Know How Islamic Financial Derivative Products Can Hedge Currency Risk

Islamic Financial Derivative Products Can Hedge Currency Risk

Islamic financial derivative products come up as an alternative to conventional products. By default, the conventional financial derivative instrument contains debt sale, excessive gharar (uncertainty), or encouraging speculation. For example, a currency forward contract provides a predetermined price and goods in a concluded contract. However, both contract’s subject matters are deliverable at the maturity date. Sharia reckons this kind of transaction as a debt sale (bay’ al-Kaali` bi al-Kaali`), which is impermissible.

Shariah scholars believe that derivative products are permissible only for hedging purposes. As such, products available in the exchange-traded market are not lawful because they trigger speculation. However, the need for foreign exchange risk hedging for export and import activities and cross-border investment does exist. There are currently two Islamic financial derivative products available within the over-the-counter (OTC) market between Islamic banks and clients.

Al-Wa’ad Based Currency Forward

In essence, the al-wa’ad based arrangement replicates a conventional forward contract. However, what distinguishes Islamic from the conventional forward contract is the nature of a signed agreement. Conventional forward concludes a multilateral binding contract as per the arrangement signed. Meanwhile, the Islamic forward maintains an initial unilateral promise arrangement that the binding contract, that is bay’ al-sarf, will occur at the maturity date.

The illustration below helps you to understand how the Islamic currency forward works. Suppose you are a Malaysian importer proceeding with a payment or domestic investor wanting to top-up your Korean balance after 30 days. The desired amount is Korean Won, KRW 100 million. By default, you are afraid of any appreciation of the KRW against ringgit as your home currency. To hedge this risk, you enter the al-Wa’ad Based Currency Forward arrangement in two steps.

Calculation Example

Firstly, on the date you sign the agreement, Islamic bank unilaterally promises to offer selling KRW 100 million at 20 KRW per 1 RM on day 30. At the same time, you unilaterally promise to buy KRW 100 million at RM 0.052 per 1 KRW on day 30. For this transaction, the Islamic bank might charge you, for example, a fee of RM 3,000.

Selling price: 100,000,000/ 20 = 5,000,000

Buying Price: 100,000,000 x 0.052 = 5,200,000

Transaction fee (Ujrah)= 3,000

Secondly, on day 30, you and the bank perform al-sarf contract. Islamic Bank sells KRW 100 million and you pay RM 5,200,000. The total cost of your hedging is locked in at the date you sign the agreement, which is RM 5,203,000. No forex volatility will affect your currency.

Option Based Currency Forward

This Islamic financial derivative contract differs essentially from the exchange-traded options contract. In an option-based currency forward contract, the contract is non-tradable because it is done in an OTC market between Islamic banks and the client. This prevents speculation from third parties seeking some profits from the market volatility. Because of the nature of a bilateral contract, both counterparties perform a lock-in transaction. Hence, they have adjusted and modified the risk of currency value volatility.

Basically, the way this product works is quite similar to al-Wa’d Based Currency Forward. However, the former product has an obligatory nature. Both counterparties must exercise the contract. Alternatively, option-based currency forward offers flexibility. This is because the nature of options is a right, not an obligation, to exercise the contract at maturity. The client would exercise the contract if, at the maturity date, the agreed price of the currency is favorable to his hedging purpose. Otherwise, he could dismiss to exercise option contract. The illustration below depicts how it works.

Suppose the scenario is the same as above mentioned case. You want to hedge KRW 100 million appreciation against RM. Instead of using al-wa’ad based currency forward, you seek a flexibility because you have projected the potential appreciation of RM against KRW. The arrangement is also the same with two steps.

Calculation Example

Firstly, on day 0, you purchase a right to buy KRW @0.05623 RM exercise price from an Islamic bank. For this arrangement, you need to pay RM 20,000 as a fee for al-wa’ad option. Secondly, on day 30, if you choose to exercise the contract, the Islamic bank will sell KRW 100 million at the exercise price. You base your choice because KRW appreciates against RM, let say KRW @0.05293 per RM. So you reduce your transaction cost, and you accomplish your hedging objective. Your total cost of this transaction will be only RM5,263,000 + RM20,000 option fee equals RM 5,283,000. You save RM10,000 (RM5,293,000 – RM5,283,000). Conversely, if RM appreciates against KRW, let say KRW @0.05023 per RM, it is better to dismiss the option contract. You will save RM20,000 at an eventual cost.

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