (i.e., the fixed rate) by giving up some of the protection at

very high rates by using an embedded option.

As different customers face various risks and have different requirements, it is beneficial

to have more than one instrument to hedge these risks. Options give customers the

ability to hedge according to their particular circumstances.

Having seen that options do meet certain needs and that they provide certain advantages,

the question arises as to why a significant number of contemporary SharÊÑah scholars

have ruled them impermissible. This is discussed next.

3. A FIQH DISCUSSION OF WHY CONVENTIONAL OPTIONS ARE

NOT PERMISSIBLE IN ISLAMIC FINANCE

There are a number of reasons why options are unacceptable in the SharÊÑah. The reasons

for the objections are not universal; in other words; there is no consensus regarding

the specific objections to options. In this paper three main objections to options are

identified and discussed below:


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• the nature and use of options are such that they amount to gambling;

• options are often used for excessive speculation

• the premium paid for the right to buy or sell an option contract is impermissible.

3.1 Gambling (Maysir) and Excessive Uncertainty (Gharar)

The first SharÊÑah objection to conventional options is that they involve gambling.

Whenever the buyer exercises the option contract because it is favourable to him it will

result in a corresponding loss to the seller. The gain of one party is equal to the loss of

the other part. In economics this is known as a zero-sum game. Obaidullah (Obaidullah,

1998, p. 84) asserts that in options the buyer and seller have diametrically opposite

expectations. Depending on the actual outcome, one of them will win at the expense

of the other. The gains are therefore in the nature of maysir, and maysir cannot occur

without the existence of gharar, being a subset of that larger category.

De Lorenzo takes a similar stance (DeLorenzo, n.d.), i.e., options, being intangibles,

are part of zero-sum markets where gains take place only with corresponding losses.

De Lorenzo opines that this sort of economic activity is clearly forbidden in SharÊÑah.

He adds that although proponents of options markets may argue that these activities

perform the function of stabilising prices and regulating risk, as far as the SharÊÑah is

concerned, these markets produce nothing of value. He concludes that “options and

futures amount to bets on the direction the market is moving in. Obviously, the ethics

of this market are unacceptable.”

El-Gamal stresses that financial options are pure gharar (El-Gamal, 1999). He goes

on to explain that this does not mean that they will necessarily be considered invalid

forever; i.e., if jurists find the benefit for allowing them to be overwhelming, then they

may be endorsed. As an example, El-Gamal explains that the salam contract contains

gharar since the object of sale does not exist at the time of the contract; however,

the SharÊÑah has permitted it due to the need for this contract to improve economic

efficiency (Al-Amine, 2008, p. 201-221).


3.2 The Negative Effects of Speculation

Scholars argue that derivatives such as option contracts are often used to speculate,

i.e., not to protect the value of the underlying assets but to gain from the increase in

value of the underlying asset. Apropos of this, much of the post-mortem literature on

the financial crisis has identified derivatives as playing a key causative role. It has been

claimed that derivatives contributed to the “financialization of the economy” whereby

the financial sector came to dominate the whole economy and forced the real sector to

change the way it did its business just to meet the requirements of the financial market.

Elgari states:

The real sector shrank in terms of growth rate and profit and contribution

to the total income of the economy. In the United States, for example, the

size of the derivative market reached $56 trillion when the GDP itself was

a mere $14 trillion. GDP as percentage of financial turnover was 79.6%

in 1956. In 2000 it was 1.9%. As derivatives are no longer tools for risk

management but for pure speculation, they can grow indefinitely and cause

havoc to the stability of the whole economy (Elgari, 2009, p. 4).

Obaidullah (Obaidullah, 1998) explains that the ability to speculate on the future

direction of the price of the underlying asset due to the random fluctuation in prices

causes the gains and losses to the parties to be random too, resulting in the options

contract being nothing more than a game of chance.

As can be seen, this argument against derivatives is usually explained together with

‘gambling’. Another term which is also confused, or used interchangeably, with

speculation is ‘investment’. It is thus appropriate to define the terms ‘speculation’,

‘investment’ and ‘gambling’ to understand the differences.

Speculation is defined as:

discussion about a possible future event. Broadly, in finance, it is the

practice of making investments or going into business that involves

risk. The term is sometimes used with pejorative undertones to apply to

investment for short-term gain. In certain markets, such as commodities

and financial futures, speculation is clearly distinguished from transactions

undertaken in the normal course of trading (physical buying or selling) or


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hedging (where the specific purpose is to minimise overall gains and losses

arising from price movements) (Dictionary of International Insurance and

Finance Terms, 2001, p. 303- 304).

Thus, speculation is described as investment for short-term gains of a risky nature.

Investment, on the other hand, is defined by the Dictionary of International Insurance

and Finance Terms (Dictionary, 2001, p. 194) as: “1. expenditure on real or financial

assets rather than the funding of consumption. In this sense, investment consists of the

purchase of any asset which is expected to increase in value. 2. To an economist, it

covers spending that results in economic growth.”

Comparing the definitions of speculation and investment, it can be deduced that

investment is supposed to describe more stable or less risky operations, with long-

term rewards, that involve economic growth, whereas speculation denotes shorter term

investments and quick gains. Speculators are often accused of recklessly betting on the

rise of certain stocks or other underlying assets, a process involving excessive risk and

gambling (Tickell, 2000).

The Dictionary of International Insurance and Finance Terms (Dictionary, 2001)

says about gambling that the term is “applied figuratively to the commitment of money

on any venture with a high degree of risk. Gambling on a stock market is similar to

speculation in that it is shorter-term, riskier and less serious-minded than investment.”

Thus gambling is described to be similar to speculation because of the short-term gain

and riskier deals or positions taken. Investment, on the other hand, is seen as something

where more effort is taken to research the possibility of profits. Investment is also

closely associated with economic growth and development and not just transfer of

wealth from one party to another. Gambling and speculation on the other hand are

described as short-term and riskier (Al-Suwailem, 2006).

However, a blanket ruling cannot be issued that all speculation is “un-Islamic” (Khan,

1988) (Khan, 1988), unlike gambling, which is clearly ÍarÉm. This is because an

element of speculation is present in all forms of business, including muÌÉrabah and

mushÉrakah (Kamali, 1999). In fact, one of the English translations of muÌÉrabah is

‘speculation’ (H. Wehr, 1980: 540). The concern is when speculation turns into a zero-

sum game that resembles maysir (Obaidullah, 2002). What this means is that when


speculation is used to create wealth, as in making an investment like muÌÉrabah or

mushÉrakah, it would be acceptable, but when speculation is used only to transfer

wealth (El Diwany, 2003) 2 from one party to another, it would amount to a zero-sum

game, like gambling (El Diwany, 2003).

However, there are proponents of options who believe that because of their usefulness

they should not be dismissed because of the elements of gambling and speculation

(Smolarski, Schapek & Tahir, 2006, p.425-443). These proponents claim that the

presence of speculators in the market enhances liquidity and provides hedgers with

parties they can pass their risk on to (Kamali, 1999) (Smolarski, Schapek & Tahir,

2006). In other words, without speculators, hedging would be very difficult or even

impossible (Al-Amine, 2008, p.114). A more general argument by analogy is that

derivatives are only tools; fiqh rulings are based on how a tool is used, e.g., a knife can

be used as a weapon or as cutlery (Mirakhor, 2009).

3.3 Can a Fee Be Charged for the Right Given in an Option?

Payment of a premium is required in an option contract for the right given to buy (or

sell) the underlying asset at a predetermined exercise price. Contemporary Muslim

jurists are divided as to whether it is lawful to charge a fee for this right.

According to Usmani (Usmani, 1996, p.10), an option is a promise, and such a promise

is itself permissible and “normally binding on the promisor”; however, the fee charged

for the promise in an option transaction makes options invalid in the SharÊÑah. This

ruling, he opines, applies to all kinds of options, both call and put options.

This view is based on the fact that options are rights, not tangible assets, and therefore

cannot be the subject matter of a sale and purchase. The Islamic Fiqh Academy of the

Organisation of Islamic Cooperation (OIC) stated in its Resolution No. 63/1/7:

2 In Islam, wealth creation is important rather than wealth transfer because wealth decays and new wealth must be created to replace the old wealth (El Diwany, 2003). If only wealth transfer was to take place, the stock of wealth would not be enough and would eventually be held by a few fortunate human beings. Wealth creation is therefore necessary for the equal distribution of wealth and more fundamentally for the survival of mankind.


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II - OPTION SALE

a) Form of Contract

The purpose of option contracts is to permit withdrawal of a commitment

to sell or buy something specific and described at a definite price during a

given period or at a given time either directly or through an organization

which guarantees the rights of the two parties.

b) The Shariah Ruling on It

Option contracts, as currently applied in the world financial markets, are a

new type of contract that does not come under any of the Shariah nominate

contracts.

Since the object of the contract is neither a sum of money nor a utility nor

a financial right which may be waived, then the contract is not permissible

in the Shariah.

As these contracts are prohibited in themselves, trading them is also

prohibited (OIC Fiqh Academy, 2001).

This decision of the OIC Fiqh Academy was confirmed by the European Council for

Fatwa and Research.3 The same stance was taken by De Lorenzo (De Lorenzo, n.d.),

who opined that the sale of options is prohibited because it involves the sale to another

party of nothing more than a right to buy.

There are, however, other scholars who disagree with the abovementioned views.

Kamali has presented strong arguments for the permissibility of compensation in an

option contract (Kamali, 1997, p.27). He begins by affirms that the concept of options

is valid under SharÊÑah under the concept of al-khiyÉrÉt, which are traceable in the

Sunnah and were further developed through ijtihÉd in the juristic writings of the ulama

(scholars learned in Islamic law). On the issue of an option being a mere right and

therefore ineligible for sale or purchase, Kamali groups the rights given under an option

under intangibles such as service and usufruct (manfaÑah). While the ×anafÊs have

3 European Council for Fatwa and Research, Final Statement of the Twelfth Ordinary 6-10 of Dhul-QiÑdah, 1423 Ah, 31 December 2003 - 4 of January 2004, (accessed May 11, 2007 from http://www.e-cfr.org/eng/article.php?sid=37.


excluded usufruct from the definition of property, the other major juristic schools have

included it (Al-Zuhayli, 2003, 4:398).

Kamali (1997) continues his argument on whether compensation is allowed under the

SharÊÑah by stating that the typical khiyÉr (option) that the Sunnah validates is the

option of stipulation (khiyÉr al-sharÏ) which grants to the buyer the option, within a

time frame, to either ratify the contract or to revoke it. Under such options, Kamali

maintains that the Sunnah entitles the parties the freedom to insert stipulations that

meet their

legitimate needs and what may be of benefit to them. Nevertheless, the

liberty that is granted here is subject to the general condition that contractual

stipulations may not overrule the clear injunctions of SharÊÑah on ÍalÉl and

ÍarÉm. Provided that this limitation is observed, in principle, there is no

restriction on the nature and type of stipulation that the parties may wish to

insert into a contract (Kamali, 1997, p.29).

Based on this argument of freedom to contract, Kamali opines that the freedom to insert

stipulations in contracts includes the request for monetary compensation. Thereby

Kamali concludes that the imposition of a fee for the right granted by options is valid

under the SharÊÑah.

This view of Kamali was followed by Al-Amine (Al-Amine, 2008), who after extensive

discussion of the right in an option and its value as property (mÉl), and the sale of

rights, came to the conclusion that “there is nothing in Islamic law which prevents the

exchange of such a right for money” (Al-Amine, 2008, p.305).

This opinion of Kamali and Al-Amine that a fee may be granted in an option contract

is a minority view. There are, however, scholars who approve the use of ÑurbËn, and

hÉmish jiddiyyah, which have a fee component to them.

Elgari (Elgari, 1993) opines that legitimate options in Islam are “affiliated to sale

contracts (and to other contracts which accept the option principle)” (Elgari, 1993,

p.13). Therefore an option as traded in the stock exchange independently and having

an existence of its own cannot have a price on its own. Islamic law recognizes trading

of intangibles such as service and usufruct (manfaÑah); however, a right given under an

option may not be the same thing as usufruct. The rights under an option do not have


16

a tangible or material quality. They are similar to pre-emptive rights such as the right

of custody and guardianship, which are allowed in the SharÊÑah but are not allowed to

be sold as an independent agreement against monetary compensation (Elgari, 1993).

Thus Elgari makes a distinction between options which are traded on their own (earlier

described as ‘stand-alone options’ in this paper) and options which are affiliated or

embedded in other contracts. Elgari (Elgari, 2009) then explains the Islamic option,

which he identifies as being the ÑurbËn contract, which he believes is exactly like a call

option. The scholar states that the down payment in ÑurbËn can be retained by the seller,

thus working as a fee for the option. The scholar then lays down two important features

or conditions that must be satisfied. The first is that the option cannot be separated from

the sale of the underlying asset. This stipulation prevents the growth of derivatives

beyond the actual needs of real transactions. Secondly, ÑurbËn should not be entered

into unless the seller actually owns the underlying asset and continues ownership for

the whole duration of the option. This is to prevent the ÑurbËn being traded separately.

The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI,

2008) in Standard 1, Trading in Currencies, has pointed out the impermissibility of

options in the SharÊÑah (AAOIFI, 2008, p.373) 4 but has instead approved the use of

ÑurbËn:

5 /2 Options

5/2/1 A contract by means of which a right is bestowed – but not an

obligation – for the purchase or sale of an identified item (like shares,

commodities, currencies, indexes or debts) at a determined price and for

a determined period. There is no obligation in this contract except on the

person selling this right.

5/2/2 The Shariah rule for options

Options contracts indicated above are not permitted, neither with respect to

their formation nor trading.

4 In Appendix B for SharÊÑah Standard No. 20 on Sale of Commodities in Organised Markets, Point 12, AAOIFI has stated that the basis for the impermissibility of options is that the subject-matter of the contract is not wealth that can be deemed suitable for compensation in the SharÊÑah.


5/2/3 Shariah substitutes for options

5/2/3/1 The conclusion of a contract pertaining to ascertained assets is

permitted according to the SharÊÑah, along with the payment of part of

the price as earnest money (urbun) with the stipulation that the buyer

has the right to revoke the contract within a specified period in lieu of

the entitlement of the seller to the amount of earnest money in case the

buyer exercises his right of revocation. It is not permitted to trade the right

established with respect to the earnest money.

This distinction brings us back to the difference between stand-alone options and

embedded options and the payment of a fee. While Usmani, the OIC Fiqh Academy,

De Lorenzo and Kamali have not made a distinction between an option that is traded

independently and an embedded option, Elgari’s distinction would seem to be in line

with the approval of ÑurbËn by AAOIFI. The authors of this paper support the view that

when an option is stand-alone and can be traded independently, the premium paid for

it is impermissible; however, when the option is embedded in a larger transaction, is

similar to ÑurbËn, and a fee is paid on it, this would be permissible.

At this point, it is worth noting the research and findings of ×ammÉd (Hammad, n.d.)

who after extensive discussion on financial compensation for an undertaking to sell

currencies at a future date, provides SharÊÑah parameters for contracts of exchange with

an undertaking. He states on pp. 24-25:

It has become obvious by the end of this study that it is permissible to

exchange money for any undertaking to either do or avoid some act, by

contractual or non-contractual disposal, by an exchange contract or a

benevolent or other contract – provided the following five conditions are

realized:

(1) It must accomplish an intended benefit for the obligee.

(2) The benefit must be valid from a SharÊÑah perspective.

(3) It must be valuable (be assigned a monetary value in custom).

(4) It must be a pledge that is possible to honour.

(5) There should be a need for it.


18

×ammÉd’s research is focussed on undertaking to sell currencies at a future date;

however, his research findings could be used in a wider context for all types of contracts

that have as their underlying other commodities.

×ammÉd does not explicitly state whether these SharÊÑah parameters apply to a

stand-alone or embedded option, or both. Can the learned scholar’s statement, “It is

permissible to exchange money for any undertaking to either do or avoid some act

by contractual or non-contractual disposal,” be taken to include stand-alone options?

The sweeping nature of this statement makes that the probable conclusion. It is the

opinion of the authors that the SharÊÑah parameters are meant for both stand-alone and

embedded options and that ×ammÉd has approved the payment of fees for both stand-

alone and embedded options.

4. OPTION CONCEPTS IN FIQH

In this section, Islamic options are explained, starting with the nominate contracts of

Islamic finance itself: ÑurbËn, hÉmish jiddiyyah, and khiyÉr al-sharÏ. Then we will

move on to Islamic options created by Islamic banks to hedge against currency risk:

Islamic FX products and structures with embedded options.

4.1 KhiyÉr

In the SharÊÑah, there are a number of options that provide one or both parties the choice

to carry on with the contract or to terminate it, based either on a stipulated condition

(khiyÉr al-sharÏ), inspection (khiyÉr al-ru’yah), discovery of a defect (khiyÉr al-Ñayb)

or the selection option (khiyÉr al-ta’yin) which gives one of the parties the right to

choose one of two objects of sale. In fact, al-Zuhayli (Al-Zuhayli, 2003, p.165-168)

has documented seventeen options approved by the ×anafÊs, two types by the MÉlikÊs,

sixteen by the ShÉfiÑÊs, and eight by the ×anbalÊs. Of these, only khiyÉr al-sharÏ (option

of stipulation) is explained in this paper. The reason for choosing it is that it is the first

Islamic alternative to conventional options to have been advanced by SharÊÑah scholars

such as Sulaiman (Sulaiman, 1982), Kamali (Kamali, 1997), Obaidullah (Obaidullah,

1998), and Al-Amine (Al-Amine, 2008).

The word khiyÉr means choice or option. KhiyÉr al-sharÏ (option of stipulation) is in

essence an option within a certain period after the conclusion of a bargain during which


either of the parties may cancel it. This implies that the parties get some time to assess

the benefits of the contract.

The validity of khiyÉr al-shart is proven by an authentic ÍadÊth:

فـقال: »إذا البـيوع، أنه يدع ف وسلم عليه للنب صلى اهلل رجل ذكر أن بايـعت فـقل ال خلبة«

A man (×ibbÉn ibn Munqidh) complained to the Prophet (peace be upon him) that

he was a victim of frequent cheating in sales. The Prophet advised him, “When you

conclude a sale, say, ‘There must be no fraud’” (ØaÍÊÍ al-BukhÉrÊ, 1422: 3:65).

Al-BayhaqÊ, in his version of the above-mentioned ÍadÊth, reported the following

addition to it:

»ث أنت باليار ف كل سلعة ابـتـعتها ثلث ليال؛ فإن رضيت فأمسك وإن سخطت فاردد «

“Then you may reserve for yourself an option lasting for three nights. If you are pleased,

keep it; and if you are displeased, return it” (Al-BayhaqÊ, 1344: 5:273).

This is further supported by a ÍadÊth of ÑAbd Allah ibn ÑUmar that the Prophet (peace

be upon him said):

بـيع إال يـتـفرقا، ل ما صاحبه على باليار منـهما واحد تبايعان كل »امل

اليار«

“The parties to a contract of sale have a right of option as long as they have not separated

except in a sale that is subject to option” (ØaÍÊÍ al-BukhÉrÊ, 1422: 3:64). This option of

stipulation has also been documented in the Mejelle (The Mejelle English Translation ,

n.d.) in Chapter VI Section I article 300-301:

‘It is permitted to make a condition in a sale, given to the seller or the

buyer, or both together, an option, within a fixed time to make valid the

sale by assenting to it, or, to annul it.


20

If the party, who has been given the option by the term giving the option, in

the time of the option, that is to say, within the time that he has the option,

wishes, he annuls the contract, and, if he wishes, it is allowed.’

4.2 ÑUrbËn

ÑUrbËn refers to a sale in which the buyer deposits earnest5 money with the seller as

partial payment of the price in advance but agrees that he will forfeit the deposit money

if he fails to ratify the contract, in which case the seller can keep it (Kamali, 2000).

ÑUrbËn differs from the conventional option contract in that the partial payment paid

is considered as earnest money; as such, if the buyer does not revoke the contract and

continues, the earnest money would form part of the purchase price. However, if the

contract is revoked within the specified time, the partial payment will be forfeited to

the seller. Thus the partial payment is not a fee or premium, as in an option contract, but

more of a deposit. As can be seen, ÑurbËn is similar to a call option, except that in the

call option the down payment is not subtracted from the contract price.

The legality of ÑurbËn is still unsettled. The ×anbalÊ School considers ÑurbËn a

legal contract, but the other schools object to it and consider it an invalid contract;

firstly, because it is considered to akin to misappropriating the property of others; and

secondly, it involves an unknown option or condition, which amounts to gharar (Al-

Amine, 2000). However a number of contemporary scholars have proposed its use

as an Islamic derivative, for example Al-Amine (Al-Amine, 2000), Kamali (Kamali,

1997) and Elgari (Elgari, 1993) (Elgari, 2009).

As stated above, Elgari approves the use of an option if it is in the form of ÑurbËn and

down payment is provided. AAOIFI also recognizes the need for SharÊÑah-compliant

substitutes for conventional options and permits partial payment through ÑurbËn, as

stated in Standard No.1 on Trading in Currencies (see above).

5 ‘Earnest’ is a term used to indicate a serious state of intent, and the term ‘earnest money’ was used in the past for a down payment for the purchase of real estate to indicate the seriousness of intent (Al- Amine, 2008).


4.3 HÉmish Jiddiyyah

There is another partial payment, known as hÉmish jiddiyyah or security deposit,

permissible in the SharÊÑah. This security deposit is exclusively used in murÉbaÍah for

a purchase orderer. SharÊÑah Standard 8 of the AAOIFI Standards explains it as follows:

2/5/3 It is permissible for an institution, in the case of a binding

promise by the customer, to take a sum of money as hamish jiddiyyah (i.e.,

a security deposit). This is to be paid by the customer at the request of the

institution, both as an indication of the financial capacity of the customer

and to ensure the compensation of any damage to the institution arising

from a breach by the customer of his binding promise. Having taken

this hamish jiddiyyah, the institution need not demand compensation for

damage as this may be charged against the hamish jiddiyyah. The hamish

jiddiyyah is considered not as urbon, i.e., earnest money. The amount of

money deposited by the customer as security for his commitment can be

either held as trust in the custody of the institution, in which case the latter

cannot invest it, or it may be held, if the customer permits the institution

to invest it, as an investment trust on the basis of Mudaraba between the

customer and the institution.

HÉmish jiddiyyah is also a partial payment, but unlike ÑurbËn, the security deposit

cannot be taken by the seller in the event the sale does not take place unless the seller

has suffered a loss. And in case the seller has suffered a loss, he can take only the

amount that compensates his loss. It should be noted that if the loss suffered is greater

than the security deposit paid, the seller can claim the extra amount from the buyer.

In ÑurbËn, the seller is entitled to all of the earnest money, whether or not losses are

suffered (AAOIFI, 2008).6 Further, in a hÉmish jiddiyyah, when the customer has

fulfilled his promise and executed the contract of murÉbaÍah for the purchase orderer,

the institution must refund the hÉmish jiddiyyah to the customer. The institution is not

to use the hÉmish jiddiyyah unless there is a breach of promise as stated above. In the

case of ÑurbËn, it is permissible for the institution to take the ÑurbËn after concluding

the murÉbaÍah sale with the customer because it is part of the price. Finally, hÉmish

6 AAOIFI has, however, stated in its SharÊÑah Standard 8, para 2/5/6, that it is preferable that the institution return to the customer the amount that remains after deducting the actual damage incurred from the ÑurbËn as a result of the breach.


22

jiddiyyah can only be used in a murÉbaÍah for a purchase orderer whereas ÑurbËn is

used in a sale.7

4.4 WaÑd

WaÑd is a promise or undertaking. It is not an option per se; however, as will be seen

below, many Islamic FX option products use the waÑd as the main instrument to make

the structure an option. This is why it is explained in this paper. The OIC Islamic Fiqh

Academy has ruled that a promise may be binding in its Resolution No. 40-41 (2/5 &

3/5):

According to the Shariah, a promise (made unilaterally by the purchase

orderer or the seller), is morally binding on the promisor, unless there is a

valid excuse. It is, however, legally binding if made conditional upon the

fulfilment of an obligation, and the promisee has already incurred expenses

on the basis of such a promise. The binding nature of the promise means

that it should be either fulfilled or compensation be paid for damages

caused due to the unjustifiable breach of the promise.

Thus the OIC Fiqh Academy has stipulated the following requirements for a waÑd to

be binding:

(6) It must be unilateral.

(7) It must have caused the promisee to have incurred some costs/liabilities.

(8) If the promise is to purchase something, then the actual sale must take place at

the appointed time by the exchange of offer and acceptance. A mere promise

should not be considered a concluded sale.

(9) If the promisor reneges, the court may force him to either purchase the

commodity or pay actual damages to the seller. The actual damages will

include the actual losses suffered by the promise and will not include the

opportunity lost (Dar, 2005).

The AAOIFI Standard SharÊÑah Standard 1: Trading in Currencies, para 2/9, and the

SharÊÑah Advisory Council of the Central Bank of Malaysia, in its 49th meeting held

7 Imam MÉlik has, however, given a more general definition of ÑurbËn that includes rent or leasing (Al-Amine, 2008, p. 237).


on 28th April, 2005, allowed waÑd to be given in a currency exchange. This opinion

is also held by the OIC Islamic Fiqh Academy in Resolution No. 63/1/7 of 1992 of its

seventh session, which recommended the use of waÑd as one of the SharÊÑah-approved

instruments to create SharÊÑah-approved alternatives to currency trading.

However, bilateral promises are not allowed. Here a distinction has to be made between

waÑd (a unilateral promise by one party), waÑdan (two independent unilateral promises

given by two parties to each other but dependent on two different conditions), and

muwÉÑadah (a bilateral promise, i.e., each of two parties issues a promise, dependent on

the other promise, to the other party). The first two promises are permissible; however,

a bilateral promise would seem to be prohibited in a sale (bayÑ).8 According to Hasan

(2008), for waÑdÉn to be allowed, the conditions for the exercise of each promise should

be different and each promise should have different economic effects.

5. OPTION STRUCTURES IN ISLAMIC BANKING

In this section, current practises related to option structures in Islamic banking and

finance are discussed. The discussion starts with option structures engineered for risk

management purposes in currency exchanges; secondly, option structures in ÎukËk are

explained; then option structures in structured products; and finally, options in dual

currency murÉbaÍah are described.

5.1 FX Option

The use of option structures engineered for risk management in currency exchange

is not universal, i.e., not all banks use these structures. The banks that do use these

structures do so upon the approval of their SharÊÑah Advisory Boards. Two structures

have been developed using waÑd. In both structures a fee is paid, one through the

mechanism of a commodity murÉbaÍah and the other with direct payment of fees.

5.1.1 WaÑd with Commodity MurÉbaÍah

The FX waÑd is a structure very similar to the conventional option. It uses a waÑd that

is binding on one party. On the start date of the transaction, the bank will undertake

8 “The basis for not allowing a bilateral binding promise is because it amounts to a contract prior to acquisition of the item to be sold” (AAOIFI, 2008, 130).


24

to the investor to exchange Currency 1 against Currency 2 at a pre-agreed rate on a

future date. On the same date, the bank will execute a commodity murÉbaÍah whereby

payment is paid on the spot; thus in reality, the bank receives a fee from the investor

for its undertaking.

Figure1: FX WaÑd and Commodity MurÉbaÍah

1. Start date:

WaÑd

Commodity murÉbaÍah for the fee:

Trader A Trader B

Price plus mark-up

Source: Authors’ own

On the future date, the investor might ask the bank to fulfil its promise or might release

the bank from its undertaking. On the maturity date, if the investor wants to execute the

waÑd, the bank and the investor will exchange the currencies. The fee will be the bank’s

to keep whether or not the investor exercises the promise or not.

5.1.2 FX WaÑd with a Fee

This FX waÑd is also a structure very similar to the conventional option. It uses the

waÑd promise binding on one party. On the start date of the transaction, the bank will

undertake to the investor to exchange Currency 1 against Currency 2 at a pre-agreed

rate on a future date. On the same date, the bank will receive a fee from the investor for

its undertaking.

waÑdIslamic Bank Customer

Islamic Bank Customer


Figure : FX WaÑd

1. Start date:


On the future date, the investor might ask the bank to fulfil its promise or might release

the bank from its undertaking. On the maturity date, if the investor wants to execute the

waÑd, the bank and the investor will exchange the currencies.

Figure 3: FX WaÑd

2. Maturity date, if the investor asks the bank to fulfil the waÑd:


The investor will want to execute the waÑd if the currency rate is favourable to him. The

upside of this contract is that the investor can wait and see whether the waÑd is more

favourable or less favourable then the prevailing market rate. However, the investor is

required to pay a fee for the waÑd.

Both the above products have a fee component in the structure. These structures have

been approved by the SharÊÑah Advisory Board of the banks that use these structures.

It could be that the SharÊÑah advisors have taken the minority view as held by scholars

like Kamali, or it could be that the SharÊÑah Advisors have allowed the fee component

after learning that the AAOIFI standards have approved ÑurbËn, and hÉmish jiddiyyah.

Islamic Bank CustomerwaÑd

fee

Islamic Bank Customercurrency

currency


26

5.2 ØukËk

Options are widely used in ÎukËk structures, usually to redeem the principal to investors

at maturity or in the event of default. The options are typically in the form of purchase

or sale undertakings to buy/sell the underlying assets using the concept of waÑd.

ØukËk structures differ from transaction to transaction, but the use of options can be

demonstrated in a simplified ijÉrah structure as shown below.

Figure 4: Use of WaÑd in ØukËk

Purchase Undertaking

Sale Undertaking


Here the issuer will sell the underlying assets to the SPV (special purpose vehicle) and

subsequently lease them back. At maturity, in order to pay back the principal to the

investors, the issuer will give a purchase undertaking to buy the assets at the principal

value. Usually, the SPV will also give a sale undertaking to ensure that the issuer gets

back the assets at maturity.

The use of options in ÎukËk does not usually involve any separate fees for giving the

undertakings. Note that some ÎukËk are callable, but even in such structures the option

premium is not separately paid; rather, it is usually embedded in the ÎukËk price.

5.3 Structured Products

Islamic structured products also use options. A typical structure is given below.

Issuer SPV InvestorsSale assets

Leased


Figure 5: Options in Structured Products


The structured product typically consists of two elements, a capital protection part and

an enhanced yield part. The enhanced yield is achieved through an option, which is

usually waÑd or ÑurbËn. Obviously, the enhanced yield is not offered by the counterparty

(C/P) for free. The premium for this option is either the earnest deposit on the ÑurbËn

or a fee for the waÑd.

5.4 Dual Currency MurÉbaÍah

Another use of options by Islamic banks is in the dual currency murÉbaÍah product.

This is a structured investment product that banks offer to clients who are seeking a

higher return than Islamic deposits placement. It works like this:

• A client (investor) places money in ringgits with a bank through a commodity

murÉbaÍah (CM) transaction.

• The bank will offer a higher return than it offers on a normal placement

• In return, the bank has a right to return the principal plus profit in ringgits or an

alternative currency.

• The bank and the client agree up-front on both the alternate currency and the

rate of conversion.

Investor Bank Counter-PartyEnhanced

Yield

Structured

Product

MarketC

apit

al

Pro

tect

ion


28

This is essentially a combination of a commodity murÉbaÍah trade and an FX Option

from the client to the bank. There is no premium paid separately by the bank as it

is priced into the increased return on the commodity murÉbaÍah. See below for the

structure.

Figure 6: WaÑd in Dual Currency MurÉbaÍah


It should be noted that there are many other types of structures, not mentioned in this

paper.

6. CONCLUSION

This paper has attempted to provide a clearer understanding of options and their use in

conventional and Islamic finance. There a variety of types of options with a number of

uses. Options provide economic benefits of hedging, flexibility, and also reduction in

the cost of hedging.

SharÊÑah objections to conventional options include the objection to the payment of a

premium, and the gambling, uncertain and speculative elements present in their use.

Within the SharÊÑah itself, many types of options are mentioned in fiqh, such as the

ÑurbËn, hÉmish jiddiyyah, and khiyÉr al-sharÏ.

Islamic financial institutions have developed various solutions for their clients for

hedging and investment purposes. Among the innovative structures created are the

Islamic FX option structures used in Islamic banks. Both FX option structures discussed

in this paper use a fee to pay for the waÑd given. This is contrary to the opinion of

Bank Client

Bank Client

CM Placementin MYR

WaÑd to buy USDin MYR


the majority of Islamic scholars on stand-alone options and also against the AAOIFI

standards. It is thus difficult to reconcile the use of these instruments with the majority

view in Islamic finance. However, there exists a minority view that the payment of a fee

should be allowed in the use of options. Further research may be required in this area

to make a final conclusion.

As for embedded options, it is the opinion of the authors that as long as they are used

in a controlled and regulated environment that precludes speculation and limits them to

hedging and investment purposes, there should be no objections or harm in their use.


30

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