Durham E-Theses Islamic Perspective on Financial Derivatives: Demand for Instruments of Risk Management in Various Businesses of Pakistan EHSAN, MUHAMMAD,ASIF How to cite: EHSAN, MUHAMMAD,ASIF (2012) Islamic Perspective on Financial Derivatives: Demand for Instruments of Risk Management in Various Businesses of Pakistan, Durham theses, Durham University. Available at Durham E-Theses Online: http://etheses.dur.ac.uk/5949/ Use policy The full-text may be used and/or reproduced, and given to third parties in any format or medium, without prior permission or charge, for personal research or study, educational, or not-for-prot purposes provided that: • a full bibliographic reference is made to the original source • a link is made to the metadata record in Durham E-Theses • the full-text is not changed in any way The full-text must not be sold in any format or medium without the formal permission of the copyright holders. Please consult the full Durham E-Theses policy for further details. Academic Support Oce, Durham University, University Oce, Old Elvet, Durham DH1 3HP e-mail: [email protected] Tel: +44 0191 334 6107 http://etheses.dur.ac.uk 2 ISLAMIC PERSPECTIVE ON FINANCIAL DERIVATIVES: DEMAND FOR INSTRUMENTS OF RISK MANAGEMENT IN VARIOUS BUSINESSES OF PAKISTAN Muhammad Asif Ehsan A dissertation submitted in fulfilment of the requirements for the degree of Doctor of Philosophy at the School of Government and International Affairs Durham University, UK December 2012 Islamic Perspective on Financial Derivatives: Demand for Instruments of Risk Management in Various Businesses of Pakistan Muhammad Asif Ehsan Abstract This study was undertaken with the aim of exploring the legitimacy or otherwise of financial derivatives according to the Islamic commercial law, and ascertaining the demand for instruments of risk management in various business and economic sectors of Pakistan. The study drew the conclusion that forward contracts and futures contracts are allowed to benefit from. However, only hedgers can take advantage of them. These instruments can never be used for purely speculative purposes where making or taking delivery is not intended. Although it is not necessary to pay the complete price to the seller at the time of the contract yet some other precautionary measures such as a bank guarantee or a fair amount of money to be given to the seller should be taken to ensure that pure speculation is scrupulously forestalled and the delivery would certainly be made. If a large amount of money is given to the seller at the time of the contract the proscription of bai al-kali bil-kali would no longer be applicable because bai al-kali bil-kali comes about where the settlement by both parties is deferred to a future date, but that is not the case here. This amount of money would later on be adjusted to the total price. Options trading is also permissible because it is simply an extension of the fundamental concept of freedom and legitimacy given by the Shari’ah in relation to commercial transactions. However, those types of financial derivatives which involve riba such as interest-rate futures, interest-rate options, interest-rate swaps and swaptions are ruled out altogether and can never be taken advantage of. Similarly, those derivatives which proceed on gambling, inordinate uncertainty, alcohol, pork and other inadmissible commodities are precluded into the bargain. To carry out the empirical part of the research, 600 questionnaires were randomly given out to the organizations operating in two commercial and industrial cities of Pakistan, namely Lahore and Faisalabad. The goal of the survey was to ascertain the demand for instruments of risk management in various business and economic sectors. The research findings indicated that there is demand for collateral, futures contracts, guarantee, and hatt wa ta’ajjal for credit risk management. As regards market risk management, arbun sale, bai al-salam, forward contracts, futures contracts, istijrar, istisna, and khiyar al-shart are in demand. In relation to currency risk management, foreign currency forwards, foreign currency futures, and foreign currency options are in demand. To mitigate interest-rate risk, forward rate agreements, interest-rate futures, and interest-rate options are in demand. The research findings further represented that a large number of the respondents want to use these instruments, if available, for hedging purposes. The researcher learnt while administering the questionnaires that the respondents who do not want to utilize the instruments or techniques of risk management are either unacquainted with their structure or, quite often, not aware of their adequate and proper use. It was therefore proposed that the Islamic as well as conventional financial institutions had better provide their clientele and other business entrepreneurs with the required risk management counselling. Another issue is germane to the Islamic legal implications of foreign currency options, forward rate agreements and interest rate swaps permitted by the State Bank of Pakistan. The illicit features of these instruments ipso facto make them impracticable for those people who are desirous of using only Shari’ah-compliant instruments. It was thus suggested that the State Bank of Pakistan should also introduce other Shari’ah-compliant instruments, that is to say istisna, salam, bai al-arbun, istijrar, forward contracts, futures contracts, options and Islamic swaps, and allow Islamic as well as conventional banks to employ them for risk management. It is scrupulously hoped that some, if not all, parts of this research would be of benefit to and applied by the Islamic as well as conventional financial institutions in Pakistan and elsewhere. ii Copyright The copyright on this thesis rests entirely with the author. No extract from it should be published without his prior written consent, and all information derived from it must be acknowledged. iii Declaration I hereby declare that no portion of the work that appears in this study has been used in support of an application for another degree in this or any other university or institution of learning iv Acknowledgements Words cannot express my unassuming gratitude to Almighty Allah for His countless and unremitting Blessings on me. He bestowed aplomb, fervour and zeal on me to do this research. Sans His Help and Protection, it would not have been possible to accomplish this study. I am deeply indebted to my supervisor, Professor Habib Ahmed, for his invaluable advices and suggestions during the process of this research. He gave me his precious time, assisted me a lot in the theoretical and empirical parts of the research, and above all magnanimously encouraged me to accomplish the aim of this study. It has, indubitably, been a great honour for me to carry out the research under his supervision. I owe a debt of gratitude to my generous and righteous parents, Mr and Mrs Ehsan Ilahi, for their devout efforts and wishes for my success. Their heartfelt supplications have unquestionably been an enormous asset to and mainstay of my life. I humbly dedicate this study and all my erstwhile achievements to my affectionate mum and dad. I am much obliged to my brothers, Mr Arif Ehsan Malik and Mr Mubashir Ehsan, for giving me financial assistance throughout my research. They also helped me to administer the questionnaires. My warmest thanks are due to my sisters, kins, and pals as well for their moral support. Last but not least, I am awfully grateful to my fidus Achates, soulmate and wife, Amna Rahat, for her incessant succour in the entire research process. She unflaggingly lent me a helping hand, eagerly egged me on, and gave me plenty of time to carry out the research work. I am also beholden to my little crony and son, Hadi Bi-Amrillah, for bringing enraptured and propitious moments for me whilst this research. Muhammad Asif Ehsan Durham University June 2012 v Table of Contents Abstract ----------------------------------------------------------------------------------------- ii Copyright -------------------------------------------------------------------------------------- iii Declaration ------------------------------------------------------------------------------------ iv Acknowledgements --------------------------------------------------------------------------- v Table of Contents ---------------------------------------------------------------------------- vi List of Tables ------------------------------------------------------------------------------- xiii List of Figures ------------------------------------------------------------------------------- xv Chapter 1: Introduction --------------------------------------------------------------------- 1 1.1. Introduction -------------------------------------------------------------------------------- 1 1.2. Problem Statement ------------------------------------------------------------------------ 3 1.3. Research Aim and Objectives ----------------------------------------------------------- 5 1.4. Research Questions and Hypotheses ---------------------------------------------------- 6 1.5. Rationale for the Research --------------------------------------------------------------- 8 1.6. Research Methods ------------------------------------------------------------------------- 8 1.7. Overview of the Research ---------------------------------------------------------------- 9 Chapter 2: Financial Derivatives: Nature and Trading Mechanism -------------- 12 2.1. Introduction ------------------------------------------------------------------------------