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1Derivatives in Islamic Finance – An OverviewDerivatives in Islamic Finance – An OverviewObiyathulla Ismath BachaManagement Centre,International Islamic University, Malaysia
2What are derivatives?What are derivatives?A derivative security is a financial asset whose value is dependent on the value of an underlying asset. The underlying asset could be a basic financial asset like common stocks, bonds, currencies or commodities.Since by this definition, a derivative is a "claim on a claim" the value of the derivative will depend on the value of the asset (stocks, bonds, etc) on which it has a claim.Common forms : Forwards, Futures, Options, Swaps. Also, exotics like, Swaptions; LEAPs, CMOs etc.At a basic level; derivatives enable the avoidance of unnecessary risks.
3Evolution of Derivative Markets/InstrumentsEvolution of Derivative Markets/InstrumentsIf one examines the evolution of derivative markets and instruments the progression has been as follows:Forward ContractsOptionsFutures ContractsSynthetic InstrumentsExotic OptionsSwaps etc.Financial Engineering
4As with any other financial product, derivatives were the result of financial innovation. Innovation that responded to the existing need to help manage risk in increasingly sophisticated business environments.While forward contracts were originally innovated for risk-management of agro-based products, the later instruments were needed as risk environments changed.Each step down the evolutionary chain; added value.Forward Futures; reduced•Liquidity risk•Counterparty risk•Avoid price squeeze etc.Futures Options•Increased flexibility•Ability to take advantage of favourable price movts (unlike lock-in)*managing contingent claims/liabilities.The objective of all these innovation is Risk Management.Rationale: Why do we need derivatives?Rationale: Why do we need derivatives?
5Risk, from a Finance viewpoint, refers to the uncertainties associated with returns from an investment. These uncertainties would translate into volatility or fluctuation of returns from an investment. Measured by std. deviation.An asset that does not come with “guaranteed” fixed returns has some amount of uncertainty. Infact even a “guaranteed” instrument has risks if the issuer’s credibility is questionable.Risk-Management;refers to the process/techniques of reducing the risks faced in an investment.It generally involves three broad steps;Identifying the source and type of risk.Measuring the extent of the risk.Determining the appropriate response (either on Balance Sheet or Off Balance Sheet) methods.What makes risk management challenging is the fact that risks and returns are generally positively correlated. Thus, the risk-return tradeoff.