Derivatives have become a useful tool in contemporary business albeit the use is limited in Islamic finance (Ismat Bacha, 2009). There is no denial that derivatives can be easily used for speculative purposes as well as their extensive use in contemporary finance is testimony to the numerous benefits that businesses can extract from the use of the derivatives (Syed Aun Raza Rizvi and Ahcene Lahsasna, 2012). The present research will be an attempt to outline the necessity of derivatives and their potential role in contemporary Islamic Finance emphasizing the Shariah qualification as well as the prohibitions on the controversial traditional derivative products. This research would shed light on the derivative products and their potential role in light of the risk management measures (Muhammad al-Bashir, 2008). Moreover, the research will be an endeavor to understand and analyze the precise need for derivatives in Islamic Finance during challenging and volatile economic conditions. It is pertinent to mention here that the Islamic Financial industry is showing tremendous growth potential in the past two decades but risk management still remains a widely unexplored area (Syed Aun Raza Rizvi and Ahcene Lahsasna, 2012)
Background and rationale of the research:
Due to the volatile economic and political situation, business in the contemporary corporate world is very challenging. In recent times elimination of scarcity has been replaced by the elimination of risk within the financial institutions whether conventional or Islamic (Muhammad al-Bashir, 2008). These numerous risks include interest rate risk, market risk, credit risk, operational risk, liquidity risk, regulatory risk, litigation and foreign exchange risk.
Market risks can derive from micro and macro sources as well as through the movement of policies and prices. The latter one is the most volatile. Interest rate risks are not directly affected in Islamic financial institutions due to the prohibition on interest charges and payments. However, it affects the institutions indirectly ‘due to their bid to determine their return’. As for the transaction benchmark they use the London Inter-Bank borrowing rate (LIBOR) as a benchmark. therefore the impact of volatile interest rates can be transmitted by this benchmark (Muhammad al-Bashir, 2008). Credit risks occur when the counterparty fails to meet obligations within the stipulated manner and it may impact the trading and banking books of the bank. Inadequate liquidity for usual operations might lead to liquidity risks and diminish the aptitude of the bank to encounter its liabilities in case of failures. Operational risks may take place due to technical and human errors of internal processes or external events.
As Islamic finance is relatively a new phenomenon, operational risks involving the human risks here can be acute and volatile due to the lack of sufficient professional personnel to conduct Islamic financial operations. Moreover the conventional banking software accessible in the market might not be appropriate for Islamic banks. Legal risks (a kind of operational risk) connect to the unenforceability of financial contracts as well as to the legislation, statute and regulations. Regulatory risks derive from the changes in a country’s regulatory framework. Islamic banks are more vulnerable to the risk of enforcement and documentation. They do not have any standard forms for financial institutions and hence the prepare contracts according to the advice of the respective Sharia Board as well as measuring local laws. From the above discussion, it is apparent that risk is inherent in the business and industrial production has escalated the risks even further as it requires a longer period for production and hence greater uncertainty.
Risks are more challenging in Islamic banking due to the compliance of the Sharia principles as well peculiar risk characteristics. “While the Basel II initiatives on the identification of credit, market and operational risks can be assimilated into Islamic banking, the initiatives have to be complemented with consideration of the other dimensions of risks that are inherent in the Islamic financial transactions” (Muhammad al-Bashir, 2008). The risk management infrastructure in Islamic financial institutions needs to identify, unbundle, measure, control, and monitor all the specific risks in Islamic financial transactions and instruments. This is to ensure that the systems and controls will be effective in the quantification and management of the risks arising from the operations.
Needs for derivative markets:
From the above discussion on the risk, it is apparent that Islamic banking requires the development of a derivative market. The contemporary financial market environment is volatile and uncertain and therefore investors required being in a position to diminish and manage the emerging risks. Islamic banking has long-term assets such as housing as well as financial instruments funded by short-term deposits, therefore creates a maturity mismatch between the liabilities and assets. Therefore it is pertinent to develop a broader range of instruments for the Islamic Financial market in order to deliver fruitful risk-mitigating instruments for the industry (Syed Aun Raza Rizvi and Ahcene Lahsasna, 2012). The economy of a number of Muslim countries relies on commodities and raw materials. Therefore investment, pricing and production of these commodities are substantially affected by the use of derivatives for risk management as well as the trade in the international arena (Muhammad al-Bashir, 2008)……………………