The Concept of Derivatives

Derivatives are innovative products designed by financial experts to control or exploit the risks of trading. Derivatives track market prices like interest rates, foreign exchange rates, commodity prices, stock prices etc. As risk management tools derivatives involve arbitrage, hedging, speculation and options. The classical purpose of derivative products is to distribute risk among market players based on their risk tolerance. If the derivatives work perfectly, everyone would gain improving efficiency and productivity. Besides hedging risks, derivatives have been also used for speculation.

Derivatives do not have any intrinsic value in themselves as usually no physical assets are involved. Only money is exchanged between parties with one party gaining and other losing. If a contract involves transfer of ownership of commodities or securities, then those contracts are not derivatives. Stock trading results in change of ownership where a seller might make a profit on purchase price of shares nd the buyer might hold on to it in hope of making further profits. This stock trading is not derivative.

Ownership of goods and associated risk drives the economics system and that is beneficial. Risk management should be integrated into the real economy. When it takes the form of derivatives and this financial activity becomes an economy in itself that is dangerous and not compatible with Shari’ah. It has been observed that the financial economy in developed markets is many times bigger than the real economy. This only benefits manipulative market players at the expense of average investors. Managing and controlling investment risk is as important to Islamic investor as it is for the conventional one. Any risk management products used in Islamic finance must be compatible with Shari’ah principles.

Arbitrage: Simultaneous currency transactions to balance the foreign exchange rates are called arbitrage. It is allowed in Shari’ah as long as it involves taking actual possession of the currency since it has an effect of balancing the foreign exchange rates.

Hedging: Purchase of a futures contract for an asset to balance the price differentials is called hedging. It is a necessary tool to safeguard against price drop. However, most of hedging is used as a gamble and comes under the concept of Qimar and Maysir, and hence not supported in Shari’ah in the current form.

Speculation: A real investor speculates about price movement of certain products he deals with, based on political, financial and economic conditions. This is a healthy economic activity and accepted in Islam. However, when people exploit the situation and have no real interest in the economic activity that would be against Shari’ah.
Options: None of the variants of options contract, namely, call, put, and put-and-call have been deemed Shari’ah compliant. These allow the option but not an obligation for purchase, sale, or both of an asset at a certain price at a future date. Some scholars have allowed these if they are related to actual purchase or sale of an object but that they cannot be themselves traded for profit making.