1 Derivatives in Islamic Finance – An Overview Derivatives in Islamic Finance – An Overview Obiyathulla Ismath Bacha Management Centre, International Islamic University, Malaysia

2 What 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.

3 Evolution of Derivative Markets/Instruments Evolution of Derivative Markets/Instruments  If one examines the evolution of derivative markets and instruments the progression has been as follows: Forward Contracts Options Futures Contracts Synthetic Instruments Exotic Options Swaps etc. Financial Engineering

4  As 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?

5  Risk , 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.