Executive Summary
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Derivatives are few and far between in Islamic countries. This is due to the fact that the compatibility of capital market transactions with Islamic law requires the development of Shariah-compliant structures that guarantee certainty of payment obligations from contingent claims on assets with immutable object characteristics. Notwithstanding these religious constraints, Islamic finance can synthesize close equivalents to conventional derivatives.
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Based on the current use of accepted risk transfer mechanisms, this article explores the validity of risk management in accordance with fundamental legal principles of Shariah and summarizes the key objections of Shariah scholars that challenge the permissibility of derivatives under Islamic law.
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In conclusion, the article also offers suggestions for the Shariah compliance of derivatives.
Types of Islamic Finance
Since only interest-free forms of finance are considered permissible in Islamic finance, financial relationships between financiers and borrowers are not governed by capital-based investment gains but by shared business risk (and returns) in lawful activities (halal). Any financial transaction under Islamic law implies direct participation in performance of the asset, which constitutes entrepreneurial investment that conveys clearly identifiable rights and obligations for which investors are entitled to receive a commensurate return in the form of state-contingent payments relative to asset performance. Shariah does not object to payment for the use of an asset as long as both lender and borrower share the investment risk together and profits are not guaranteed ex ante but accrue only if the investment itself yields income—subject to the intent to create an equitable system of distributive justice and promote permitted activities in the public interest (maslahah).
The permissibility of risky capital investment without explicit earning of interest has spawned three basic forms of Islamic financing for both investment and trade: (1) synthetic loans (debt-based) through a sale–repurchase agreement or back-to-back sale of borrower- or third party-held assets; (2) lease contracts (asset-based) through a sale–leaseback agreement (operating lease) or the lease of third party-acquired assets with purchase obligation components (financing lease); and (3) profit-sharing contracts (equity-based) of future assets. As opposed to equity-based contracts, both debt- and asset-based contracts are initiated by a temporary (permanent) transfer of existing (future) assets from the borrower to the lender or the acquisition of third-party assets by the lender on behalf of the borrower.
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