Risk Management in Islamic Finance: Derivatives and Shariah Compliance

This report delves into the critical topic of risk management within the Islamic finance sector, specifically examining the role of derivatives. It addresses the challenges in managing risk within the trillion-dollar Shariah-compliant industry and explores alternatives to conventional derivatives, which are not Shariah-compliant. The paper provides an overview of various derivative instruments, including forwards, futures, options, and swaps, and their application in Islamic finance. It also highlights the importance of Shariah compliance, analyzing the views of Shariah on conventional derivatives and underlining the features of Islamic contracts, such as Salam, Bay al Arbun, and Istijrar contracts, that can serve as a foundation for establishing Shariah-compliant derivatives. The report utilizes external sources like Bloomberg, World Cat, and Google Scholar to provide a comprehensive analysis of the subject matter. The report aims to provide insights into the current state of risk management practices and the potential for innovation in the field of Islamic finance.

Running Head: Risk management
Islamic Finance
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Table of Contents
Risk Management in Islamic Finance: Derivatives....................................................................3
How risk management is achieved through derivatives in Islamic finance...............................3
Derivatives.................................................................................................................................3
There are four derivatives used by Islamic Finance...............................................................3
Derivative Structure that makes Shariah Compliant..............................................................3
Reference list..............................................................................................................................5
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Risk Management in Islamic Finance: Derivatives
How risk management is achieved through derivatives in Islamic finance
Islamic Banks traditionally follows instruction and rules because of borrower bear risk in
investment and returns. Risk assessment tools and techniques can be evolved to eradicate this
risk (Khaliq et.al., 2017).
They understand the need of the people and provide them their desired product. It develops
Islamic law and Islamic economics. They follow bay' al-salam where people have to pay first
their products will be delivered later. If they innovate their financial management techniques,
it can contribute to the development of the Islamic banking system (Sakti et.al., 2016).
Derivatives
There are four derivatives used by Islamic Finance
Forwards- Forward is a contract between two parties for the transaction at a future date. In
this contract, features, measures, maturity is negotiated by two people. The terms are made at
initiation and transaction is made on the maturity date. With forward derivative, two parties
undertake a transaction that involves producers and consumers. In option, the bank evolves
economic mechanism where all issues are resolved.
Futures- Futures derivative is an exchange-traded forward contract. In Future derivatives,
futures contracts are introduced which gives benefit to both the parties. It improves liquidity
and reduces transaction costs.
Options- It provides the right to buy or sell an asset at a predetermined price. Call and puts
options that provide the right to them. Call give right of purchase and put gives right but not
obligation to sell.
Swaps- Swaps derivative are arrangements where swap transactions are made. It is the
process of exchange of an asset to another underlying asset.
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Derivative Structure that makes Shariah Compliant
Derivatives were made for risk management of the Islamic Bank and to minimize risk. Bank
issue credit cards and no interest is involved (Said, 2017). They also provide safe custody
services to the clients. The derivative instrument and risk management are achieved through
product innovation. Every new product provides value to its clients and it gives value to
Islamic Banks. Islamic Bank does risk management through these innovative techniques.
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Reference list
Khaliq, A., Thaker, H.M.T., Thaker, M.A.M.T. and Pitchay, A.A., 2017. Interest Rate Risk
Management and Islamic Banking: Evidence from Malaysia. Journal of Islamic
Finance, 176(5527), pp.1-15.
Idris, M., 2019. STRENGTHENING RISK MANAGEMENT OF SHARIA BANKING IN
INDONESIA. Madani Legal Review, 3(1), pp.1-11.
Sakti, M.R.P., Syahid, A., Tareq, M.A. and Mahdzir, A.M., 2016. Shari’ah issues, challenges,
and prospects for Islamic derivatives: a qualitative study. Qualitative Research in Financial
Markets.
Said, A., 2017. Managing Financial Risk by Using Derivatives: A Study of United Arab
Emirate Listed Companies. Economics and Finance Review, 5(02), pp.05-13.
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