Derivative products and innovation in Islamic finance: A hybrid tool for risk-sharing options

Abstract

Purpose

The purpose of this paper is to highlight the possibility of structuring an Islamic option which includes an element of risk sharing as opposed to risk transfer.

Design/methodology/approach

The approach adopted in this research involved a combination of a wa’ad (promise) and murabaha (cost plus sale) and examining if they could form a risk-sharing Islamic option. The payoffs were assumed to be dependent on bi-period outcomes.

Findings

The paper attempted to create a hybrid risk-sharing option by combining elements of both wa’ad (promise) and murabaha (cost plus sale). The results yielded are dependent on the eventual direction of the market (in-the-money, at-the-money and out-the-money). While the results are not definitive, they do provide arguments for the adoption of a risk-sharing, as opposed to a risk-transfer, methodology when it comes to structuring risk management instruments.

Research limitations/implications

One of the major limitations of this research is the inability to assess the Shariah compliance of the proposed instrument. Shariah compliance is determined by a Shariah Supervisory Board, and every effort has been made to ensure that Shariah financial principles are adhered to in the creation of this structure.

Practical implications

The structure provides some interest arguments in the creation of risk management tools under a Shariah financial framework. The structure illustrates the benefits of having a risk-sharing mode over the conventional risk-transfer stances of most risk management tools.

Originality/value

The paper offers a new way of structuring a risk management tool in Islamic finance. It explores the highly debated area of derivatives in Islamic finance and proposes a new way of creating a risk management tool that involves some elements of risk sharing.

Citation

Kiong Kok, S., Giorgioni, G. and Laws, J. (2014), "Derivative products and innovation in Islamic finance: A hybrid tool for risk-sharing options", International Journal of Islamic and Middle Eastern Finance and Management, Vol. 7 No. 3, pp. 242-257. https://doi.org/10.1108/IMEFM-07-2013-0084