No.

88/2016

ISRA Research Paper

Issues in Islamic Hedging
Practices:
A Critical Analysis
Research Team

Dr. Noor Suhaida binti Kasri

Head of Islamic Capital Market Unit
noor@isra.my

Dr. Zaharuddin Abd Rahman

International Islamic University Malaysia (IIUM)

Dr. Shamsiah Mohamad

Dr. Farrukh Habib

International Shari’ah Research Academy for Islamic Finance (ISRA)

Note:
The authors would like to express their sincerest appreciation to Siti Syafira
Zainal Abiddin, Mohammad Mahbubi Ali and Nor Fahimah binti Mohd Razif
for their contribution in this research project

© 2016 International Shari’ah Research Academy for Islamic Finance (ISRA)

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No part of this publication may be reproduced, stored in a retrieval system, or transmitted

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otherwise without prior permission of the publisher.

Printed and Designed by ISRA


Issues in Islamic Hedging Practices: A Critical Analysis
Hedging is an important concept in overall risk
management in conventional finance. The need
for hedging is also recognised in Islamic finance,
although hedging strategies in Islamic finance are
different from those of conventional finance in the
sense that they must be in compliance with Sharīʿah
principles. Accordingly, the following international
Sharīʿah standard-setting bodies and other Sharīʿah
authorities outside Malaysia have issued resolutions
acknowledging the need for hedging and discussing
various instruments to be used for that purpose:
y the Islamic Fiqh Academy of the Organisation
of Islamic Cooperation (IFA-OIC);
y the Accounting and Auditing Organization
for Islamic Financial Institutions (AAOIFI);
y the International Islamic Financial Market
(IIFM);
y Dallah al-Baraka (DAB);
y National Sharia Board-Indonesian Council
of Ulama (DSN-MUI).
The following local Sharīʿah standard-setting bodies
have also issued relevant resolutions:
y the Shariah Advisory Council of Bank Negara
Malaysia (SAC-BNM);
y the Shariah Advisory Council of Securities
Commission Malaysia (SAC-SC) .
A careful examination of these resolutions reveals
that the hedging approved for use in Islamic finance
is distinct from hedging in conventional finance. The
distinction lies in four major factors: (1) the hedging
contract and its underlying assets must be Sharīʿah
compliant; (2) the use of the hedging mechanism
is not to be for speculation and gambling; (3) the
hedging transaction is to be carried out based on
actual underlying risk arising from an investment
which adds value to the real economy; and (4) the
strategy or technique involved in hedging risk does
not sever the risk from its underlying assets. Though
the Sharīʿah advisory bodies mentioned above are
Executive
Summary
in agreement on the need for hedging, they are not
unanimous on the legality of the prevalent hedging
products. In general, foreign currency forward
hedging products are allowed by almost all of these
Sharīʿah advisory bodies. However, other hedging
products like options, swaps, and futures contracts
are approved only by the SAC-BNM and the SAC-
SC.
Despite the resolutions of the SAC-BNM and the
SAC-SC that the abovementioned hedging products
are Sharīʿah-compliant, the practice on the ground
seems to show otherwise. Based on this background,
this paper attempts to investigate the practice
of Islamic hedging and unearth issues related to
it. Four fundamental issues have been identified
pertaining to hedging: speculation; superficial use
of commodity murābaḥah/tawarruq as a hedging 1
arrangement; compensation for breach of waʿd; and
mark-to-market gain/loss in Islamic profit rate and
Issues In Islamic Hedging Practices: A Critical Analysis
Islamic forward. These four issues are discussed
by addressing the following questions under their
respective areas:
(1) Is there any difference between hedging and
speculation in terms of practice?
(2) Can a hedger be allowed, instead of profiting
from the real exchange or transaction of
underlying business or commodities, to profit
from external factors that are uncertain at
the time of entering into the contract; for
example, the future interest rate, the future
currency exchange rate, etc.?
(3) Do hedging arrangements entered through
the execution of promises and commodity
murābaḥah/tawarruq represent a real
exchange in their use to facilitate mark-to-
market gain/loss? Can the resultant profit be
considered lawful like the gain derived from a
valid and independent sale contract?
(4) Does the Sharīʿah allow one party in particular
to gain when the gain is realised based on
mark-to-market, instead of depending on the
cost of holding the commodity? Would such
a scenario trigger the element of gambling in
the hedging structure?
 (5) Is the compensation/damage, in the form of reconsider the Sharīʿah permissibility of using the
the close-out amount, paid by the party that conventional formula in determining the close-out
breaches the waʿd based on the actual loss? amount in Islamic profit rate swap as well as the
superficial use of commodity murābaḥah/tawarruq
(6) As the close-out amount based on mark-to-
to facilitate mark-to-market gain/loss in Islamic
market allows one of the contractual parties
hedging arrangements. Lastly, further research is
to gain based upon market movement in its
recommended on speculation, with particular focus
favour, would the Sharīʿah allow the party
on parameters for distinguishing between excessive
who breached the waʿd to gain if the market
and moderate speculation and identifying the
moves in its favour?
Sharīʿah basis for the distinction.
(7) Is the mark-to-market gain/loss imposed due
to the termination or extension of waʿd in FX
forward based on the actual loss?
Keywords:
Given the research questions, this paper concludes
that there are differences between hedging and Islamic hedging, speculation, close-out amount,
taḥawwuṭ, commodity murābaḥah, mark-to-
speculation. Accordingly, a hedger cannot be
market
allowed to profit on the basis of an external factor
that is uncertain at the time of entering into the
contract, for example, the future interest rate, the
future currency exchange rate, etc. This paper also
finds that the execution of promises and commodity
murābaḥah/tawarruq to facilitate mark-to-market
gain/loss does not represent a genuine exchange
2 in Sharīʿah; thus, the resultant profit could not be
considered a lawful gain. It also finds that Sharīʿah
does not allow one party to gain when the payment
Research Paper No. 88/2016

of gain is given not on the basis of holding a

commodity but on the basis of mark-to-market, as
this would trigger the element of gambling. The
paper further concludes that the compensation/
damage paid by the party that breaches the waʿd in
an Islamic profit rate swap, which is in the form of the
close-out amount, is based on actual loss. Thus, the
party that incurs a loss due to the breach is allowed
to be compensated but not the party which breaches
the waʿd. Similarly, the mark-to-market gain/loss
imposed due to the termination or extension of waʿd
in an FX forward is to be borne by the party which
breaches the waʿd and not otherwise. The charges
imposed must also be based on actual loss and not
on opportunity loss.

There is, therefore, a definite need for related

Sharīʿah advisory bodies to revisit their Sharīʿah
resolutions. The criteria of Islamic hedging as
proposed in this paper ought to be considered and
met in their resolutions. It is also important that the
real need of hedging and its impact on the economy
and society be taken into consideration in the
revision. It is hoped that it will increase confidence
in the Islamic financial industry and the economy as
a whole, thus giving assurance that their resolutions
remain adequate and effective. It is also necessary to

INTRODUCTION
The Malaysian International Islamic Finance Centre
in its report “2014 – A Landmark Year for Global
Islamic Financial Industry” (Bank Negara Malaysia,
2014) announced that Islamic finance was forecasted
to grow at 3.8% (USD 2.1 Trillion) in 2015, an uptrend
compared to 3.3% growth in 2013 and 2014 estimates.
Nevertheless, financial market sentiment remains
vulnerable to exogenous events such as geopolitical
crises and the unwinding of easy monetary policy
in the advanced economies, particularly the Federal
Reserve’s quantitative easing program, which have
led to volatility in the market yields of emerging
economies. Thus, the need for appropriate risk
management strategies is indispensable.
Hedging is an important strategy in managing risk.
The need for hedging is conspicuous as risk can
be found in all business and economic activities.
Through hedging, corporations and financial
institutions can minimize the risk of loss in their
profits and the value of their assets. In view of the
need for hedging, a number of Sharīʿah standards
and resolutions have been issued by international
Sharīʿah standard-setting bodies and other Sharīʿah
authorities outside Malaysia such as:
y the Islamic Fiqh Academy of the Organisation
of Islamic Cooperation (IFA-OIC);
y the Accounting and Auditing Organization
for Islamic Financial Institutions (AAOIFI);
y the International Islamic Financial Market
(IIFM);
y Dallah al-Baraka (DAB);
y National Sharia Board-Indonesian Council of
Ulama (DSN-MUI).
The following local Sharīʿah standard-setting bodies
have also issued relevant resolutions:
y the Shariah Advisory Council of Bank Negara
Malaysia (SAC-BNM);
y the Shariah Advisory Council of Securities
Commission Malaysia (SAC-SC)
Section 1
“ The need for hedging is
conspicuous as risk can be found
in all business and economic
activities
”
These authorities are in agreement on the need for
hedging but are not unanimous with regards to the
legality of current Islamic hedging instruments.
Though there is an immense demand for hedging in
the Islamic finance industry, it is important to note
that the hedging structures used by Islamic financial
institutions differ from those used by conventional
financial institutions in terms of the mechanisms and
contracts used. This paper examines the difference
between conventional hedging and the hedging 3
strategies employed in Islamic finance by analysing
the Sharīʿah standards and fatwas that have been
issued by the abovementioned Sharīʿah advisory
Issues in Islamic Hedging Practices: A Critical Analysis
bodies on the permitted Islamic hedging contracts
and their structures. Although Islamic hedging
products like Islamic profit rate swap and Islamic
FX forward have been approved by the SAC-BNM
and the SAC-SC, examination reveals that there are
still Sharīʿah issues underlying the operations and
practices of those products.
This paper examines four critical issues:
y the relationship between hedging and
speculation;
y superficial use of commodity murābaḥah/
tawarruq as the hedging arrangement;
y compensation for breach of waʿd; and
y mark-to-market gain/loss charges in Islamic
profit rate swap and Islamic forward
contracts.
This paper adopts a qualitative research methodology
by using a documentary analysis approach.
Classical Sharīʿah literature, including books of
the four schools of fiqh, is analysed along with
contemporary references like prevalent Sharīʿah
resolutions and standards of the international and
 local Sharīʿah advisory bodies, as well as Malaysian
trading rules and regulations. Non-structured
interviews and discussions were held with a number
of market players in Malaysia to gather adequate
understanding of the practice of Islamic hedging
on the ground and identification of Shariah issues
related to the practice.

The paper is divided into five parts. Section 1 is

the introduction. Section 2 defines conventional
hedging and Islamic hedging. Section 3 examines
the legality of Islamic hedging instruments issued
by several international and Malaysian Sharīʿah
standard-setting bodies. Section 4 analyses the
four critical issues underlying the operation of
Islamic hedging products. Section 5 lays out some
recommendations to overcome the issues discussed
in Section 4 and subsequently concludes the paper.

4
Research Paper No. 88/2016

DEFINITION
(1) Conventional Hedging
“Hedge”, the noun, is defined as “a way of
protecting, controlling or limiting something”
(Cambridge Free English Dictionary and
Thesaurus, 2016). In a technical sense,
“hedging” is defined in the Dictionary
of International Investment and Finance
Terms as a method of protecting against
price fluctuations commonly used on the
commodities futures market (Clark, 2001).
It is also used to describe the practice of
protecting against fluctuations in exchange
rates (by buying forward) to minimize risks
and possible losses. Hence, by hedging, one
could protect an investment against the risk of
possible loss due to adverse price fluctuation.
In addition to describing hedging as a strategy
to protect an investment, the Dictionary of
Investment Terms (Martz, 2006) extends the
definition by explaining the mode of hedging,
namely by entering into another transaction
that could offset any loss in the original
investment. The International Dictionary of
Derivatives echoes and elaborates by stating
that hedging is a protection on investment
against possible loss by buying investments
of a fixed price for future delivery (Kiam,
2009).
(2) Islamic Hedging
Some scholars expand the scope of hedging
beyond the protection of investments,
considering it also as a means to maximize
profits. For instance, Gregoriou (2009) defines
hedging as a method of minimizing exposure
to risk and enjoying the profit from an
investment. Kamara (1982) also states that
the main purpose of hedging is the desire to
stabilize income and increase profits. These
definitions point out that by hedging one
could enjoy the profit arising therefrom.
Contrast that with Hull (2006), for example,
who considers hedging as a trade designed to
reduce risk.
From the descriptions above, one can reflect
that hedging is a means of protecting an
investment against the exposure to the
risk of potential loss due to adverse price
Section 2
fluctuation.1 To do so, the investor would
have to enter into a number of transactions
with the aim of offsetting any losses on
his investment. In view of that, hedging is
often perceived as investment insurance; it
resembles insuring an investment against
any potential loss (Gregoriou, 2009). The
next issue is whether hedging as understood
in conventional financial world bears any
similarity with hedging as conceived in
Islamic finance.
“ In(2010:
a technical sense, AAOIFI
494) in its Shariah
Standard No. 27 describes
hedging/taḥawwuṭ as “a method 5
for mitigating investment risks
(such as market risks) by using
Issues in Islamic Hedging Practices: A Critical Analysis
financial instruments available
in the market to curb the risks
that may arise from severe price
changes”
”
In Arabic, hedging is known as taḥawwuṭ
(‫)تَ ُّوط‬,
َ which is derived from the word ḥāṭa
(‫)حاط‬. Hedging is also known as ḥiyāṭah,
iḥtimẚ or taghṭiyyah. The word ḥiyātah
linguistically includes precaution, protection,
attention and patronage (Ibn Manẓūr, 2002).
Elgari (n.d.) states that the concept of
ḥiyāṭah is reflected in the Arabic statement,
“Yataḥawwaṭu akhāhu ḥīṭatan ḥasanah,”
which means: “He takes care of his brother
and pays good attention to his affairs.”
Ḥawwaṭahu, according to him, means “he
built a wall around it” (Elgari, n.d.).
In a technical sense, AAOIFI (2010: 494) in its
Shariah Standard No. 27 describes hedging/
taḥawwuṭ as “a method for mitigating
investment risks (such as market risks) by
 using financial instruments available in the
market to curb the risks that may arise from
severe price changes”. Echoing AAOIFI’s
definition, Dallah al-Baraka (2002) in its
Resolution No. 6/27 describes the practice
of hedging as “an agreement where parties
agreed to enter into a contract in the future
for the protection of the buyer and seller
as a safeguard against fluctuations of the
market rates.” Meanwhile, Elgari (n.d.) defines
taḥawwuṭ as “the adoption of processes and
arrangements and the selection of contractual
formats that guarantee reduction of risks
to a minimum while maintaining good
possibilities for return on investment”. Based
on the above definitions, it can be inferred
that the meaning of hedging in Islamic
finance bears a similarity to its definition in
conventional finance.

“ Hedging processes must conform

to the requisites of the Sharīʿah;
6 otherwise, the activity would be
deemed unlawful
”
Research Paper No. 88/2016

The similarity is perhaps due to the similarity in

the objective of protecting underlying businesses
or investments against the risk of potential loss,
which is indeed a norm in economic activity.
According to al-Suwailem (2006), in this sense
the concept of hedging aligns with an objective
of Islamic economics. It could be said to be one of
the means of achieving the Sharīʿah’s objective of
wealth protection (ḥifẓ al-māl). However, the ruling
on particular cases depends on the intentions of the
contracting parties and the mechanisms adopted.
Hedging processes must conform to the requisites
of the Sharīʿah; otherwise, the activity would be
deemed unlawful. On that note, the following
section highlights the Sharīʿah standards or
resolutions issued by international and local Sharīʿah
advisory bodies regarding hedging instruments and
structures.

LEGALITY OF ISLAMIC HEDGING IN INTERNATIONAL AND LOCAL
SHARĪʿAH RESOLUTIONS AND STANDARDS
A number of Sharīʿah resolutions, fatwas and
standards on Islamic hedging have been issued by
international and local Sharīʿah advisory bodies
around the world. The legality of hedging instruments
like futures, forwards, options and swaps has been
deliberated and resolved. The focus of the discussion
in this paper is on the Sharīʿah resolutions that
approve Islamic hedging. The ensuing discussion of
these resolutions is intended to identify the criteria
that must be incorporated in hedging mechanisms
to make them Sharīʿah compliant.
The permissibility of hedging structures can be
found in the following Sharīʿah resolutions and
standards:
AAOIFI in its Shariah Standard No. 1 declares that
it is permissible for institutions to hedge against
future currency devaluation. The parties concerned
could hedge via:
(1) Back-to-back interest-free loans (qarḍ) by
using different currencies. The conditions for
permissibility for this hedging instrument are
that: (a) no parties should give or take extra
benefit out of these loans; and that (b) the two
loans are not contractually connected to each
other (AAOIFI, 2010: Article no. 2/4 (i)). This
structure and rule are applicable in the case
of foreign currency hedging. This mechanism
enables parties to overcome the Sharīʿah
restriction imposed on bayʿ al-ṣarf (currency
trading), which requires the delivery of the
two currencies on the spot. This simplistic
method of Sharīʿah-compliant foreign
currency exchange has been used in day-
to-day dealings between some local traders
and that too in small amounts (Hussain &
Mehboob, 2008).
(2) A promise (waʿd) is another instrument whose
use is allowed as a hedge against currency
devaluation risk. However, the condition
for its permissibility is that the promise
should not be a binding bilateral promise to
purchase and sell currencies even though it
is meant for the purpose of hedging against
Section 3
currency devaluation risk (AAOIFI, 2010:
Article 2/9 (i)). According to this resolution,
the permissible promise would be in the form
of one party agreeing to purchase a specific
currency at a certain rate at an agreed date.
Thus, by entering into such promise, the party
who is interested in acquiring such currency
can hedge the risk by locking in the value of
the currency at the time the promise is given.
(3) In AAOIFI’s Shariah Standard No. 20, Article
no. 5/2/3, a Sharīʿah-compliant option in
the form of ʿurbūn is allowed. It views that
a contract concluded on an ascertained
asset is permitted in the Sharīʿah along with
the payment of part of the price as earnest
money (ʿurbūn). This contract incorporates
the stipulation that the buyer has the right to 7
revoke the contract within a specified period
while the seller is entitled to retain the earnest
Issues in Islamic Hedging Practices: A Critical Analysis
money in case the buyer exercises his right
of revocation. However, this right established
via the earnest money is not tradable.
Dallah al-Baraka offered a limited endorsement of
hedging in its Sixth Symposium for Islamic Economy
on 2-6 March 1990. The participants resolved that
hedging, which they defined as an agreement to
enter into another contract in the future, is lawful
when the subject matter of the contract is lawful.
In the same Symposium, however, the participants
declared option contracts to be unlawful on the
basis that they are “speculative contracts in which
no actual sale is intended. Furthermore, trading
the right [embodied in] an option to buy or sell is
not permissible because such a right is not a valid
subject matter of a sale [contract]” (Abū Ghuddah,
Aḥmad, and al-Tamīmī, 1995, pp. 41-42). One kind of
hedging contract that they explicitly endorsed is a
forward sale (salam) of a commodity, as stated under
Fatwa No. 1 in the Second Forum of DAB (I-Fikr,
n.d.). Salam differs from an option, however, in that
the price must be delivered up front in the contract
session, and it is a binding contract on both parties.
In 2016, the Sharīʿah board of the International
Islamic Financial Market (IIFM) approved FX
 forward through the use of waʿd (by single waʿd or
two independent waʿds). Earlier, in 2010, the IIFM
approved profit rate swaps through the use of waʿd
and the contract of murābaḥah (cost-plus-profit sale
where the profit margin is disclosed to the buyer) or
musāwamah (a general sale contract where the profit
margin is not disclosed to the buyer). This hedging
arrangement is used to hedge against adverse profit-
rate movements usually by swapping or exchanging
floating payment obligations with fixed payment
obligations or vice versa (Kunhibava, Thomas, &
Mokhtar, 2012). To do so, one of the contracting
parties (the buyer) offers a promise (waʿd) that, if
required by the other contractual party (in this case,
the seller), he will enter into a murābaḥah contract
under which he will buy from the seller an agreed
quantity of agreed Sharīʿah-compliant assets at an
agreed price (or at an agreed formula for calculating
a price) on the relevant exercise date. A series of sales
contracts is used because it allows cash to flow from
one contracting party to the other at each agreed
interval. If one of the contracting parties defaulted
in exercising its waʿd to purchase the Sharīʿah-
compliant assets, another type of sale contract,
8 musāwamah, is used. The reason for the use of these
contracts and the related process involved in the
case of default will be further elaborated later in this
paper.
Research Paper No. 88/2016
It should be noted that in 2010 the IIFM also
approved a general guideline for undertaking
hedging arrangements. The guideline enumerates
that:
(1) The transactions entered into shall only be
for the purpose of hedging actual risks of the
relevant party.
(2) The transactions should not be entered into
for the purpose of speculation, which means
that the actual settlements of assets and
payments must take place. Cash settlement
should relate to actual transactions involving
a deliverable asset.
(3) The asset must be ḥalāl.
(4) No interest (whether called interest or an
alternative name that represents interest) is
chargeable under a transaction.
In 2015, the National Sharia Board-Indonesian
Council of Ulama issued a fatwa (NO:96/DSN-MUI/
IV/2015) permitting hedging in a foreign currency
exchange by use of a bilateral promise (muwaʿadah),
subject to the following restrictions and conditions:
(1) It is not to be used for the purpose of
speculation.
(2) The usage is based on real need.
(3) The right under a bilateral promise is not
tradable.
(4) Hedging can only be used to reduce the risk
exposure due to the volatility of a foreign
currency as well as liabilities created due to
foreign currency contractual obligations.
(5) The users of hedging consist of certain
institutions identified in the DSN-MUI fatwa.
(6) The rate for the currency exchange must be
mutually agreed to by the parties at the time
of entering into the bilateral promise.
(7) The hedging arrangement must be settled in
full at the point of maturity. Netting is only
allowed in the event of rollover, roll-back,
or termination due to change of the hedging
subject matter.
“also
The SAC-SC and SAC-BNM have
issued a number of Sharīʿah
resolutions permitting Islamic
hedging products
”
The SAC-SC and SAC-BNM have also issued a
number of Sharīʿah resolutions permitting Islamic
hedging products. Examples of the Councils’
Sharīʿah resolutions are as follows:
(1) The SAC-BNM (2007) in its 49th meeting,
held on 28th April 2005/19th Rabiʿul Awal
1426, resolved that an Islamic banking
institution is allowed to enter into a forward
foreign currency transaction based on a
unilateral binding promise (binding only on
the promisor – waʿd mulzim) and that if the
promisor breaches the promise, he is bound to
remit compensation for the breach.
However, this permissibility is only applicable
to currency hedging purposes. This hedging
transaction may be arranged between an
Islamic banking institution and
(a) its customer, or
(b) another Islamic banking institution, or
(c) a conventional banking institution.
 The SAC-BNM also approved at its special
meeting on 13 April 2007 forward foreign
currency exchange by using bayʿ muʾajjal
(deferred payment sale) and bayʿ ṣarf (sale
of currency) as an alternative to using
waʿd.
(2) Besides approving the forward foreign
currency transaction, the SAC-BNM also
approved the foreign currency option. In
its 79th meeting, dated 29 October 2008, it
resolved that the structure of the proposed
foreign currency option product based on waʿd
and two independent tawarruq transactions
is permissible, provided that the following
conditions are satisfied:
(a) The option product shall only be
undertaken for hedging purpose.
(b) Waʿd shall be made independently from
the tawarruq transaction and shall not
form part of the condition to perform
the tawarruq transaction.
(c) The Islamic financial institution
shall ensure that every transaction is
conducted independently from the other
regarding documentation and sequence
of transactions.
(d) The underlying asset used in the
tawarruq transaction shall be Sharīʿah
compliant.
(3) With regards to swaps, the SAC-BNM (2007)
resolved in their 44th meeting, dated 24 June
2004, that the arrangement of Islamic profit
rate swap through the contract of bayʿ al-ʿīnah
conducted amongst financial institutions or
between an Islamic financial institution and
another counterparty is permissible. As part
of the Islamic profit rate swap mechanism, the
offset practice (muqāṣṣah) or netting between
the two debt obligations arising from the two
bayʿ al-ʿīnah contracts is declared permissible
by the SAC-BNM as it does not amount to
the sale of debt for debt, which is prohibited
in the Sharīʿah. In addition, it resolved in its
54th meeting, dated 27 October 2005, that the
methodology in determining the close-out
amount under the conventional interest rate
swap could be applied to the Islamic profit rate
swap. The close-out transpires when the party
with a debt obligation to the other party makes
an early termination. In the conventional
interest rate swap, the close-out amount
is determined based on the market quote
methodology, which refers to the standard
formula adopted by market participants to
determine the payable compensation amount.
A similar methodology of calculation is
deemed to be acceptable and applicable to the
Islamic profit rate swap.
(4) The SAC-SC (2006) also took a similar
stance towards hedging products. In its 11th
meeting, on 26 November 1997, the SAC-
SC resolved that the crude palm oil futures
contract (a commodity futures contract where
parties sell and purchase crude palm oil at an
agreed price and future date of delivery) is
permissible as it is free from any element of
gharar (uncertainty) and maysīr (gambling).
It also resolved that the issues pertaining to
bayʿ al-maʿdūm (buying something that does
not exist), speculation and non-existence
of the ʿiwaḍ (consideration) do not occur in
crude palm oil futures trading. Even if these
elements exist, the SAC-SC resolved that their
existence has been overcome by the trading
rules and regulations that govern the crude
palm oil futures contract. 9
(5) In addition to approving the legality of the
crude palm oil futures contract, the SAC-SC
Issues in Islamic Hedging Practices: A Critical Analysis
in its 13th meeting, on 19 March 1998, resolved
that the composite (stock) index futures
contract (a type of financial futures contract)
does not contradict the Sharīʿah principles.
The composite (stock) index futures contract
is an agreement between the seller and the
buyer to make and take delivery of a certain
number of shares (which comprise selected
share components) at an agreed price and a
determined future date. The SAC-SC resolved
that stock index trading is allowed as long as
it is Sharīʿah compliant, which is realised by
ensuring that the index component is made
up of Sharīʿah-compliant securities.
A careful examination of these resolutions reveals
that for hedging to be deemed Islamic hedging,
it must meet these four criteria: (1) the hedging
contract and its underlying assets are Sharīʿah
compliant; (2) the usage of the hedging mechanism
is not for speculation and gambling; (3) the hedging
transaction is entered based on real underlying risk
arising from real investment that adds value to the
real economy; and (4) the strategy or technique
involved in risk hedging does not sever the risk
from its underlying assets.
 Though several Islamic hedging instruments and
structures were approved by these institutions,
there are still ongoing Sharīʿah issues in the current
Islamic hedging practices. Though some were
mentioned in the Sharīʿah resolutions above, for
example, the issue of speculation and gambling,
the importance of these issues warrants that they
be thoroughly and critically analysed as to their
existence and permissibility. Most of the issues
raised in the ensuing section have yet to be broached
or adequately resolved by any of the Sharīʿah
resolutions above.

10
Research Paper No. 88/2016

SHARĪʿAH ANALYSIS ON ISLAMIC HEDGING PRACTICES
Based on observation of hedging practices in
Malaysia and discussions held with some Islamic
finance market players, this paper extracted four
issues that are critical to determination of the
Sharīʿah compliance of current practice. The issues
are as follows:
First Issue
What is the difference between hedging and
speculation? Can a hedger be allowed, instead of
profiting from the real exchange or transaction of
underlying business or commodities, to profit from
external factors that are uncertain at the time of
entering into the contract; for example, the future
interest rate, the future currency exchange rate, etc.?
Second Issue
The hedging structure uses a commodity murābaḥah/
tawarruq transaction to materialize the transfer of
the payment of the differential sum from one party
to the other. The price of the commodity could be
broken down into two: (1) the actual cost of the
commodity, quoted as notional; and (2) the profit,
which represents the difference between the two
market prices or interest rates. This differential sum
is what is transferred from one party to the other.
The questions are:
(1) Do hedging arrangements entered through
the execution of promises and commodity
murabahah/tawarruq represent a real
exchange in their use to facilitate mark-to-
market gain/loss?
(2) Can the resultant profit be considered
lawful like the gain derived from a valid and
independent sale contract?
(3) Does the Sharīʿah allow one party in particular
to gain based on mark-to-market instead
of depending on the cost of holding the
commodity? Would such a scenario trigger
the element of gambling in the hedging
structure?
Section 4
Third Issue
Waʿd is one of the Sharīʿah instruments used in
hedging arrangements. The structure of waʿd binds
a party to execute a defined obligation at an agreed
price and time in the future. According to the
Sharīʿah resolutions issued on waʿd by the IFA-OIC,
AAOIFI and the SAC-BNM, in case there is a breach
of waʿd, the party who suffered due to the breach
is entitled to claim for compensation/damages. The
criterion for the compensation/damages is that it
must be based on actual loss. These questions then
arise:
(1) Is the compensation/damage paid by the
party that breaches waʿd based on actual loss?
(2) The close-out amount that arises from mark-
to-market allows one of the contractual 11
parties to gain when the market rate moves
in its favour. Would the Sharīʿah allow a party
Issues in Islamic Hedging Practices: A Critical Analysis
who breached its waʿd to gain in case the
market moves in its favour?
Fourth Issue
In foreign currency trading practices, the Islamic
finance industry adopts the ruling of the Association
of Banks in Malaysia (ABIM) for cancellation,
termination, extension or rollover of FX forward
that results in mark-to-market gain/loss. The
mark-to-market gain/loss is imposed on one of the
parties at the time the waʿd is terminated or rolled
over. As mentioned above, the Sharīʿah resolutions
state that in case there is a breach of waʿd, the
party who suffered due to the breach is entitled
to claim for compensation/damages. However, the
compensation/damages must be based on actual
loss. The questions are:
(1) Is the mark-to-market gain/loss charge
imposed due to the rollover or cancellation of
waʿd based on the actual loss?
(2) As the charges are based on mark-to-market,
which allows one of the contractual parties
to gain when the currency rate moves in its
favour, would the Sharīʿah allow a party who
breached its waʿd to gain in case the currency
moves in its favour?
 Discussion on the First Issue: What is the
difference between hedging and speculation?
The Concept of Hedging
Hedging refers to a strategy to cover an open
position by mitigating risk. Accordingly, a hedger
is a person who typically engages in the production,
distribution, processing, storing or consumption
of actual commodities. Hedgers take an offsetting
position in a hedging instrument to balance any loss
to the underlying asset and eliminate the volatility
associated with its price (Al-Amine, 2008, p. 142).
The best way to understand hedging is to perceive it
as insurance. When people decide to hedge, they are
insuring their investment against a negative event.
The major goal of hedging is not to make profit but
to protect from loss. Like insurance, every hedge
has a cost; for example, the cost of an option or lost
profit from being on the wrong side of a hedging
instrument. This cannot be avoided as it is the price
that hedgers have to pay to avoid uncertainty.
The following are two examples of the use of
12
financial instruments for the purpose of hedging:
(1) Hedging through a Commodity Futures
Research Paper No. 88/2016
Contract: ABC Company is a crude palm
oil refiner and exporter. It has a sale contract
in which it has to deliver oil to BCX in six
months. With the knowledge that crude palm
oil prices may increase in the near future,
the company needs to protect itself from
the volatility of the crude palm oil market.
For the purpose of protection, the company
purchases a six-month crude palm oil futures
contract, thus enabling it to lock in a price that
will offset the possible loss, even if the crude
palm oil experiences a 15% price increase.
Although hedgers are protected from losses,
their possible gains are also restricted.
1) Hedging through an Option: Mr.
Z owns 20% of the shares of BJ Oil
Service Ltd (BJS). He is worried about
a short-term price fall of BJS shares due
to uncertainty in the oil industry. To
protect himself from a price fall in BJS
shares, he could purchase a put option
(a derivative) from the company that
gives him the right to sell BJS shares at a
specific price (strike price). This strategy
is known as a “married put.” If the stock
price in the market tumbles below the
strike price, he would have the option to
sell those shares at the strike price; thus,
the loss due to a fall in the market price
of shares of BJS would be offset by gains
in the put option.
In both instances, for the matter to be considered
Islamic hedging, the hedger must have an underlying
business or asset that requires protection from
market volatility.
The Concept of Speculation
The term “speculation” has connotations that
include hypothesis, theory, postulation, opinion,
contemplation and even gambling and taking risks
(Urdang, 1993).
In the financial market context, speculation can be
defined as buying or selling goods or securities in
the hope of making a profit on the price movement.
The application is not limited to shares or goods
but could also involve land, properties, weather, the
result of a sports match, or anything else that might
offer a chance to make a gain out of a risk taken
(Spencer, 1974; Simpson & Weiner, 1989).
In contrast to a hedger, who seeks to cover the
risk of his underlying business or commodities, a
speculator accepts and even seeks out such risks to
make a profit. If a speculator correctly anticipates a
future change in the market rate, he makes a profit.
Speculation takes place in the spot market as well
as all derivatives markets, namely forwards, futures,
and options markets.
The following are examples of how speculation is
used to obtain profit:
(1) If a speculator believes that the spot rate of a
foreign currency will rise, he could purchase
the currency now and hold it in a bank deposit
for resale later. If he is correct in his estimate,
he will earn a profit on each unit of foreign
currency equal to the spread between the
buying rate and selling rate. If his estimate is
wrong, he will incur a loss.
(2) If a speculator believes that the future price of
the foreign currency will fall, he could borrow
the foreign currency for three months,
immediately exchange it for domestic currency
at the prevailing rate, and then deposit it in a
bank to earn interest. After three months, if
the rate is lower as anticipated, he will earn
a profit by purchasing foreign currency to
repay his foreign exchange loan.
From the above examples, it can be deduced that a
speculator could be a hedger and vice versa. Hedging
instruments can also be regarded as two-edged “alsoHedging instruments can
be regarded as two-edged
instruments that can be used for both hedging and instruments that can be used
speculative purposes alike. In fact, there are more
speculators than hedgers in the hedging markets,
for both hedging and speculative
and these speculators use hedging instruments for
their speculative purposes.
purposes alike
”
Although there is no scientific formula to distinguish
speculation from hedging (Kreitner, 2000), below A hedger’s A speculator’s approach is
are some basic features of hedging and speculation involvement in to make use of everything,
which could facilitate an understanding of the hedging instruments even “untrue factors or
is usually based on rumours” in making a
distinctions between the two.
facts and proper judgment (Salamon, 1998).
research.
Table 1: The Distinction between a Hedger and
a Speculator A hedger is a person A speculator does not have
who typically engages any on-going commercial
in the production, interest in a physical
Hedger Speculator
distribution, commodity or business (al-
A hedger seeks to A speculator accepts and processing, storing or Amine, 2008).
mitigate a risk. even seeks out a risk (an consumption of actual
open position) to make a commodities.
profit.
Source: Authors’ own
A hedger is risk A speculator is a risk lover. 13
averse. Economist Fahim Khan divided speculation into two
kinds; the first is unrelated to any real economic
Hedging restricts A speculator seeks to

Issues in Islamic Hedging Practices: A Critical Analysis

the hedger’s possible maximise gain. activity and is meant to be merely a financial or
gain. monetary transaction. It is simply a way of making
good guesses with no intention of receiving or
A hedger normally A speculator prefers a delivering anything but money. According to him,
prefers a long-term short-term transaction to this kind of speculation is unacceptable. The second
transaction. gain profit with less risk. form of speculation occurs when it is a part of some
A hedger only A speculator frequently real activity, helping to shift risks from producers
involves in hedging involves in derivatives who are unable to bear all the risk to those who can
instruments for the with the intention of afford to bear it. For instance, getting liquidity for
present business, accumulating considerable farmers to increase their volume of production is a
which requires gain. There is a philosophy desirable and permissible activity despite the fact
protection from of speculators which is that it involves speculation (Khan, 1995).
market volatility of called “small profits and
the exchange rate, quick return,” meaning to Khan’s classification may need some clarification.
interest rate, etc. make continual profit and Modern hedging arrangements can be divided
as frequently as possible
into two types. In the first type, both parties
(Aubrey, 1896).
are speculators. Neither is seeking to protect an
A hedger depends A speculator is focused on underlying real asset or business activity; they
on fewer elements the element of luck as he are placing side bets on real economic activities
of luck and betting involves in betting where and trends without playing any role in actual
as he only covers his one party’s loss is the other value creation. In the second type, one party is a
position from possible party’s gain. speculator and the other is a hedger. The hedger
losses. is seeking to mitigate a risk associated with an
underlying real asset or business activity that he is
engaged in. Practically speaking, the hedger needs
a speculator to accomplish that goal. In theory,
there could be derivative exchanges which match
pairs of hedgers with exactly offsetting needs; for
 example, a buyer who wants to protect himself
against a rise in oil prices and a seller who wants
to protect himself against a fall in oil prices (Lynch,
2014). However, most derivatives are sold as over-
the-counter products in which a financial institution
is the ultimate acceptor of risk.
Al-Suwailem (2006) criticises the argument that
derivatives shift risk to those who can afford to bear
it. While the derivatives market allows risk to be
transferred to those who are more willing to take
it, they are not necessarily more able to manage it.
This is particularly the case for low net-worth, cash-
constrained agents who might be more willing to
take such risks if they are paid up front, even though
they are unable to bear such risk. Consequently, the
system might end up allocating risks to those who
are least able to bear them even if they are the most
willing to accept them. As a result, risks are likely to
develop rather than being controlled and reduced.
It may be noted that al-Suwailem made the argument
in this form at a time when neo-liberal economists
claimed to have solved the problem of market
14 cycles. A year later, the financial crisis of 2007-2008
laid bare the falsehood of such claims. It was not low
net-worth, cash-constrained agents who accepted
risks that they could not afford to bear; it was the
Research Paper No. 88/2016
largest financial institutions in the world. The most
conspicuous was AIG Insurance, which had sold
“insurance” in the form of derivatives for which it had
not set aside any reserves. It did not do so because
the mathematicians who developed the risk models
for those derivatives completely miscalculated
the nature and size of the risks involved. The US
government decided it had no choice but to cover
USD 180 billion of AIG’s positions because its
default would have triggered the bankruptcy of
the other major financial institutions that were its
counterparties. That would have brought about the
collapse of the world financial system.
Other commentators associate the increase in the
use of derivatives instruments with speculation
and gambling activities; this is because 99% of all
derivatives contracts are settled before maturity
(Pilbeam, 2005). Also, what aggravates the situation
is the fact that a limited level of speculation is not
only desirable but it is a necessity for the smooth
functioning of any exchange.
Opponents of derivatives endeavour to prove
that derivative are gambling instruments which
inherently lend themselves to excessive speculation
and have contributed to a long list of destructive
impacts on the economy at large. On the other hand,
proponents of derivatives typically suggest that the
exploitative use of financial derivatives in recent
years has not been because of the inherent gambling
factor but because of three primary external forces:
y Volatile markets;
y Deregulation of interest rates;
y New technologies (Siems, 1997).
This is a rather strange argument because derivative
use became widespread in order to deal with the
risks arising from volatile markets and interest rates,
which resulted from the collapse of the Bretton
Woods monetary system in the 1970s. Also, to blame
new technologies is irrelevant because once new
technologies are adopted they are not renounced
unless new technologies supersede them. Thus, it
is impossible to separate the practice of derivatives
from the technological system that facilitates their
transactions.
Many agree that derivatives serve a useful function
in the area of hedging and risk management. Indeed,
they have become a prominent feature of modern
risk management. Without hedging, financial
institutions and corporations could be exposed
to substantial losses with knock-on effects on the
whole economy. However, derivatives users are also
exploiting these instruments to gain huge profits by
gambling on other parties’ risks, which may result
in a lot of negative consequences and impacts on the
whole economy and people at large.
Though the above discussion clarifies the distinction
between hedging and speculative practices, there is
still a need for further research into this issue, which
will be proposed in the Recommendation part of this
paper.
Discussion on the First Issue: Can a hedger,
instead of profiting from an actual exchange of
commodities or transaction of underlying business,
be allowed to profit from external factors that are
uncertain at the time of entering into the contract;
for example, a future interest rate, future currency
exchange rate, and so on?
This question will be addressed in the ensuing
discussion on the Second Issue as they are
interconnected.
Discussion on the Second Issue: The hedging
structure uses the commodity murābaḥah/tawarruq
transaction to materialize the transfer of payment
of the differential sum from one party to the other.
The price of the commodity could be broken down
into two: (1) the actual cost of the commodity, which
is quoted as notional; and (2) the profit, which
represents the difference between the two market
rates or interest rates. This differential sum is what
is transferred from one party to the other. The
questions are:
(1) Do hedging arrangements entered through
the execution of promises and commodity
murābahah/tawarruq represent a real
exchange in their use to facilitate mark-to-
market gain/loss?
(2) Can the resultant profit be considered
lawful like the gain derived from a valid and
independent sale contract?
(3) Does the Sharīʿah allow a party to gain when
the gain is realised based on mark-to-market
instead of depending on the cost of holding
a commodity? Would such a scenario trigger
the element of gambling in the hedging
structure?
“which
The tawarruq transaction,
is also known in Islamic
finance as “parallel commodity
murābaḥah” or “reverse
murābaḥah”, is claimed to be
the Achilles heel of Sharīʿah-
compliant hedging products
” Sharīʿah scholars have affirmed this concept. The
The tawarruq transaction, which is also known in
Islamic finance as “parallel commodity murābaḥah”
or “reverse murābaḥah”, is claimed to be the Achilles
heel of Sharīʿah-compliant hedging products. Most
of the current Islamic hedging products applied
by the Islamic financial institutions are based on
commodity murābahah (also known as tawarruq
maṣrafī).
Tawarruq-based hedging products, such as options,
swaps, futures, and forwards, regardless of variation
in the details of the products, have at least one
common issue: when one party realizes that it
will be in a losing position, it will not exercise the
commodity trade transaction; the other party, which
is in the money, will certainly exercise the promise
(waʿd) and receive the margin difference as “profit”.
Every person who engages in business is unavoidably
exposed to a certain level of risk. The following are
some of the major risks that Islam recognizes in
transactions:
(1) A seller is required to bear specific
responsibilities (which could be deemed as
risks) while selling his goods, namely by
ensuring that the goods are functioning and
free from defects and that they match the
agreed descriptions.
(2) Both the seller and buyer may be exposed to
certain risks, such as the inability to make the
instalment payment or delivery on time.
(3) The buyer is responsible for ensuring that
goods which need to be returned are in their
original condition.
(4) A seller has to face market risk such as a
decline in demand which renders him unable
to sell the goods in stock and which reduces
the value of the inventory.
(5) The movement of the currency exchange rate
poses a risk to both the seller and the buyer.
15
Whenever a party tries to transfer inherent and
inevitable risk to other parties, it will infringe
principles of the Sharīʿah by violating the
Issues in Islamic Hedging Practices: A Critical Analysis
requirements of justice and undermining the win-
win result that a transaction is supposed to realise
for the transacting parties. This rule applies to
buyers, sellers, capital providers, entrepreneurs,
partners and so on. Both traditional and modern
great Ḥanbalī scholar Ibn Taymiyyah (1410H) stated:
Risk falls into two categories. [The first
is] commercial risk when one buys a
commodity to sell it for profit and relies on
Allah ( ) for that. This risk is necessary
for merchants, and one might occasionally
lose as this is the nature of commerce.
The other type of risk is that of gambling,
which implies consuming the wealth [of
others] without justification, which is
what Allah ( ) and His Messenger ( )
have prohibited.
There are several legal proofs which dictate the
necessity of a merchant bearing risk, such as the
statements of the Prophet ( ):
ِ ‫« اَ ْلَراج بِالضَّم‬
» ‫ان‬
َ َُ
 “Benefit goes with liability” (Ibn Mājah,
n.d.) 2
and:
ْ ُ‫ ِربْ ُح َما َلْ ي‬...‫« ال َِي ُّل‬
» ‫ض َم ْن‬
“It is not lawful to profit from something
for which no liability is taken” (Abū
Dāwūd, n.d.).3
The other basic evidence is the prominent legal
maxim:
» ‫« اَلْغُْرُم بِالْغُْن ِم‬
“Liability accompanies gain” (al-Nadwī,
2000).
The statements above can be summarised to mean
that the entitlement to returns from an asset is
intrinsically related to the responsibility for the loss
of that asset. Al-Zuḥaylī (2006) clarified that “the
person who bears the cost and the risk of loss is the
16
one deserving the benefit or profit whenever it is
available” (p. 543).
Research Paper No. 88/2016
“ Al-Zuḥaylī (2006) clarified that
“the person who bears the cost
and the risk of loss is the one
deserving the benefit or profit
whenever it is available” (p. 543)
” time make a profit.
Several contemporary Sharīʿah scholars, such
as Ṣiḍḍīq al-Ḍarīr and Hussain Hamid Hassan,
draw a line between tolerable and intolerable risk.
They suggest that risk is tolerable if it satisfies the
following conditions (al-Ḍarīr, 1990; Ḥassān, 1980):
(1) It is inevitable: This implies that to uphold
justice in business transactions one has to
be exposed to the risk of loss or failure. This
type of risk is inseparable from real and
value-adding transactions. Exchange of pure
liability for a given price is prohibited by the
majority of Sharīʿah scholars.
(2) It is insignificant: This emphasises that the
possibility of failure should be smaller than
the prospects of success. If the opposite is the
case, it would mean that the person is putting
himself into a detrimental situation, which is
not appreciated in the Sharīʿah. This aspect
is vital to draw a distinctive line between a
legitimate business or investment and a pure
speculative activity like gambling. In a lottery,
the probability of losing a ticket’s price is
substantially large; it could exceed 99%, which
is clearly unacceptable in the Sharīʿah since
it is almost certain that loss will occur. It is
the size of the prize that deceives people into
making such a losing decision.
(3) It is unintentional: Risk cannot be the intended
part of a transaction; the objective must be
value creation and not risk exploration.
Based on the explanation above, the question arises
as to whether the gain derived from a hedging
arrangement is acceptable in the Sharīʿah. The
example of tawarruq-based hedging products will
be looked at to address this question.
(1) (A promise to conclude the purchase or sale
of a commodity involves risk when it is
dependent on an uncertain factor such as the
future movement of a market price or rate.
This sort of risk should be avoided and cannot
be a means of obtaining excess income at the
expense of the other party. In tawarruq-based
hedging products such as IPRS, the risk which
is the volatile market price is being taken as
a core determinant of gain or loss for the
participants; one party ends up as the gainer
and the other the loser. As a result, the winner
will succeed in avoiding loss and at the same
Some have contended that the key fiqh issue
in the use of parallel tawarruq contracts for
hedging purposes is the attachment of each
contract to a future event. There are actually
two ways that a contract could be appended
to the future. The first is simply to append it
to a future date while the second is to append
it to a future event. Obviously, the uncertainty
of attaching it to a future event is greater than
the uncertainty of attaching it to a future
date. That is because the date will surely come
unless the Day of Judgment comes first or, for
the contracting parties, if one of them dies
before the date. A future event, on the other
hand, such as the arrival of a certain person
from a journey, may not occur at all. Al-
Zaylaʿī, as quoted by Ibn ʿĀbidin (1992, 7:519),
had this to say about appending contracts to
a future date:
 ٌ‫(إل الْ ُم ْستـَْقبَ ِل) َع َشَرة‬ َ ُ‫إضافـَتُه‬ ِ َ‫(وما َال ت‬
َ )‫ص ُّح‬
While the madhhabs and the majority of
ََ scholars considered a sale made conditional
َّ ‫ َو‬،ُ‫ َوالْ ِق ْس َمة‬،ُ‫ َوفَ ْس ُخه‬،ُ‫ َوإِ َج َازتُه‬،‫(الْبـَْي ُع‬
،ُ‫الش ِرَكة‬ upon occurrence of a future event to involve

،‫الص ْل ُح َع ْن َم ٍال‬ُّ ‫ َو‬،ُ‫الر ْج َعة‬ َّ ‫ َو‬،‫اح‬ ِ gharar (uncertainty) and qimār (gambling),
ُ ‫ َوالنِّ َك‬،ُ‫َوا ْلبَة‬ Ibn Taymiyyah and Ibn al-Qayyim disagreed
‫ات لِْل َح ِال فَ َل‬ ِ ِ
ٌ ‫البـَْراءُ َع ْن الدَّيْ ِن) لَنـََّها تَْلي َك‬ ِْ ‫َو‬ with them and opined that a conditional sale

‫اف لِِل ْستِ ْقبَ ِال َك َما َال تـَُعلَّ ُق بِالش َّْر ِط لِ َما‬
is permissible (al-Ḍarīr, 1990). Al-Ḍarīr argues
ُ ‫ض‬ َ ُ‫ت‬ in favour of the majority in his analysis of the
.‫فِ ِيه ِم ْن الْ ِق َما ِر‬ dissenting opinion, saying:

[Contracts] that cannot be validly attached
(to a future date) are ten (sale and purchase;
ratification or cancellation of a sale; division
of jointly owned property; partnership;
giving a gift; marriage; retraction of a
revocable divorce; settlement of a dispute
by a transfer of property; and total or partial
debt forgiveness). That is because these are
contracts that transfer ownership and as such
have immediate effect and cannot be attached
to a future date or be made conditional
upon a future event. [Both] would entail
gambling.
Ibn ʿĀbidīn (1992, 7:519), in his explanation of
the above text, says:
.‫يك َعلَى َسبِ ِيل الْ ُم َخاطََرِة‬
‫« لن العقد املعلق يف أكثر صوره ال يدري ل‬
‫ وإذا حصل ال يدري وقت‬،‫يصل أم ال يصل‬
.» ‫حصوله فهو عقد مستور العاقبة‬
“That is because the sale which is made
conditional upon a future event, it is not
known in most of its forms whether or not it
will be transacted; and if transacted, it cannot
possibly be known when it will take place;
hence it is a contract of unknown result” (p.
168).
He also said:
‫« وإح ــدى الـعـلــل يف فـســاد الـبـيــع املـعـلــق ي‬ 17
‫الغرر فإن كل من املتبايعني ال يدري ل يصل‬
‫المــر املعلق عليه فيتم البيع أم ال يصل فل‬
ِ‫اصلُه أَنـَّـه تَْل‬
ِ ‫« وح‬ .» ‫يتم‬

Issues in Islamic Hedging Practices: A Critical Analysis

ٌ ُ ُ
ِ‫ولَـ َّـمـَـاَ َكــانـَـت ـ ِـذ ِه َتـْـل‬
ِ ‫ـال َل ي‬
‫ص َّح‬ ِ ‫ـات لِـ ْلــحـ‬
ٌ ‫ـ‬ ‫ك‬
َ ‫ـ‬ ‫ي‬ ‫ـ‬
َْ َ ِ َ ْ َ
ِ ِ
.» ‫الَطَ ِر ل ُو ُجود َم ْع َن الْق َمار‬ ِ ْ ِ‫تـَْعلِي ُق َها ب‬
“One ʿillah (effective cause) that makes
a conditional sale void is the presence of
gharar, as neither transacting party knows
“In conclusion, such an arrangement is a whether the conditional event will occur so
transfer of ownership on the basis of risk. that the contract is completed, or will not
Since all contracts that transfer ownership occur and hence the contract will not be
must be made at once, it is invalid to make completed.”
the contract dependent upon a risk because
that is the substance of gambling.” This issue will be discussed further to answer
the next question.
(2) When the agreed time arrives, whichever

“majority
While the madhhabs and the
of scholars considered
party realizes that it will gain enters into the
transaction and gains the net difference from
the other. Do these arrangements resemble
a sale made conditional upon the substance of a zero-sum game or game of
occurrence of a future event to chance?
involve gharar (uncertainty)
This is the scenario in several tawarruq-based
and qimār (gambling), Ibn hedging products like swaps and options
Taymiyyah and Ibn al-Qayyim in the practice of several Islamic financial
disagreed with them and opined institutions.4 When a party hedges its risk
that a conditional sale is exposure to a currency exchange rate or any
permissible (al-Ḍarīr, 1990)
” movement of profit or interest rate, the party
who gains (i.e., is in the money) will sell the
commodity to the other party (who is out of the
money) at the price that is above the market
 price. Such trading means that one of the two
parties will enjoy the difference payment. It is
argued that such enjoyment of profit triggers
the issue of gambling as the substance of a
zero-sum game is evident in the arrangement.
This is despite the fact that such “gain” is rarely
realised as income in practice because Islamic
financial institutions normally square off the
risk exposure with another party. The issue
which remains as the focal point of discussion
is the first contractual relationship between
the two parties, their arrangements and the
effects of their arrangements. The subsequent
arrangement of another transaction and its
effect may not be a valid reason to neutralize
the existence of the forbidden element in
the former transaction. For example, if two
persons enter into a wager, whatever happens
to the money of the winner after winning
the bet will not defuse the prohibition in
the bet, even if he uses it for a valid cause
such as squaring off his obligation to a third
party.
The difference of opinion among scholars
18 regarding a sale contract that is made
conditional upon a future event is not
ultimately very relevant to this issue.
Research Paper No. 88/2016
The reason is that the future commodity
murābaḥah sale in the hedging product is
not a standalone conditional sale but, rather,
two parallel conditional sales. Each contract
is made conditional upon a specific future
event whose occurrence is a matter of chance;
for example, movement of an interest rate
or currency exchange rate. Classical jurists
discussed the conditional sale (bayʿ muʿallaq)
and the unilateral promise of a future
transaction that are not based on pure chance,
whereas chance is central to the sales in the
contemporary hedging arrangement.
This concern is more obvious in a Sharīʿah-
compliant option. The client pays a fee to the
Islamic bank for a put option, for example. If
the market price moves in the client’s favour,
the client will exercise the transaction by
purchasing the commodity from the market
and selling it to the bank at a price higher
than the market price to realise a gain. On
the other hand, if the currency rate or interest
rate moves against the client, the client will
do a calculation to ensure that the loss of the
“premium fee” is less than the loss that is
derived from the transaction. The element of
qimār is evident in this scenario.
Gambling (qimār) is defined by jurists
as:
"‫"كل لعب تردد بني غرم وغنم‬
“every game having the possibility of either
gain or loss” (al-Bujayrimī, 1995, 4: 186).
Ibn Qudāmah (1968, 9: 468) clarified further
by saying:
‫لن القمار أن ال خيلو كل واحــد منهما‬..."
."‫من أن يغنم أو يغرم‬
“…because in gambling it is inevitable that
one of the two bettors will gain and the other
lose.”
Sulaymān Milḥam (2008, p. 568) in his
Ph.D. thesis titled “Al-Qimār, Aḥkāmuh wa
Ḥaqīqatuh” explains the effective cause of
qimār:
‫« مناط احلكم يف القمار ومتعلق التحرمي فيه‬
ً‫املخاطرة اليت يعلق خروج كل داخل فيها غامنا‬
.» ‫أو غارماً على أمر ختفى عاقبته‬
“The focus of the Sharīʿah ruling prohibiting
gambling is the risk which links each
participant’s gain or loss to the uncertain
outcome of some affair.”
“ prohibiting
The focus of the Sharīʿah ruling
gambling is the risk
which links each participant’s
gain or loss to the uncertain
outcome of some affair
”
To clarify the context of the current hedging
product scenario, namely profit rate swap with
an embedded option element, an illustration
is given below:
M Bank wishes to issue a sukuk totaling USD
400 million which bears x% fixed profit per
annum.
(1) M Bank’s clients are charged at floating rates
while M Bank’s obligation to the sukukholders
is at a fixed rate. M Bank is exposed to the
risk of adverse movements in the floating rate
index (LIBOR) on the asset side against the
fixed rate liabilities.
 (2) To address this concern, M Bank can hedge T1
Commodity
its floating rate exposure with X Bank via Murabahah
a Sharīʿah-compliant hedging transaction 2
known as profit rate swap.
M X
(3) In such arrangement, M Bank pays to X Bank
Libor + 1.46% (on a quarterly basis) and X Counterparty
Bank pays 3% to M Bank (on a semiannual pays Bank
$100m +$600k
basis). 3
1
Based on the arrangement, there will be two
M as Agent
undertakings as described below: $100m $100m

Bank Undertaking and Customer Undertaking.

y Two unilateral promises (waʿdān) to enter A
A B
into a murābaḥah transaction.
y The bank undertakes to enter into murābaḥah T2
Commodity
Murabahah
with the customer if certain conditions are
2
met.
M X
y The customer undertakes to enter into
murābaḥah with the bank if certain Bank pays
conditions are met. Counterparty
$100m +$400k
1
19
Only one undertaking is exercised on any settlement
3 M
date where the “in the money” party will send an $100m $100m as Agent

Exercise Notice to the “out of the money” party. The

Issues in Islamic Hedging Practices: A Critical Analysis

“out of the money” party will have to send a signed
Acceptance Notice. Only upon acceptance of the
Acceptance Notice will murābaḥah be concluded on B A

any Settlement Date.

Further clarification of the structure is shown in T1

Diagram 1:
Step Description
Diagram 1: IPRS structure
1 M Bank buys the commodity from Broker A.

2 M Bank sells the commodity to X Bank.

T0 Waʿd 1 - Bank undertakes to pay if First 3 X Bank (through M Bank as an Agent) sells
Rate > Second Rate the commodity to Broker B.

M X

T2

Waʿd 2 - Counterparty undertakes to pay Step Description

if Second Rate > First Rate
1 X Bank (through M Bank as an Agent) buys
the commodity from Broker A.

2 X Bank sells the commodity to M Bank.

3 M Bank sells the commodity to Broker B.

 Features:
y Hedging product via exchange of cash flows;
y M Bank undertakes to pay X Bank if First
Rate > Second Rate.
y X Bank undertakes to pay M Bank if Second
Rate > First Rate.
y Payments realized via commodity murābaḥah
transactions.
Assumptions:
y Two-year swap with annual reset/settlement
frequency;
y Notional $100m;
y M Bank pays Floating Rate of 6-month Libor
(First Rate).
y Counterparty (X Bank) pays Fixed Rate of
3.00% (Second Rate).
y 6-month LIBOR amounts are 1.0% (T1) and
20 1.5% (T2).
Outcomes:
y T1 – Second Rate > First Rate →
Research Paper No. 88/2016
Counterparty (X Bank) pays M Bank $600k.
y T2 – First Rate > Second Rate → M Bank
pays Counterparty (X Bank) $400k.
In the above example of the Islamic profit rate
swap, at the agreed date, the outcome of the price
will be either T1 or T2. In both scenarios, one
party will have to pay the excess money from the
commodity trading to the other by way of setting
off and entering into the commodity murābaḥah
transaction in which the objective is to create the
payment of the difference between the agreed rate
and actual market rate on the payment date. In the
above structure, X Bank undertakes to pay M Bank
by exercising the commodity trade, that is if the
First Rate is more than the Second Rate, while M
Bank undertakes to pay X Bank if the Second Rate is
higher than the First Rate.
“ Bytawarruq-based
examining the application of
hedging, there
are two pertinent characteristics
of gambling which must be
carefully scrutinized to ensure
whether or not the profit
gained by one party resembles a
gambling transaction
”
By examining the application of tawarruq-based
hedging, there are two pertinent characteristics
of gambling which must be carefully scrutinized
to ensure whether or not the profit gained by one
party resembles a gambling transaction:
(1) Two persons enter into a competition
where both parties contribute a fund as a
prize for the winner.
For example, two players place USD 1000
each; the one who wins will take all of the
USD 2000, while the other will get nothing.
There is no possibility that both could win;
thus, it is clear in this scenario that one player
gains at the expense of the loser (al-Suwailem,
2006).
With regard to the above arrangement,
the majority of the scholars including the
Ḥanafīs (Al-Kāsānī, 1986), Mālikīs (Ibn ʿAbd
al-Barr, 1398 H), Shāfiʿīs (al-Ramlī, 1984) and
Ḥanbalīs (al-Mardāwī, n.d) and the Islamic
Fiqh Academy of the OIC pronounced it to be
ḥarām.
Al-Mawsūʿah al-Fiqhiyyah al-Kuwaytiyyah
(1992) summarized the meaning of gambling
from the words of past jurists:
‫ إن ل تطر السماء غدا فلك‬:‫كأن يقوال مثل‬
‫ وإال فلي عليك مثله من‬،‫علي كذا من املــال‬
‫ والر ان هبذا املعن حرام باتفاق الفقهاء‬،‫املال‬
‫بــني امللتزمني بــأحـكــام الس ــلم مــن املسلمني‬
‫ لن كل منهم مرتدد بني أن يغنم أو‬،‫والذميني‬
.‫ و و صورة القمار احملرم‬،‫يغرم‬
[An example of betting] is when two persons
agree, “If there is no rain tomorrow, I am
obliged to pay you this amount of money;
otherwise, the obligation is on you.” Betting
in this way has been unanimously declared
ḥarām by Muslim jurists, as well as Jewish
 and Christian scholars, because each of the
parties is exposed to either gain or loss, which
is exactly a form of prohibited gambling.
(23:171)
A similar scenario is noticed to occur in a tawarruq-
based option in which the fee, which is sometimes
called ʿurbūn, is paid upfront by one party (the
client). When this happens, both parties will have to
observe both the strike price and the market price
(of the external item and not the commodity sold
in tawarruq). At the agreed date, if the strike price
is in favour of the client (i.e., lower than the market
price), he will exercise the commodity purchase via
tawarruq and gain through the money received from
the tawarruq transaction. However, if the strike
price moves against him, the client may withdraw
and lose the upfront fees. This element of the zero-
sum game also appears in the tawarruq-based swap
and forward. However, when compared to the
gambling example given above, in this transaction
the placement of money is yet to materialize at
the time of the transaction as it takes the form of
a binding promise to purchase or sell from either
party. The gain only materializes after the promise is
exercised by the party who is in the money.
(2) Two persons enter into a competition
where both parties give a promise that
the loser will pay for any expenses of the
game and/or other expenses.
Such game has been in existence for hundreds
of years. The scholars such as Al-Kāsānī (1986,
6:206) explained:
‫« ال جيــوز لنــه يف معن القمار حنو أن يقول‬
،‫علي كذا‬
ّ ‫ إن سبقتين فلك‬:‫أحدمها لصاحبه‬
.» ‫وإن سبقتك فلي عليك كذا فقبل اآلخر‬
“It is impermissible for it has the meaning of
gambling; e.g., one person says to another, ‘If
you outrace me, I will owe you such-and-such
amount, but if I beat you, you will have to pay
me,’ and the other party accepts.”
The term “zero-sum” indicates that the interest of
players are directly opposed since each party is
seeking to profit from the other’s loss; it becomes,
therefore, a sort of “consuming others’ wealth
wrongfully,” which is strictly condemned in the
Qur’ān (al-Suwailem, 2006). Zero-sum games are
also called “strictly competitive games”. This kind
of transaction is a pure transfer of wealth for no
counter-value as each party is seeking profits rather
than donations.
Hence, zero-sum games represent the highest level
of gharar that seeks for the undesired level of risk
(al-Suwailem, 2006). However, Ḥanafīs (al-Zaylaʿī,
1313 H), Shāfiʿīs (al-Qalyūbī, 1995) and Ḥanbalīs
(al-Mardāwī, n.d.) said that if only one competitor
promised to pay to those who win, such a game will
no longer be considered gambling.
The Islamic Fiqh Academy of the OIC (IFA-OIC,
2003) during their Sixteenth Conference, on 16
January 2003, defined the substance of gambling in
contests and games, as follows:
y Each and every type of game in which the
loser is required to pay the winner;
y Another person’s property is acquired by
entering into a risk (mukhāṭarah) with the
intention of winning at the expense of the
other.
The only difference between the example given
above by al-Kāsānī and tawarruq-based hedging is
that the loser in traditional gambling pays the prize
money via a direct payment, whereas in tawarruq-
based hedging such as profit rate swap, the party 21
that is out of the money is obliged to purchase
the commodity in order to pay the gainer a price
margin between the strike price and the market
Issues in Islamic Hedging Practices: A Critical Analysis
price. Neither party will transfer the cash payment
to the other at each sale and purchase transaction;
they will only pay the difference amount to each
other by netting off (muqāṣṣah). By comparing the
agreed exchange rate with the current rate, both
parties will know which party is obliged to pay the
difference. It resembles the case of the winner and
loser in a zero-sum game.
Similarly, in conventional options, futures, and
forwards, if a trader has bought a contract and then
the price falls, the trader will only be required to pay
additional funds to cover the current unrealized loss.
The trader will be in a similar position if a contract
has been sold on the futures and options market and
the price rises. For instance, say a call writer (who
is in the money) is to exercise its options to buy the
asset; the put writer is obliged to sell and deliver
the asset to the buyer (Securities Commission, 1999).
Such conventional option contracts have been
viewed by the majority of scholars as gambling or a
zero-sum game in nature. Obaidullah (1999) suggests
that excessive uncertainty or gharar in conventional
options leads to the possibility of speculation, which
is forbidden, the worst form of speculation being
gambling. According to DeLorenzo (2002), this
sort of economic activity is clearly forbidden in the
 Sharīʿah. Al-Salāmī (1992, 7:1/223-247) classifies the Table 2: The Distinction between
conventional option contract as the sale of a right a Sale Transaction and Tawarruq or
created by the seller. He concludes that options Commodity Murābaḥah
are unlike any nominate fiqh contract but that the
contract they resemble most closely is gambling. This
Sale Transaction Tawarruq or Commodity
is because of the zero-sum nature of the transaction: Murābaḥah Trading
any gain by one party comes from the corresponding Arrangement
loss by the counterparty. However, in the discussion
of his paper at the IFA-OIC Conference where he The risk is directly The risk is not associated
presented it, he did acknowledge that, while the associated with the with the subject matter of
instruments can be used for gambling, they can also subject matter of the the commodity but linked to
transaction. external factors such as the
be used for buying and selling with the intention
future currency rate, interest
of hedging against the risk of price fluctuation (al- rate, and other benchmarks.
Salāmī, 1992, 7:1/584-5).
The element of profit The element of profit
It is understood that a certain type of risk in trading and loss is embedded and loss in commodity
and gain from a price increase are allowable in in the transaction murābaḥah depends on
Islam, as Ibn Taymiyyah (1406H) explains: itself; for example, external factors. The waʿd
in a salam sale the to enter into the purchase
As for risk (mukhāṭarah), there is no seller’s profit (if any) or sale of the commodity
Sharīʿah evidence which would denote originates directly will only be exercised in
from the subject the future (triggered by
total prohibition. In fact, it is known that
matter and the sale the external factor) by the
Allah ( ) and His Messenger ( ) did not transaction. party which is in the money,
forbid all kind of risks nor all transactions while the other party will
22 which are exposed to loss and profit…. have to buy and pay the net
[The trader] anticipates profits from price after deduction of the
his business and fears loss. This type of notional amount.
risk is permissible based on the Quranic
Research Paper No. 88/2016

evidence, ḥadīth, and ijmāʿ (consensus), There is clear value No clear value is added
and every trader takes such type of risk. creation in the as the sale transaction
(p. 535) transaction where is correlated to an
the subject matter is external factor which
However, there are crucial differences between the the core determinant is the core determinant
real trading transaction as cited by Ibn Taymiyyah for concluding the for concluding the sale.
and the tawarruq or commodity murābaḥah trading sale. The parties do not intend
arrangements for Islamic derivatives. The differences to receive and use the
are listed in Table 2 below: commodity; the motive is
only to benefit from the
transfer of money from
one party to the other.

Win-win situation One party gains at the

expense of the other.

Source: Authors’ own

Discussion on the Third Issue: Waʿd is one of the

Sharīʿah-compliant instruments used in hedging
arrangements. The structure of waʿd allows a party
to be bound by its promise to execute a defined
obligation at an agreed price and time in the future.
According to Sharīʿah resolutions issued on waʿd—
in particular those of the IFA-OIC, AAOIFI and the
SAC-BNM—in case of a breach of waʿd, the party
who suffered due to the breach is entitled to claim
for compensation/damages. The criterion for the
compensation/damages is that it must be based on
actual loss. The question then arises:
(1) Whether the compensation/damages in the
form of the close-out amount paid by the
party that breached the waʿd is based on the
actual loss?
(2) As the close-out amount that is mark-to-
market allows one of the contractual parties
to gain when the market rate moves in its
favour, would the Sharīʿah allow the party
who breached the waʿd to gain on the basis
that the market has moved in its favour?
“theIt iscaseunanimously agreed in
of breach of waʿd that
the party who incurred loss or
damages because of such breach
is entitled to compensation
” that in the event of a breach of promise regarding
It is unanimously agreed in the case of breach of
waʿd that the party who incurred loss or damages
because of such breach is entitled to compensation.
The Islamic Fiqh Academy of the OIC (2000), for
example, resolved that if the promisor breaches his
promise, the promisee can seek legal remedy in a
court of law for specific performance or damages.
AAOIFI (2015) in Standard No. 8, article 2/5/4 states:
In the case of the customer's breach of
his binding promise, the Institution is not
permitted to retain Hamish Jiddiyyah as
such. Instead, the Institution’s rights are
limited to deducting the amount of the
actual damage incurred as a result of the
breach, namely the difference between the
cost of the item borne by the Institution
and the price at which the item is sold to
a third party. The actual damage to the
Institution may not include the loss of its
mark-up in the Murabahah transaction,
that is, its opportunity loss.
The same ruling was issued by Dallah al-Baraka,
as stated in article no. 6/18: “In the event of failure
of the promisor [to fulfil his promise] to purchase,
[the promisee] may not be compensated except the
amount of actual damage, which is the difference
between the cost of buying and selling currency
to [a party] other than the promisor” (Dallah al-
Baraka, 2002, p. 340).
In another jurisdiction, the Shari’a Supervisory
Board of Qatar Islamic Bank (Fatwa No. 53) declared
that if the execution of the purchase promise failed
due to reasons related to the promisor, then he has
to bear the expenses and the costs of the actual
damages incurred thereof.
Bank Negara Malaysia (2016) issued a Concept
Paper on waʿd on 11 April 2016. It stipulates that the
promisor is deemed to breach the waʿd if he does not
fulfill the conditions specified therein. As a result,
the promisee is entitled to claim for compensation
for any actual loss suffered, and the promisor shall
fulfill the claim by the promisee. This position echoes
the Sharīʿah resolution issued by the SAC-BNM in
its 49th meeting, held on 28 April 2005/19th Rabiʿul
Awal 1426, which resolved that in case the promise is
breached, the promisee will be compensated (BNM,
2007). In addition, the SAC-BNM (BNM, 2010) in
its 73rd meeting, dated 20 February 2008, resolved
a currency option, the innocent party who suffers
loss may recover the actual amount of loss from the
value of the hāmish jiddiyah.
23
The question then is how to measure the actual
loss from the breach of waʿd. Para 16.9 of the 2016
Concept Paper on waʿd stipulates that the Islamic
Issues in Islamic Hedging Practices: A Critical Analysis
financial institution shall determine the actual loss
in accordance with the prescribed mechanism or
methodology or customary market practices (ʿurf
tijārī). It further states that, with regards to the
prescribed mechanism or methodology, the Islamic
financial institution shall ensure that the actual loss
consists of
(1) at a minimum: (a) the outstanding principal
amount, which includes the amount of
shortfall between the cost of asset acquisition
and the disposal value of the asset; and (b)
actual direct cost incurred; and
(2) any additional components as specified in the
policy papers issued by the BNM.
This position on measurement of actual loss runs
in tandem with other SAC-BNM resolutions; for
example, the SAC-BNM (BNM, 2010) in its 73rd
meeting, dated 20 February 2008, resolved that:
(1) The actual loss shall be measured based on
the difference between the sale price of the
commodity and the promised purchase price
of the commodity; or
 (2) The Islamic financial institution may acquire
the whole amount of the hāmish jiddiyah
to recover the actual losses if the calculated
amount based on the above methodology is
equal to or more than the value of the hāmish
jiddiyah. If the actual loss is lower than the
value of the hāmish jiddiyah, the customer
may agree to channel the residual amount to a
charitable organisation under the supervision
of the Sharīʿah committee of the said Islamic
financial institution.
Similarly, with regards to the prescribed mechanism
or methodology, the SAC-BNM (BNM, 2010) in its
54th meeting, dated 27 October 2005, resolved that the
use of conventional interest rate swap methodology
in determining the close-out amount is applicable
in the case of IPRS. This position is important as
the close-out amount reflects the amount that one
party has to pay in the event of a breach of waʿd in
the IPRS. This close-out amount as described by the
SAC-BNM is determined based on the market quote
methodology. This is the standard formula adopted
by market participants in determining the payable
24
compensation amount. However, the permissibility
of referring to the conventional method of calculating
the close-out amount is subject to the satisfaction
Research Paper No. 88/2016
of the contracting parties that the outcome of such
application represents actual loss suffered by a party
as a result of a default by the other party.
Notwithstanding the Concept Paper and the Sharīʿah
resolutions above on the permissibility of claiming
compensation in case of breach of waʿd, the criteria
to determine actual loss are not really clear. What
has been repeatedly mentioned is that the person
who suffered from the breach could claim for the
shortfall between the cost of asset acquisition and
the disposal value, and that the actual loss can be
determined in accordance with the prescribed
mechanism or methodology or customary market
practice (ʿurf tijārī).
In determining the criteria of actual loss, this paper
also refers to the Tahawwut Master Agreement
(TMA). TMA is a standard master agreement issued
by the IIFM and International Swaps and Derivatives
Association, Inc. (ISDA) to govern the IPRS
operations. According to the TMA, in determining
the close-out amount, the contractual parties have
the option to either use the Market Quotation
method or their own calculation of their loss. The
amount determined under the Market Quotation
method is based on quotations from institutions
called “Reference Market-makers”. In section 14 of
the TMA, Reference Market-makers refers to:
Four leading dealers in the relevant
market selected by the party determining
a market quotation in good faith: (1)
from among dealers of the highest credit
standing which satisfy all the criteria that
such party generally applies at the time in
deciding whether to offer or to make an
extension of credit or financing; and (2) to
the extent practicable, from among such
dealers having an office in the same city.
However, if a Market Quotation cannot be
determined or would not, in the reasonable belief
of the party making the determination, provide a
commercially reasonable result, the party would be
required to calculate its “Loss”.
Loss is defined in section 14 of TMA.
“Loss” means, with respect to one or
more Non-Fully Delivered Terminated
Transactions or, as the case may be, one or
more Terminated DFT Terms Agreements
and a party, the Termination Currency
Equivalent of an amount that party
reasonably determines in good faith to be
its total losses and costs (or gain, in which
case expressed as a negative number)
in connection with that Non-Fully
Delivered Terminated Transaction or
group of Non-Fully Delivered Terminated
Transactions or Terminated DFT Terms
Agreement or group of Terminated DFT
Terms Agreements, as the case may be.
Loss includes losses and costs (or gains)
in respect of any payment or delivery
required to have been made (assuming
satisfaction of each applicable condition
precedent) on or before the relevant Early
Termination Date and not made, except,
so as to avoid duplication, if a Market
Quotation has been determined for the
payment or delivery. A party may (but
need not) determine its Loss by reference
to quotations of relevant rates or prices
from one or more leading dealers in the
relevant markets.
 2
(2) Client A refuses to execute the murābaḥah
“ From the description of the
“Market Quotation” and “Loss”,
sale confirmation and hence breaches its waʿd
to purchase the commodity from Bank A.
as provided for under the TMA, (3)
3 Despite Bank A not receiving the payment
it is observed that the TMA does from Client A, Bank A is still bound to pay
not specify in detail the items to Bank B the agreed fixed profit rate amount at
5%. At the same time, Bank A is still holding
be considered in its calculation
the commodity purchased from Broker A.
of Market Quotation and Loss
except it being the replacement (4)
4 For Bank A to pay Bank B, Bank A will have
to borrow money from the Islamic Interbank
cost due to the breach
” Money Market (IIMM). Bank A may incur
some cost in doing so.
(5)
5 Using the money borrowed from the IIMM,
From the description of the “Market Quotation” and
Bank A pays to Bank B the agreed fixed profit
“Loss”, as provided for under the TMA, it is observed
rate amount at 5%.
that the TMA does not specify in detail the items to
be considered in its calculation of Market Quotation
and Loss except it being the replacement cost due Diagram 3: An Overview of the
to the breach. However, according to Kasri and Consequence of Breach of Waʿd by Client A
Zainalabiddin (2015), the loss incurred by Islamic in the Event That Bank A Has Yet
financial institutions due to the breach of waʿd in to Purchase the Sharīʿah-Compliant
IPRS could be described in the following Diagrams Commodity
2 and 3.
25
Diagram 2: An Overview of the
Consequence of Breach of Waʿd by Client A in
the Event That Bank A Has Purchased IIM M

Issues in Islamic Hedging Practices: A Critical Analysis

the Sharīʿah-Compliant Commodity from
Broker A 2 1 3
Fixed:5%
A B

Float: Klibor
+ 4.0%
IIMM Fixed:5% Float: Klibor
X + 4.0% Float: Klibor
4 + 4.0%
3 5

Fixed:5%
1 A B A B
A
Float: Klibor
+ 4.0%
Fixed:5% Float: Klibor
X + 4.0% Float: Klibor Source: Kasri and Zainalabiddin (2015)
+ 4.0%
2
(1)
1 Even though Bank A has not purchased the
A B
Sharīʿah-compliant commodity from Broker
A, Bank A is still bound to pay Bank B the
agreed fixed profit rate amount at 5%.
(2)
2 As mentioned earlier, to pay Bank B, Bank A
Source: Kasri and Zainalabiddin (2015)
will have to borrow money from the Islamic
Interbank Money Market (IIMM). Bank A
may incur some cost in doing so.
(1)
1 Broker A purchases a Sharīʿah-compliant
(3)
3 Using the money borrowed from the IIMM,
commodity and after that sells the commodity Bank A pays Bank B the agreed fixed profit
to Bank A. Bank A delivers an exercise notice rate amount at 5%.
and murābaḥah sale confirmation to Client A.
 To analyse whether the above commodity price, the
payment of the fixed profit rate, the cost of funds
and the penalty can be considered as actual loss
from the Sharīʿah perspective, it is important to
explain what actual cost is in the Sharīʿah. In this
respect, according to Khir et al. (2014: pp. 35-36),
the parameters for actual cost can be discerned as
follows:
(1) The actual cost includes payment made by
the Islamic financial institutions to internal
and external parties for the benefit of the
customer.
(2) Based on para (1) above, direct labour cost can
be counted as an actual cost. It includes actual
expenses incurred by the Islamic financial
institution to pay the salaries of employees
who are engaged in the loan processing
service and debt recovery process on a full-
time basis or most of their working hours are
spent for the above tasks.
In this case, the Islamic financial institution
is obliged to provide substantive proof of the
requirement, which may include calculation
26
of the cost per person and hour.
(3) In the event that the Islamic financial
institution incurs a cost due to the payment
Research Paper No. 88/2016
of salaries for employees who spend most
of their working hours for the benefit of the
customer (debtor), it shall itemize the costs to
qualify them as actual costs transferable to
the customer.
(4) Actual labour cost also includes any payment
made to external parties such as lawyers,
auctioneers, valuers and others who are
specifically hired to handle matters of benefit
to customers or due to customer defaults.
(5) The actual cost also includes direct material
costs such as actual expenses incurred by
the Islamic financial institution to obtain
items or material goods for the interest of
the customers, such as those necessary for
the provision of a financing facility to the
customers, or due to the customer’s default
such as those necessary for the debt recovery
process.
(6) The actual cost, either in the category of
direct labour cost or direct material cost, must
be identified and measurable.
(7) The original rule is that actual cost must be
calculated for each individual case; however,
if the Islamic financial institution faces
difficulty in doing so, the actual cost may be
calculated on a portfolio basis.
(8) The imposition of actual cost should not
serve as a mechanism for profiteering
(istirbāḥ). Thus, the actual cost incurred by an
Islamic financial institution for managing or
providing financing to its customers cannot
be charged in the form of a percentage of the
financing amount.
(9) The actual cost may be determined by relevant
authorities or professional bodies in the form
of a fixed amount without the element of
istirbāḥ (profit generation).
(10) The actual cost must be precisely determined
and approved by the Sharīʿah supervisory
body with assistance from experienced
professionals in the related field.
Based on the above parameters, it can be concluded
that the actual cost is whatever cost is paid by an
Islamic financial institution to internal or external
parties (such as lawyers, Sharīʿah advisors and
valuers) for the benefit of the customers. It includes
direct labour cost such as salaries of employees
who are engaged in related products and services
and direct material costs such as actual expenses
incurred by an Islamic financial institution to obtain
items or material goods for the interest of the
customers.
“ Itcosts
is submitted that the actual
borne by the promisee
can be considered as actual
damages which entitle it to claim
compensation due to a breach of
waʿd by the promisor
”
It is submitted that the actual costs borne by the
promisee can be considered as actual damages
which entitle it to claim compensation due to a
breach of waʿd by the promisor. The reason is that
the promisee—from the date the waʿd is entered
until the date it is breached—has undertaken some
arrangements that may incur costs in order to ensure
it can deliver what is stated in the related promise.
Therefore, the costs incurred have a significant
relationship with the promise as the subject matter
of the promise cannot be delivered without such
arrangement, which is made for the promisor’s
interest and benefit. Hence, if the promisor
breaches its promise, the costs must be borne by the
promisor as the breach of waʿd is considered to put
the promisee in a detrimental situation. There are
numerous Quranic verses and ḥadīths that prohibit
acts or statements that inflict harm on others. For
example, Allah ( ) says:
‫وأشهدوا إذا تبايعتم وال يضار كاتب وال‬
‫شهيد وإن تفعلوا فإنه فسوق بكم‬
“Take witnesses when you conclude a
contract. The scribe and the witnesses
should not be harassed; if you do so, you
shall be guilty of sin” (Sūrah al-Baqarah
(2):282).
Also, Allah’s Messenger ( ) stated:
»‫«ال ضرر وال ضرار‬
“Harm shall neither be inflicted nor reciprocated”
(Ibn Mājah, 2009, 3:430, no. 2340).
The legal maxim “‫”الضرر يزال‬, which means “harm is
to be eliminated,” has been formulated on the basis
of such recurrent evidence (ISRA, 2011, p. 110).
The Quranic verse, ḥādith and legal maxim
mentioned above clearly mention that harm must
be avoided, and if it does occur that it should be
eliminated. The objectives of the Sharīʿah can be
summarized as realizing benefit and preventing
harm in the five essentials (religion, life, intellect,
dignity and wealth) (ISRA, 2011). Based on this, it is
argued that imposing compensation on the promisor
who breaches his promise, if his act brings harm to
the promisee, is permissible in Islam.
The ensuing discussion examines whether the
elements mentioned in Diagrams 2 and 3 earlier
could be considered as actual loss incurred by the
contracting parties in the IPRS or, for that matter,
any Islamic hedging arrangement.
(1) Commodity price
Para 16.10 of the 2016 Concept Paper on waʿd
stipulates:
“…the IFI shall ensure that the actual loss
consists of the following:
(a) at minimum
(i) the outstanding principal amount,
which includes the amount of shortfall
between the cost of asset acquisition and
the disposal value of the asset; and
(ii) the actual direct cost incurred; and
(b) any additional components with
regards to the waʿd as specified in the
policy documents issued by the Bank
including on Sharīʿah contracts.”
By the same token, the SAC-BNM (BNM, 2010) in its
73rd meeting, dated 20 February 2008, resolved that
in the event of a breach of promise in the case of
a currency option, the innocent party who suffers
loss may recover the actual amount of loss from the
value of the hāmish jiddiyah. On the measurement
of actual loss the SAC-BNM resolved as follows:
(a) The actual loss shall be measured based
on the difference between the sale price
of the commodity and the promised
purchase price of the commodity; or
(b) The Islamic financial institution may
acquire the whole amount of hāmish 27
jiddiyah to recover the actual losses if
the calculated amount based on the
above methodology is equal [to] or
Issues in Islamic Hedging Practices: A Critical Analysis
more than the value of hāmish jiddiyah.
If the actual loss is lower than the value
of hāmish jiddiyah, the customer may
agree to channel the residual amount
to charitable organisations under the
supervision of the Sharīʿah committee
of the said Islamic financial institution.
Similarly, AAOIFI (2015) also permits the promisee
to claim compensation from the promisor if he
breaches his waʿd, but the compensation is limited
to the actual damages, i.e. “the difference between
the cost of the item borne by the institution and
the price at which the item is sold to a third party”.
This is in line with the Shari’a Supervisory Board of
Qatar Islamic Bank (Fatwa No. 53), which declares
that if the execution of the purchase promise failed
due to reasons related to the promisor, then he has
to bear the expenses and the costs of the actual
damages incurred thereof.
Based on the above rulings issued by several
authoritative institutions, it is crystal clear that the
cost of the commodity borne by Bank A and paid to
Broker A (see Diagram 2) is a real loss or damage.
Therefore, this item can be factored in calculating
the close-out amount in the case of breach of waʿd.
 (2) Payment of Fixed Profit Rate
From a micro-perspective, it is submitted that the
arrangement that Bank A made with Bank B via
back-to-back hedging is for the benefit of Bank A. It
follows that this arrangement is not for the benefit
of Client A. This is because Bank A can do hedging
with Client A without the back-to-back hedging,
or in other words, back-to-back hedging is not part
and parcel of the hedging process. Based on this
perspective, it seems that Bank A cannot claim the
fixed profit rate from Client A as it is considered a
separate arrangement that has no relationship with
Client A’s hedging transaction.
However, when one considers this issue from a
macro-perspective, Bank A will not be able to
make a hedging arrangement with it clients unless
it enters into a back-to-back hedging arrangement
with a third party, Bank B. The back-to-back hedging
arrangement is deemed as ḥājah (necessity) in the
case of small Islamic banks. These banks would not
be able to offer IPRS or any Islamic hedging products
to their customers without it. The main purpose of
28 doing back-to-back hedging is to minimise their
exposure to risk. In Islam, it is encouraged to manage
risk, and an act that exposes oneself to unnecessary
risk is prohibited. Allah ( ) says:
Research Paper No. 88/2016
‫وال تلقوا بأيديكم إل التهلكة‬
“Do not expose yourselves to damage” (al-
Qurʾān, 2:195).
However, to manage this risk, these small Islamic
banks are not allowed to hedge using Sharīʿah non-
compliant hedging methods.
With regards to whether Bank A could claim the
cost of back-to-back hedging, the question would be
whether Bank A is allowed to transfer the risk to
Client A. It is submitted that if Bank A has a need
(ḥājah) to do the back-to-back hedging, as it cannot
offer IPRS product to its customer without it, then
Bank A is justified to transfer the risk to Client A
and, accordingly, is entitled to claim for the loss
incurred in relation to this arrangement.
One may raise a hypothetical question in this
regard: if Islamic banks were barred from claiming
the cost of the back-to-back hedging arrangement,
what would the implication be for these Islamic
banks and the industry as a whole? Could these
banks offer IPRS products? From a different angle,
how would customers react to this prohibition?
Would customers be forced to get Interest Rate
Swap arrangements from conventional banks? If the
answer is affirmative, what is the solution that Islam
could offer? It is submitted that the concept of ḥājah
is applicable in this case. This is because Islamic
banks at the current moment cannot offer IPRS, an
alternative to Interest Rate Swap, without entering
into the back-to-back hedging arrangement. In other
words, barring Islamic banks from claiming the cost
of the back-to-back hedging arrangement would
cause hardship (ḥaraj) to them and their customers,
and this contradicts the statement of Allah ( ):
‫َوَما َج َع َل َعلَْي ُك ْم ِيف الدِّي ِن ِم ْن َحَرٍج‬
“…and He has not imposed any hardship
on you in the religion…” (Sūrah al-Ḥajj
(22):78).
Mayyārah mentioned that one of the principles of
the Mālikī School is:
ِ ‫ات َكما يـراعي الضَّرور‬
.»‫ات‬ ِ ‫احلاج‬
َ َْ ‫«يـَُراعي‬
َُ َُ َ
“Ḥājah (significant need) must be given
consideration just as consideration is
given to ḍarūrah (dire need)” (Mayyārah,
n.d., 2:102).
Based on the Quranic verse and what was
mentioned by Mayyārah, it can be concluded that
putting human beings in hardship is not consistent
with the teachings of Islam. By considering their
ḥājah, hardship can be avoided. In supporting
this argument, this paper refers to the Indonesia
National Shariah Board (No. 43/DSN-MUI/VII/2004),
which issued a fatwa on compensation (taʿwīḍ). It
states, amongst others:
(a) The loss that is liable for compensation
is real loss that can be calculated clearly;
(b) Real loss is cost that is issued for
collecting the rights that must be
settled; and
(c) The value of the compensation is
according to the value of real loss that
occurred (fixed cost) in the transaction
and not opportunity loss.
Based on this fatwa, it is further argued that the
payment from Bank A to Bank B is real loss as Bank
A has to use its funds or raise them from the IIMM
to pay Bank B. The payment is actual and is directly
caused by Client A’s breach of payment of a sum of
money to Bank A in return for the commodity (Kasri
& Zainalabbidin, 2015). In short, Islamic banks can
claim this cost so as to avoid hardship upon them as
well as their customers.
(3) Cost of funds
On the issue of cost of funds, according to the
SAC-BNM’s resolution (BNM, 2010), in its 111th
meeting, dated 28th April 2011, the cost of the funds
may not be accepted as actual loss. The SAC-BNM
resolved that the cost of funds cannot be considered
in determining the amount of taʿwiḍ. The Sharīʿah
basis supporting such resolution is not mentioned
anywhere in the resolution; however, this position
seems to be supported by research undertaken by
Khir et al. (2014) which states that under the principle
of taʿwīḍ it is impermissible to calculate the actual
loss based on the cost of funds because the cost of
funds does not amount to an actual financial loss.
Their rationale is on the basis that the imposition of
taʿwīḍ is only allowed in two circumstances:
(a) In the case of a person who caused
damage (itlāf) to a physical asset or a
bodily part or loss of benefit due to an
act of usurpation (ghaṣb); and
(b) In the case of a breach of trust.
However, according to Kasri and Zainalabiddin
(2015), the above Sharīʿah resolution on the cost
of funds could be distinguished by taking into
consideration two perspectives. Firstly, if the
potential involvement of cost of funds in the event
of breach is made known to the parties at the time
of signing, the parties’ acceptance of such terms
could be considered to be fairly and reasonably
contemplated by both parties. Thus, the occurrence
of such cost of funds when the relevant party
breaches the waʿd allows the other party to claim it
as real loss or damages. Secondly, the facts involved
in the cost of funds in the case of plain vanilla Islamic
financing are different from IPRS. Taking the earlier
example when Client A breached its waʿd, Bank A
lost the cash flow that would have been used to pay
Bank B. Because of the said breach, Bank A would
have to raise its own funds to meet its commitment
to pay Bank B. In the example given earlier, Bank A
would have to borrow such funds from the IIMM to
cover its commitment to Bank B. It is submitted that
the cost of getting such funding (the cost of funds)
be viewed as real loss suffered by Bank A and that
the loss incurred by Bank A is because of the breach
by Client A.
The scenario for plain vanilla Islamic financing
is different. Imagine that Client A breached its
contractual payment obligation to Bank A under an
Islamic home financing. Normally, Bank A would
not, because of this sole breach, go out to get funding
to meet its commitment to another party. This is so
because Bank A does not enter into any financial
commitment or arrangement solely for the Islamic
home financing with Client A, nor does it become
the intermediary to arrange cash flow from Client A
as in the case of IPRS. Islamic financings are arranged
or structured on a portfolio basis. Hence, the cost of
funds, if so incurred in Islamic financings, is due to
the need to cover portfolios rather than a direct one-
to-one basis as in the case of IPRS. In other words, if
Client A were to breach in Islamic home financing,
Bank A would not necessarily incur a cost for the
cost of funds to cover such breach as the cost could
be covered under the respective portfolio. Based on
the above analysis, it is submitted that because of the
indirect impact of the failure to pay under Islamic
financing and the independence of the cost of funds,
the SAC-BNM resolution on the cost of funds is
applicable to breach of waʿd under Islamic financing
but may not be applicable to the case of breach of 29
waʿd for IPRS. (A similar observation could also be
made for other Islamic hedging products such as
Islamic FX forward, Islamic option, and so on).
Issues in Islamic Hedging Practices: A Critical Analysis
“incurred
Hence, the cost of funds, if so
in Islamic financings,
is due to the need to cover
portfolios rather than a direct
one-to-one basis as in the case of
IPRS
”
Based on the above discussion, it can be concluded
that the cost of funds in IPRS and other Islamic
hedging products needs to be treated differently
from a plain vanilla Islamic financing. Because of
the existence of a relationship between the cost of
funds and the breach of waʿd, it is submitted further
that this cost of funds can be claimed by Bank A as
actual loss.
(4) Penalty
With regards to the penalty, it is viewed that penalty
is not part of the actual loss. As mentioned earlier,
the AAOIFI standard states, “The Institution’s rights
are limited to deducting the amount of the actual
damage incurred as a result of the breach.” A similar
 ruling has been issued by Dallah al-Baraka (2002),
the Shari’a Supervisory Board of Qatar Islamic Bank
(Fatwa No. 53) and the SAC-BNM (BNM, 2010) as
well as the BNM (2016) Concept Paper on waʿd.
Based on the above resolution, it can be concluded
that no penalty can be counted in determining the
close-out amount.
Discussion on the Third Issue (ii)
The close-out amount that is mark-to-market allows
one of the contractual parties to gain when the
market rate moves in its favour. The question arises,
would the Sharīʿah allow the gaining party who
breached the waʿd to gain if the market moves in its
favour?
According to Kasri and Zainalabiddin (2015), it is
not always the case that the party who breached the
waʿd has to pay the close-out amount. It depends on
the result of the calculation of the close-out amount
(which is tied to the movement of the interest or
commodity or currency rates at the time of the
breach). When there is a breach of waʿd in an IPRS,
30 one of the parties—usually the non-defaulter—will
calculate the close-out amount. However, which
party will have to pay the close-out amount depends
on whether the result of the calculation is positive
Research Paper No. 88/2016
or negative for the counterparty. A positive result is
referred to as a cost to the calculator. The calculator
(non-defaulting party) would have to pay that amount
to the counterparty. A negative result is referred to
as a gain to the calculator, who would receive the
amount from the counterparty. As a result, the party
exercising the waʿd for the musāwamah sale may
be the non-defaulter or the defaulter, depending on
whether the calculation results in a cost or a gain.
Diagram 4 below illustrates the scenario involved in
determining who will pay the close-out amount.
“ Based on our discussion earlier
on the permissibility of getting
compensation from the party
that caused harm to the other
party (non-defaulting party),
it can be deduced that it is not
allowed in the Sharīʿah for
the defaulting party to gain
because it is supposed to pay
the close-out amount to the
non-defaulting party and not
otherwise
” to the rollover or cancellation of waʿd based
Diagram 4: Who Pays the Close-Out Amount
• Non-defaulting
party will exercise
waʿd to enter into
musāwamah contract
+RI • Defaulting party will
receive RIV from the
non-defaulting party
Relevant
Index Value
(RIV) • Defaulting party
will exercise waʿd
to enter into
musāwamah contract
-RI
• Non-defaulting party
will receive RIV from
the non-defaulting
party
Source: Kasri and Zainalabiddin (2015)
This arrangement raises the question of whether the
party who breaches the waʿd should have the right
to gain when it is the one that caused the breach
that results in the other contractual party bearing
the loss arising from the breach. Based on our
discussion earlier on the permissibility of getting
compensation from the party that caused harm to
the other party (non-defaulting party), it can be
deduced that it is not allowed in the Sharīʿah for
the defaulting party to gain because it is supposed
to pay the close-out amount to the non-defaulting
party and not otherwise. The close-out amount is
considered compensation for breaching the waʿd,
and therefore, the party who suffered the breach is
entitled to it.
Discussion on the Fourth Issue: In foreign
currency trading practices, the Islamic finance
industry adopts the ruling of the Association of Banks
in Malaysia (ABIM) for cancellation and rollover of
FX forward resulting in mark-to-market gain/loss.
The mark-to-market gain/loss is imposed on one
of the parties at the time the waʿd is terminated,
cancelled extended or rolled over. As mentioned
above, the Sharīʿah resolutions state that, in case
of a breach of waʿd, the party who suffered due to
the breach is entitled to claim for compensation/
damages. However, the compensation/damages
must be based on actual loss. The questions are:
(1) Is the mark-to-market gain/loss imposed due
on the actual loss?
 (2) As it is based on mark-to-market that allows
one of the contractual parties to gain when
the currency rate moves in its favour, would
the Sharīʿah allow the gaining party who
breached the waʿd to gain on the basis of a
currency move in its favour and not based on
the cost of holding currency?
Waʿd, according to the BNM (2016) Concept Paper
on waʿd, can be cancelled or extended, though the
permissibility of these measures is dependent on
certain conditions. However, the Concept Paper is
silent on whether mark-to-market gain/loss can be
imposed on the non-defaulting party. To further
understand the scenario, Diagrams 5 and 6 describe
how mark-to-market gain/loss is imposed on one
of the parties at the time that waʿd is terminated/
cancelled or extended/rolled-over.
Diagram 5: Calculation of Mark-to-Market
Gain/Loss When Waʿd Is Terminated/
Cancelled
MYR/USD
MYR/USD 3.8100 (10mil) + MYR/USD
3.8100 (10mil) Basis Point 3.8150 (10mil)
T0 Tcancel
1/3/2016 23/3/2016 31/3/2016
Position:
Sell (-)10mil @ MYR 3.8150 (to Client A)
Buy (+)10 mil @ MYR 3.8140 (from Trader A)
Bank A squaring-off the above open position on
23/3/2016:
Mark-to-market = 3.8100
Source: Authors’ own
In this case, Client A wishes to acquire USD
10 million to facilitate its purchase of a certain
commodity to be imported from the United States.
Client A approaches Bank A for the USD 10 million.
(1) Client A and Bank A entered into waʿd on
1/3/2016 (T0). On this dealing date, Client A
promises to purchase USD 10 million at the
rate of USD 10M/MYR 3.8150M on the value
date, 31/3/2016 (T1).
(2) To hedge against the volatile movement of the
currency rate (in case the currency rate does
not move in favor of Bank A, the Bank enters
into a swap arrangement with a third party,
Trader A, on the same dealing date, 1/3/2016.
Under this swap arrangement, Trader A
promises to sell to Bank A USD 10 million at
the rate of USD 10M/MYR 3.8140M.
(3) However, Client A communicates with Bank
A to cancel/terminate the waʿd on 23/3/2016
and Bank A agrees to its request.
(4) Due to such cancellation, Bank A has to
close out by reversing the swap position that
it entered with Trader A. This reversing/
closing out entails Bank A revaluing the price
of the FX currency using the spot price on
23/3/2016. Say the spot price on 23/3/2016 is
MYR 3.8100M.
(5) Previously, on 1/3/2016, Bank A bought USD
at the rate of USD 10M/MYR 3.8150M; but on
23/3/2016 when Bank A has to square off its
open position, it has to do that at the market
value on 23/3/2016, which is USD 10M/MYR
3.8100M. Due to this, Client A makes a gain
of RM 0.0050 by paying at the rate of 3.8100
instead of 3.8150 while Bank A makes a loss
because it had to square off its position at
3.8100 instead of 3.8150.
[Swap Selling Price to Client A - Mark-to-
31
Market Price] x USD 10M
= [3.8150 - 3.8100] x USD 10M
Issues in Islamic Hedging Practices: A Critical Analysis
= 0.050 x USD 10M
T1 = 50,000
(6) So the loss that Bank A has to suffer is RM
50,000. 8
Diagram 6: Calculation of Mark-to-
Market Gain/Loss When Waʿd
Is Extended/Rolled Over
MYR/USD MYR/USD MYR/USD
3.800 (10mil) 3.8200 (10mil) 3.8350 (10mil)
T0 T1 T2
1/3/2016 31/3/2016 30/4/2016
Position: Position:
Sell (-) 10mil at MYR 3.8150 Buy (+) 10 mil
Buy (+) 10 mil at MYR 3.8140 at MYR 3.8350
Mark-to-market = 3.8200
(value on 31/3/2016)
Close position:
Sell (-) 10mil at MYR 3.8200
Source: Authors’ own
 In this case, Client A wishes to acquire USD
10 million to facilitate its purchase of a certain
commodity to be imported from the United States.
Client A approaches Bank A for the USD 10 million.
(1) Client A and Bank A enter into a waʿd on
1/3/2016 (T0). On this dealing date, Client A
promises to purchase USD 10 million at the
rate of USD 10M/MYR 3.8150M on the value
date, 31/3/2016 (T1).
(2) To hedge against the volatile movement of the
currency rate (in case the currency rate does
not move in favor of Bank A, the Bank enters
into a swap arrangement with a third party,
Trader A, on the same dealing date, 1/3/2016.
Under this swap arrangement, Trader A
promises to sell to Bank A USD 10 million at
the rate of USD 10M/MYR 3.8140M.
(3) However, on 31/3/2016, Client A communicates
with Bank A to extend the waʿd, and Bank A
agrees to its request to extend it to 30/4/2016
(T2).
(4) Due to such extension/rollover, Bank A will
32 have to extend its swap position to T2. This
extension requires Bank A to re-evaluate the
new rate based on mark-to-market. Say the
spot price at T2 (30/4/2016) is MYR 3.8350M.
Research Paper No. 88/2016
The re-evaluation of the new rate leads to
Bank A making a gain as follows:
[Mark-to-Market Price - Swap Selling Price
to Client A] x USD 10M
= [3.8200 - 3.8150] x USD 10M
= 0.050 x USD 10M
= 50,000
The provision for mark-to-market gain/loss imposed
due to the breach of waʿd can be found in one sample
FX forward contract which states:
(1) When a customer requires a cancellation or
an extension of a Transaction or any part
thereof, the Customer shall inform the Bank
in writing not later than 11.00am on the date
the Transaction matures (‘the FX-I maturity
dates’) stating its reason for requiring a
cancellation or an extension.
(2) If the Bank grants the customer’s request
under clause 8.3(a) above for a cancellation
and/or extension of a Transaction or any part
thereof, a new Transaction shall be deemed to
have been entered into between the Bank and
the Customer at that time, and all terms and
conditions applicable to FX-i shall mutatis
mutandis apply to the new Transaction.
(3) The new Transaction shall be calculated
at the Current Spot Market Rate. “Current
Spot Market Rate” is the prevailing delivery
or settlement spot rate for an exchange of
different currencies quoted by the Bank on
that day. If a Transaction is extended or rolled
over on its FX-I Maturity Date at the existing
foreign currency rate in the Transaction
(“Historical Rate”), the resulting marking to
market (MTM) cost shall be indemnified to
the Bank by the Customer.
(4) If on cancellation, extension or rollover (as
the case may be) of a maturing Transaction at
the Current Spot Market Rate, the Customer
makes a gain, the Current Spot Market Rate for
the new Transaction may at the Customer’s
discretion be adjusted downwards to take into
account the gains or be paid into the Current
Account, provided there are no outstanding
sums owing by the Customer on any other
Transaction or under any other facilities
with the Bank. Where the customer incurs a
loss, the loss will be debited to the Current
Account or the Customer’s other account(s).
The above provision may be read together with
the Ruling of the Association of Banks in Malaysia
(ABIM) which states that for any extension of
contract resulting in marked to market (MTM) gain
or loss exceeding RM 10,000, the PFX-I contracts
are to be extended using the current market rate.
However, if the gain or loss is RM 10,000 or lower,
the said PFX-I contracts are to be extended using the
historical rate. The following calculation explains
how waʿd could be extended based on the mark-
to-market rate or historical rate, using examples in
Diagram 6.
Mark-to-market (MTM) = (the MTM
rate – the contract rate) x the Contract
Amount
If the MTM results in more than RM
10,000 loss/gain, the extension will be
based on the MTM rate. However, if the
MTM rate results in less than RM 10,000
loss/gain, the extension will be based on
the historical contract rate.
Based on the example above,
MTM = [3.8200 - 3.8150] x USD 10M = RM
50,000
Therefore the waʿd will be extended using
the MTM rate.
 MTM >10M = MTM rate + swap basis
point5
= 3.8200 + 0.0150
= 3.8350
However, if the mark-to-market result is
below MYR 10M, the calculation will be
based on the historical rate; for example:
MTM <10M = Historical rate + Swap
basis point
= 3.8150 + 0.0150
= 3.8300
Considering the description in Diagrams 5 and 6 and
supported by the legal provision that allows for the
settlement of mark-to-market gain/loss, the question
is whether the Sharīʿah allows for this settlement to
be imposed due to the breach? Additionally, would
the Sharīʿah allow for it to be imposed on the party
that did not cause the breach?
It is important to note at the outset that when the
promisor has requested cancellation or extension
of its promise, the promisor has deemed to have
breached its promise and that if such request led to
some actual loss to the promisee, the promisee must
be compensated. As a result of this breach, if the
promisee suffers material hardship, the promisor
is obliged to pay compensation to the promisee, as
discussed extensively in the earlier discussion on
Issue 3.
As clearly shown in the Diagrams 5 and 6 above,
the charges or costs that are imposed by the Bank
are determined based on mark-to-market. The effect
of this is that if the market rate moves against
Customer A, Customer A would have to pay Bank
A the difference between the prevailing market rate
and the original rate agreed earlier. On the other
hand, if the market rate moves against Bank A, Bank
A would have to pay Customer A the difference.
This arrangement suggests that the payment of
the differential sum depends on the currency rate
movement rather than who breached the waʿd.
It is contended that the use of mark-to-market as a
mechanism to determine who is gaining and who
is losing, with the loser having to pay the gainer, is
not in compliance with the Sharīʿah. The reasons are
as follows: first, a number of Sharīʿah resolutions
issued by various institutions have determined that
the promisor who breaches the waʿd is liable to pay
compensation to the other party who suffers and
faces hardship due to the breach of waʿd, and not
otherwise. These Sharīʿah resolutions are supported
by numerous texts of the Qurʾān and Sunnah, as well
as Islamic legal maxims, which prohibit a person
putting another in hardship and which require the
removal of any hardship that has been imposed.
This has also been touched on in the previous
discussion. Second, the differential amount that is
paid by one party to the other should involve an
exchange for some counter-value (ʿiwaḍ). Without
the exchange of counter-values between the parties,
the structure would resemble a zero-sum game,
which is prohibited in Islam. Third, the resolutions
that allow the imposition of a compensation for
damages qualify it by stating that the amount must
reflect real damages and nothing more. When the
close-out amount favours the party who breached
the promise, the “compensation” cannot possibly
reflect real damages because the party who breached
the promise is the one who inflicted the damage.
The question then is whether the mark-to-market
gain/loss charge imposed for the breach of waʿd in
FX forward is an actual loss? In the example given
in Diagrams 5 and 6 above, when Bank A agrees to
Client A’s request for termination or extension, it 33
will have to manage an open FX position arising
from the termination or extension. It has to
accordingly adjust the availability of the cash flow
Issues in Islamic Hedging Practices: A Critical Analysis
by one week ahead of schedule. This requires Bank
A to square the original position and create a new
deal at the prevailing market rate. As a result, it will
close the FX position arising from the cancellation
or extension and adjust the cash flow from the
original date to the cancellation or extension date.
Due to the above exercise, mark-to-market gain/loss
is created due to the difference between the original
and prevailing market rate.
“ required
Thus, clear evidence would be
to ascertain whether
the mark-to-market gain/loss
charge paid to Bank A due to a
breach by Client A represents
actual loss to Bank A
”
Thus, clear evidence would be required to ascertain
whether the mark-to-market gain/loss charge paid
to Bank A due to a breach by Client A represents
actual loss to Bank A. The explanation above shows
that Bank A does incur some loss as it had to manage
an open FX position arising from the cancellation
or extension and adjust the availability of the cash
 flow by one week. However, what is still unclear is
whether the charge that Bank A imposes on Client
A represents Bank A’s actual loss. Because of the
mark-to-market nature of the charge and the lack
of clarity on its composition, it is difficult to reach
an informed decision as to whether the actual loss
represents the whole charge or only a part of it. To
overcome this conundrum, Islamic banks could lay
clear terms in the FX forward contract that clearly
itemize the actual loss that the bank would suffer in
the event of cancellation or rollover.

34
Research Paper No. 88/2016

CONCLUSION AND RECOMMENDATIONS
This paper has discussed hedging from conventional
and Islamic perspectives and analysed the relevant
Sharīʿah resolutions issued by the international
Sharīʿah standard-setting bodies, namely the IFA-
OIC, AAOIFI, IIFM, DAB, as well as local Malaysian
Sharīʿah standard-setting bodies, namely SAC-BNM
and SAC-SC. Based on that, this paper revealed
that hedging as understood in conventional finance
is slightly different from hedging as conceived in
Islamic finance. The difference between the two
lies in four critical criteria: (1) the contracts and
underlying assets used in hedging must be Sharīʿah
compliant; (2) the hedging mechanism is not to be
used for speculation and gambling; (3) the hedging
transaction is to be entered into based on real
underlying risk arising from real investment that
adds value to the real economy; and (4) the strategy
or technique involved in risk hedging should not
sever the risk from its underlying assets.
It is also discovered that the said Sharīʿah advisory
bodies are in agreement on the substantial need
for hedging in Islamic finance though they are not
unanimous on the legality of particular Islamic
hedging products. Even in the approved Islamic
hedging arrangements, it is discovered that there
are still some underlying Sharīʿah issues pertaining
to their practices. This research has highlighted and
examined four critical issues:
(1) the distinction between hedging and
speculation;
(2) superficial use of commodity murābaḥah/
tawarruq as the hedging arrangement;
(3) compensation for breach of waʿd;
(4) and mark-to-market gain/loss charges in
Islamic profit rate swap and Islamic forward
contracts.
Based on the examination and discussion of these
issues, the paper concluded that there are differences
between hedging and speculation. Accordingly,
a hedger cannot be allowed to profit based on
an external factor that is uncertain at the time of
entering into the contract; for example, the future
interest rate, the future currency exchange rate,
and so on. The paper found that the execution of
Section 5
promises and of commodity murābaḥah/tawarruq to
facilitate mark-to-market gain/loss does not result
in a real exchange in the Sharīʿah; thus, the resultant
profit cannot be considered a lawful gain. It also
found that the Sharīʿah does not allow one party in
particular to gain when the payment of gain is not
based on the cost of holding a commodity but rather
on mark-to-market as this would trigger the element
of gambling. This paper further concluded that the
compensation or damage paid by the party that
breached the waʿd in Islamic profit rate swap, which
is in the form of the close-out amount, is based on
actual loss. Thus, the party that incurs a loss due to
the breach is allowed to be compensated but not the
party who causes the breach. Similarly, with regards
to the mark-to-market gain/loss imposed due to the
cancellation or rollover of waʿd in FX forward, it is
to be borne by the party who breached the waʿd and 35
not otherwise. The charges imposed must also be
based on actual loss and not opportunity loss.
Issues in Islamic Hedging Practices: A Critical Analysis
“ Based on the above findings,
this paper recommends
that the Sharīʿah advisory
bodies concerned revisit their
resolutions
”
Based on the above findings, this paper recommends
that the Sharīʿah advisory bodies concerned revisit
their resolutions. The revision should consider the
criteria of Islamic hedging as suggested in this paper
and ensure that these criteria are incorporated into
their resolutions. It is also important that the real
need of hedging and its impact on the economy and
society be duly considered in the revisit exercise.
This initiative will boost confidence in the Islamic
financial industry as well as the economy in general
by giving assurance that adequate and effective
resolutions are being produced. In addition, this
paper also recommends that the relevant party
reviews their resolution on the permissibility of
using the conventional formula in determining the
close-out amount in Islamic profit rate swap and
also the superficial use of commodity murābaḥah/
tawarruq to facilitate the mark-to-market gain/loss.
 Finally, further thorough research on speculation is
recommended. The focus should be on assessing and
determining the level or threshold of what is deemed
to be excessive speculation and the supportive
Sharīʿah basis for that determination.

36
Research Paper No. 88/2016
 End Notes

1
It is important to note here that in conventional
finance, the term “investment” refers to the
purchase of something that is expected to
increase in value, generally with a view to selling
it for a profit at a later date. Though traditionally
that “something” could be tangible goods or
property (real assets), in today’s market, financial
instruments such as bonds, commodities, futures,
options, shares, stocks, unit trusts and warrants
are also considered “property” (Clark, 2001).
Hence, an investor who invests in such property
would now be able to hedge against any risk of
potential loss in his investment which may be
incurred due to the change in the price of the
asset, interest rate, equity, credit or currency.
2
Al-Khaṭṭābī said: the ḥadīth is not strong by itself;
however most of the jurists accepted it based
on other sources. It is best to limit its usage for
commercial issues only. Al-Suyūṭi & al-Albāni
declared it ḥasan (al-Khaṭṭābī, Maʿālim al-Sunan,
37
5:160).

Issues in Islamic Hedging Practices: A Critical Analysis

3
However, there are disagreements over the
authenticity of this ḥadīth and its chain of
transmission.
4
This argument is based on a series of interviews
with several Islamic financial institutions that
have tawarruq-based hedging products. These
institutions have not been mentioned by name in
this research to maintain confidentiality.
5
The swap basis point is based on the interbank
swap rate as advertised in the swap FX market.
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