Option Contract In Islamic Finance
An option is a contract that gives buyer the right, but not the obligation, to purchase or to sell a specific quantity of an asset for a set price at the specific date in the future. In exchange for this right, the buyer pays a price, known as a premium, to the seller. Two basic kinds of option exist: a call option, and a put option. The call option gives the buyer the right to buy the asset by a certain date for a specific price. The put option gives the buyer the right to sell the asset by a certain date in the future for a specific price.
For example, if A believes that stock of company X is going to increase in value. A can either pay full price and buy the stocks, or pay a fraction of the price (i.e. premium) and buy call options. If the price increases A can benefit either way. If the stock decreases in value, A can let options lapse. Thus, A does not bear any loss more than the premium. This is an example of call option (right to buy).
For an example of put option, imagine B is worried that the value of her stock is going to decrease. She can either sell her stocks or buys put options. If the price decreases, She can sell her stocks for the set price; her only cost is the premium. If the price increases, she can simply let options lapse.
These are example of simple options. To hedge their risks businesses often combine put options and call options. Combined options are commonly used to hedge against currency fluctuation. They are also used to hedge against commodity price fluctuation as well. The premiums in combined options can be set up in a way so they cancel each other. For example, if C is worried that the fluctuation in the value of USSD may affect its ability to perform a contract, C can hedge her risk by buying a combined option—basically she will buy both put and call options. If the value of USSD increases the profit she makes from the put options—being able to buy for the less than market price—will set off her loss from the call options, and vice versa.
Options described above are called “stand-alone” options meaning they are bought and sold separately. Stand-alone options are regularly sold in the security markets. There is another kind of options called “embedded options”. These options are not sold separately rather they are embedded in another product. An example of embedded option is cancellation option. Some products have a built-in cancellation feature that enables one party (buyer or seller) to cancel the transaction without any further obligations. The cost of premium in this kind of transaction is not paid separately rather is part of the price of product.
Benefits of Options
Options, like other derivatives, can be used for risk management and hedging purposes. They also can be used for arbitrages and/or speculation.
As a hedging instrument, options provide their holders with the protection against adverse move in the price for a low cost, as was the case in the examples discussed above. Option is also used as a tool for arbitrage. Arbitrage is a process of taking advantage of price difference between the markets. Another use of options is to speculate on the direction of the market. Options are commonly used as speculative tools. Speculation is the practice of exposing oneself to risk and hoping to profit from doing so.
Options are widely used in conventional financial markets for all three purposes.
Permissibility of Conventional Options under Islamic Law
The permissibility of the conventional options under Shari’ah is subject to disagreement. The majority of Muslim jurists have found conventional options to be impermissible. The Islamic Figh Academy of the Organization of Islamic Cooperation (IFA-OIC), which is an ISB stated, “Since the subject of [option] contracts is neither sum of money, nor a utility, nor a financial right which may be waived, then the contract is not permissible in Shari’ah”. [1] The majority’s opinion is grounded on three different reasons: 1) nature and the use of options are such that amounts to maysir (gambling); 2) options are used for excessive speculations; and 3) the premium paid is impermissible.
There is an influential minority, on the other hand, that opined options to be permissible. The SBs embedded in IFIs have commonly adopted the minority opinions, and developed Shari’ah compliant options that are alternative to conventional options.
Maysir
Qur’an 5:90-91 and 2:219 prohibits maysir. Muslim jurists have interpreted maysir to mean any form of game of chance, and gambling. Hassan and others defined maysir, “A game of chance or gambling that involves the acquisition of wealth by chance or winning the game or speculation without any form of consideration or compensation for such wealth.”[2] Obaidullah, [3] De Lorenzo [4], and El- Gamal[5] have opined that options are a kind of maysir because the transaction has a zero sum game nature. In options, they argue, buyers and seller have diametrically opposite expectations. The gain of one party results from the loss of other party. Depending on the actual outcome one party wins at the expense of other. Therefore, they argue, it is an example of maysir.
Gharar
The prohibition against speculative transactions that entail excessive risk-taking and uncertainty, known as gharar, has been drawn from the Sunnah using inductive reasoning. Classical examples of contracts prohibited due to gharar are: the purchase of unborn animal in womb’s of its mother, milk in the udder without measurement, birds in the sky, fish in the sea, a runaway animal [6].
The majority has argued that options are used to speculative on the direction of the market, so they entail excessive risk-taking, and uncertainty. Obaidullah, for example, argued, in the options the benefits are tied to random changes in the direction of a market that are highly uncertain; this makes the practice, in essence, gambling [7].
As it can be seen the prohibition of options on the ground of gharar is closely connected to the prohibition of maysir. However, unlike later, which is a certain prohibition, the former is not a blanket prohibition because all form of business involves a degree of risk-taking, and uncertainty. Therefore, the question is how much risk and uncertainty is too much?
Iqbal[8], Obaidullah[9], El Diwanny[10], have argued, when the practice turns to a zero-sum game it is tantamount to gambling, therefore, is impermissible. In other words, when speculation is used to create wealth, like musharkah (partnership), the practice is permissible, on the other hand, when its only purpose is to transfer wealth, it turns to a zero-sum game, which is gambling.
The pro-options minority argues that options are useful instruments; therefore, they should not be prohibited based on maysir and gharar. The presence of speculators enhances liquidity in the market. In absence of speculators, the businesses cannot pass on their risks. In short, they argue Islamic businesses, like their conventional counterparts, need to manage risks, and prohibiting options, will make it impossible for them to do so. The minority employs a purpose-driven (maqasad-oriented) interpretation of Shari’ah that looks at options as an instrument for achieving a goal. In absence of a clear prohibition, if the goal is permissible—they argue managing risk is a permissible goal—the instrument ought to be permissible.
Premium
There is also disagreement among jurists as to whether the right transferred in an option can be sold. That is whether the premium paid in options is permissible. The majority argues that those rights are not tangible assets; therefore, they cannot be subject to purchase or sale. [11] The minority, on the other hand, argue that the right transferred in option is equivalent to service and usufructs.[12] The majority of jurists, except classical Hanafi jurists, recognize that the usufructs are intangible but permissible subject of sale. They also use Shari’ah concepts, al-Khiyarat (“options”) to support their claim.
Al-Khiyarat are based on the Sunnah, and juristic opinions. The most common Khiyar in Shari’ah is Khiyar al-shart (option of stipulation) whereby stipulation of the parties in the contract creates a right for a party (or both of them) to terminate or validate the contract within a specified time. Pro-option jurists argue that as Khiyar al-shart is a creature of contract, the contract can also provide for payment in exchange for such right.
Here the distinction between stand-alone and embedded options is relevant. The Khiyar al-shart like other Al-Khiyarat, are embedded in a contract of sale or lease, and are not separately saleable rights. This kind of embedded options (a right of cancelation or validation embedded in a contract) is generally considered permissible by all jurists as long as it is not independently priced. If the contract provides for an independent financial right in exchange for the Al-Khiyarat (embedded option), majority considers such options impermissible.
Option Contract Utilized by IFIs
Despite the majority’s opinion, most IFIs provide alternative to conventional options via
different Islamic law concept such as ‘Urbun, Wa’ad, and Murabaha. The Shari’ah-compliant products developed using these concepts are approved by the Shari’ah Boards of the IFIs that provide them. Approving SB may base their opinion on the minority view or may issue an independent fatwa.
Fiqh concepts utilized by IFIs
‘Urbun
‘Urbun is a contract whereby the buyer pays some money as earnest, and agrees to forfeit that money if fails to ratify the contract, in which case the seller keeps the money. ‘Urbun differs from conventional option in that the money is not paid as a premium rather it is earnest. It is a down payment on the price of contract; therefore, if the buyer does not terminate the contract within specified time, the payment will become part of the purchase price. However, if the buyer terminates the contract—ostensibly because the market price has moved in adverse direction—the buyer will only forfeit the earnest to the seller. In effect, ‘Urban is an alternative to the call option. The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), which is ISB, has approved the permissibility of ‘Urbun as a Shari’ah alternative to option contract. [13]
Wa’ad
Wa’ad is a promise or undertaking. As such it is not option per se; however, IFIs have used it as the main vehicle to structure options. IFA-OIC has opined that a unilateral promise made by purchaser, orderer or the seller may be legally binding under Shari’ah “if made conventional upon fulfillment of an obligation, and the promise has already incurred expenses on the basis of such a promise.” [14] The Shari’ah Advisory Council of Malaysia Central Bank has also allowed Wa’ad to be given in currency exchange.[15] AAOFI has concurred with this opinion as well.[16]
Two different structures using Wa’ad has been developed: Wa’ad with commodity murabaha, and Wa’ad with a fee. In the former IFIs uses a murabaha to receive fee whilst in the later direct fee is paid.
Murabaha is an Islamic transaction that is widely used by IFIs to avoid the prohibition of riba (usury) where the IFIs purchases an asset from the customer or from a party identified by the customer, then sales it to the customer at a marked-up price with deferred payment. It is setup to have the same effect as an interest-bearing loan without violating the prohibition of riba.
Wa’ad with commodity murabaha is basically an option. The IFIs undertake a unilateral undertaking to exchange Currency 1 with Currency two at a pre-agreed rate in the future. On the same date, the IFIs will execute a murabaha whereby a payment is made on the spot (unlike ordinary murabaha which is executed with deferred payment). So, in effect, the IFIs receive a fee. The Wa’ad with a fee is similar to Wa’ad with commodity murabaha. The only difference is that in the former instead of executing a murabaha the buyer of option pays the fee directly.
Structures developed by IFIs that uses options
Sukuk
Sukuk is commonly known as “Islamic Bond”. Unlike conventional bonds that merely confer ownership of debts, sukuk confers a share of undivided ownership of assets, along with commensurate cash flow and risk. Sukuk is a Shari’ah-compliant structure that is designed to avoid the prohibition of riba.
Option is usually used in sukuk structures to redeem the principal to the investor upon maturity or in the event of default. Since in sukuk the investor owns the underlying asset or a percentage of it, she is vulnerable to the adverse change in the price of asset. Options are used to protect the investor from this risk.
The sukuk structure varies. In principle, the options are in form of sell/buy undertakings using Wa’ad. In a simplified ijarah (lease) transaction, the issuer (IFIs) will sell the underlying asset to the SPV (special purpose vehicle) and then lease it back. At the maturity, to pay back the principal to the investor, the issuer will give a purchase undertaking using Wa’ad to purchase the underlying asset at the principal value. The SPV will also give a sale undertaking in form of Wa’ad. The structure guarantees that at the maturity, or in the event of default, the principal value of the underlying asset is redeemed to the investor. This kind of Sukuk structure is an embedded option; the premium is negotiated along with the original transaction, and is not separately paid.
Structured Products
Structured product is a principal protected investment product if hold until maturity. A conventional structured product consists of element: capital protection part and enhanced yield part. The enhanced yield part uses a call or put option; the return due on the investment depends on the performance of underlying currency exchange rate. Shari’ah-compliant version is not different from the conventional one except that in the former the enhanced yield part is delivered using Wa’ad or ‘Urbun. The IFIs receive a fee directly if Wa’ad is used, or in form of earnest if ‘Urbun is used.
Dual Currency Murabaha (DCM)
DCM is a structured investment product. For example, an investor places money in dirham through a commodity murabaha; the IFIs offers the investor higher return than ordinary deposit; in return, the IFIs has a right to return the principal and profits in dirham or an alternative currency. The parties agree, ex ante, on the alternative currency and the conversion rate. In effect, it combines commodity murabaha and option.
Conclusion
Islamic businesses need to manage the risk, too. IFIs recognize this need and provide Shari’ah compliant alternative to conventional options. However, most of Muslim jurists opined that the options contradict the doctrines of Shari’ah because they have a zero-sum game economic structure. Some jurists, who are in the minority, on the other hand, argue that the options are useful hedging tools; denying access to options harms Islamic businesses, and halts economic development. The practice in Islamic finance industry is partial toward the minority; it is highly likely that in the near future options acquire wide acceptance among jurists.
Source: Option Contract In Islamic Finance, Author: Haroun Rahimi
[1] Resolution No. 63/1/7 (2001).
[2] M.K. HASSAN, ET. AL, INTRODUCTION TO ISLAMIC BANKING AND FINANCE 71 (2013).
[8] I. Iqbal, et,. al, Application of Options in Islamic Finance, Research Paper no 46, 10 (2012).
[10] T. EL DIWANY, THE PROBLEM WITH INTERNET (2003)
[11] M. Usmani, Futures, Options, Swaps, and Equity and Instruments, NEW HORIZON, 10-11 (1996).
[13] AAOIFI, SHARI’AH STANDARDS (2008).
[15] Meeting 49th, April 28, 2015.
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