Derivatives Instruments in Islamic Countries and the European Regulation on Derivatives

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Derivatives Instruments in Islamic Countries and the European Regulation on Derivatives[1]

 

 

Financial Globalization facilitates greater diversification of investment and enables risk to be transferred across national financial systems through derivatives.  

 

Derivatives are financial contracts whose inherent value derives from, and exists by reference to, a pre-determined payoff structure of securities, interest rates, commodities, credit risk, foreign exchange or any other tradable assets, indices and/or baskets of any combination of the above with varied maturities.

 

Derivatives assume economic gains from both risk shifting and efficient price discovery by providing hedging and low-cost arbitrage opportunities.

 

Islamic Countries are governed by Shari’a that bans interest, short selling and speculation, and stipulates that income must be derived as profits from shared business risk rather than guaranteed return.

 

Islamic Finance relies on structural arrangements of asset transfer between borrowers and lenders to emulate traditional interest-bearing financial contracts.

 

 

Islamic Finance

 

Islamic Finance system prohibits Riba (interest). Since only interest-free forms of finance are considered permissible in Islamic finance, financial relationships between financiers and borrowers are not governed by capital-based investment gains but shared business risk (and returns) in lawful activities.

 

Any financial transaction under Islamic law implies direct participation in asset performance. The Shari’a does not object to payment for the use of an asset as long as both lender and borrower share the investment risk together and profits are not guaranteed ex ante but accrue only if the investment itself yields income. Different Islamic financing structures:

 

-          Synthetic loans (debt-based): the borrower repurchases the assets from the lender at a higher price than the original sales price;

 

-          Lease contracts (asset-based): the borrower under a lease back agreement repurchase the assets at the same price at the end of the transaction and pay quasi-interest in the form of leasing fees for the duration of the loan.



[1] The handout is based on the readings provided in class. Highlighting the most important features. For any question please forward an email to my email address at the top of each page. 

 

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