HEDGING BY DERIVATIVES A CRITICAL ANALYSIS AND SHARIAH ALTERNATIVE

Abstract

Despite their importance for financial sector
development, derivatives are few and far between in countries
where the compatibility of capital market transactions with
Islamic law requires the development of Shariah-compliant
structures. It is a well-known reality that Islamic finance is
governed by the Shariah, which bans some kinds of speculation,
but stipulates that income must be derived as profits from shared
business risk rather than interest or guaranteed return. This
paper explains the fundamental principles of Islamic finance,
which includes the presentation of a valuation model that help
illustrate the Shariah-compliant ruling of financing through
derivative and option arrangement. Based on the current use of
accepted risk transfer mechanisms in Islamic structured finance,
the paper explore the validity of derivatives and options from an
Islamic legal point of view and summarizes the key objections of
Shariah scholars that challenge the permissibility of derivatives
and options under Islamic law. A shariah analysis of derivatives
and its alternatives has also been presented in this paper.