Many people believe that hedging is not acceptable in Islam. They think that hedging involves reducing risk in an investment, which may lead to a risk-free investment in the case of a perfect hedge. Aversion to hedging also stems from doubts over hedge funds in Islamic banking and finance.
It is important to understand hedging before pronouncing it shari’a-compliant or otherwise. Hedging involves reducing risk of an investment by making an offsetting investment. For example, if someone buys 10,000 PTCL stocks for Rs25 per share, then the person has a total (risk) exposure of Rs250,000 in this investment. In an extreme case where the PTCL stock loses all its value, the investor will lose all his investment, foregoing Rs100,000 if the stock goes down to Rs15 per share when he sells it back in the market.
One possible way of hedging against market price fluctuations entails the investor part buying and part borrowing the same stock. For example, the investor may decide to buy 10,000 stocks of PTCL for Rs25 per share and also borrow 5,000 PTCL stocks from a brokerage firm by paying a one per cent premium (interest) for a period of three months. Thus, the investor’s portfolio comprises 10,000 purchased stocks and Rs125,000 in cash that he receives from the sale of the borrowed stocks. Suppose that after three months, the PTCL stock goes down to Rs20 per share. The investor loses Rs5 on his purchased shares (ignoring transaction costs), with a total loss of Rs50,000. However, the investor buys 5,000 PTCL stocks from the market for a price of Rs20 per share for a total price of Rs100,000, and delivers these to the broker to close his borrowing position with him. In this second leg of the transaction, the investor makes a gross profit of Rs25,000 (or a net profit of Rs23,750, which takes into account the interest payments). This strategy reduces the loss of the investor from Rs50,000 to Rs26,250.
The question that arises is whether it is shari’a compliant to do so. The above example is that of a long-short strategy for hedging. The following shari’a matters must be considered when judging a long-short hedging strategy.
1. Purchase of stocks of companies that are involved in shari’a compliant activities is permissible
2. Borrowing stocks for a premium (interest) is not acceptable in Islam
3. There is a general consensus among contemporary jurists that onward sale of a borrowed item (including shares of listed companies) is not allowed
So, the way the above long-short strategy is implemented in conventional financial markets, is not permissible. However, there are other ways of hedging risks in a shari’a compliant way. For example, one may wish to limit exposure by way of using shari’a compliant options. A simple call option is based on the concept of arbun, a sale that allows the buyer to pay a fraction of the price upfront as a deposit to confirm the sale. Later, he is obliged to pay the remainder of the price and take delivery. A major difference between Islamic options and conventional options is that while the latter can be sold separately before an actual sale may take place; the former cannot be sold for a price other than what is determined as part of the price of the object of sale. Shari’a does not allow the sale of unbundled options. This is primarily due to the fact that Islam does not allow trading in derivative contracts. However, it is legitimate to minimise risk in trading by way of hedging it, using shari’a compatible techniques.
In Islamic banking and finance, there are now an increasing number of hedging tools and products available. However, it is fair to say that at present there is a dearth of shari’a compliant hedging products available to Islamic banks operating in Pakistan – a point raised by Mr Yaseen Anwar (deputy governor of the State Bank of Pakistan), at an Islamic banking seminar in Karachi, organised by the Bahrain-based International Islamic Financial Market (IIFM). The IIFM is a body set up by major stakeholders in the Islamic financial services industry to develop shari’a compliant hedging instruments for Islamic banks and financial institutions. It has recently been successful in launching a shari’a compliant ISDA agreement, which can be used by Islamic banks and financial institutions for shari’a compliant hedging.
The writer is shari’a advisor to a number of banks and financial institutions and can be contacted at [email protected].
