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Islamic Derivatives

4 July 2007    Warren Edwardes interviewed by Don Brownlow - IBS Publishing, on behalf of New Horizon

The acceptance of Islamic derivatives is widely debated but they are deemed more acceptable in Malaysia than in The Gulf. There are a number of structures being talked about but most of them are proprietary with public details sketchy. Various ancient precedents have been borrowed by Islamic Financial Engineers especially Arboun (down payment) and Wakala (agency management fee).

And of course the tried and tested sale and purchase agreements can be brought to work – Murabaha, Salam and Tawaruk. After all anything is possible with Murabaha. Enter into three-way circular sale and purchase agreements on a commodity to generate a debt on behalf of a Black Box Special Purpose Vehicle and that Special Vehicle can invest in Pork Bellies or interest bearing securities or link to the value of any equity including banks and gaming firms. And all this combined with The Doctrine of Ibaha (Permissibility). If it has not been banned it is permissible.

Perhaps in order to create Islamic derivatives it is worthwhile going back to first principles on derivatives and recall how they were created in the early 1980’s. Interest rate swaps, FRAs, currency swaps, futures and options were just being talked about – at least in Europe. But there were back-to-back cross-currency loans, Forward-Forwards and HOLDs (Hedges on Loans and Deposits) which were on balance sheet precursors to currency swaps, FRAs and Futures. Even option effects were managed via delta hedging. And option premiums were embedded into Break Forwards and Participating Forwards.

It is also worthwhile to look into what is widely acceptable in terms of Islamic risk management – Takaful - and apply Takaful principles into creating derivatives. In 1985 at Midland Bank I was involved in the creation of a novel foreign exchange product – The SCOUT. This was the Shared Currency Option Under Tender contract. Several parties shared the costs and benefits of a currency option. Very similar to Takaful.

Warren Edwardes