Derivative assignment PDF

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issues regarding derivatives in asean countries...

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In Malaysia, Kuala Lumpur Commodity Exchange (KLCE) is the first derivative exchange established in 1980. Crude Palm Oil Future (FCPO) contract is the first derivative product that introduced by KLCE. FCPO contract remain as the main product of KLCE even though other commodity contracts such as rubber, tin and cocoa. Although FCPO contracts are more concerned by KLCE compared to other contracts, but they are better substitute contracts traded on foreign exchanges for example in London and Tokyo. Kuala Lumpur Options and Financial Futures Exchange (KLOFFE) introduced a KLCI Stock Index Future (SIF) contract in 1995. It became the second derivative exchange in Asia due to establishment of SIF contract. Commodity and Monetary Exchange of Malaysia (COMMEX) which was the result of merger of KLCE and Malaysian Monetary Exchange (MME) in 1998. Malaysian Derivatives Exchange (MDEX) which was the result of merger of COMMEX and KLOFFE in December 2000 and named as Bursa Malaysia Derivatives Berhad. Nowadays, Bursa Malaysia Derivatives Berhad has 7 commodity derivatives, 3 equity derivatives and 4 financial derivatives. It is establishing to meet the need for financial risk management in Malaysia. It ensures the integrity of the market and the futures and options trading. There is various different platform for the contracts listed in Bursa Malaysia and it required a different licensing arrangement for the broker to trade in the derivative contracts. In World Federation of exchanges’ (WFE) 33 rd Annual Clearing and Derivatives Conference, the chief executive officer (CEO) of Bursa Derivatives K. Sree Kumarsaid that total contracts traded has more than doubled over the years from six million in 2010. The volume is grown substantially especially for FCPO product. Sree said the FCPO and FBM KLCI future (FKLI) products will continue to be the main drivers of Malaysia’s derivative market. Since hedging and risk management are valid economic activities, shariah does not prohibit it. Nevertheless, derivatives can also be used for speculation which is harmful to the financial system and society. There are different opinions from shariah on the subject of financial derivatives. Some of the disagreements for the forbiddance of financial derivatives comprise of the element of gharar (uncertainty) and the gambling element inherent in such instruments (Obaidullah, 1998). Financial institutions and companies use derivatives both for hedging and speculation. For conventional finance, risk management is an essential in strategies business planning

which has led to the use of financial derivatives as a risk management tool. In addition, there is also an element of leverage in financial derivatives trading. There is a chance of great gains or losses from a small capital base due to small movements in the derivatives’ underlying assets. The above mentioned have led to the disagreements since the derivatives show elements of gharar (uncertainty), riba (usury), jahalah (ignorance) and aim for speculative objective, which are inconsistent with shariah principles (Haron, 2014). The Makkah Fiqh Academy (1984) have make a decision to stop its use because the derivative markets do not solve any maslahah (public interest) which is allowed by Islamic law. Other than that, derivative contracts are not real transactions in one sense that the market participants do not transfer any actual underlying asset. Most of the cases, the sellers are selling what they do not own to their counterpart. In addition, the derivative contracts are often sold and resold until maturity date to other parties. Furthermore, the derivative markets serve the taste of large traders at the cost of small traders by a way of market manipulations which in turn lead to market failures. The OIC Jeddah Fiqh Academy (1992) concluded that options are forbidden under Islamic law. This is because option contracts contain some features which including the lack of ownership of the underlying asset, selling of non-existent asset at time of the contract, it involves in gambling and speculation activities by market participants. Besides, to carry out of this options contract is independent its underlying asset and the transfer of these contracts to third parties is not allowed. Usmani (1999) asserts that forward contracts are different from salam contracts since it is more similar to the sale of one debt for another (Bay Al-Kali Bil-Kali) which is forbidden under Islamic law. The forbiddance of Bay Al-Kali Bil-Kali comes from a hadith by the Prophet Muhammad since it can be used to facilitate the trading of debt (Al-Amine, 2008 and Usmani (2010). Forwards and futures contracts are prohibited because it is considered a type of gambling activity which aimed to take advantage of price changes to achieve capital gains (Gupta, 2006). This is due to leverage element for financial derivatives contract, where the participants are required to deposit only small amount of contract value and in return they have potential to gain a huge amount of profit by speculation. Trading volume of futures contracts is often much more than other contracts due to gambling activities in financial derivatives (Bacha, 1999).

The primary challenge about the validity of Islamic derivative is not all jurisdiction may agree some of the shariah contracts to be used. For instance, there are some constraints put on the commodity murabahah or tawarruq in Indonesia. As a result, the derivative market is not well developed in Indonesia. So the challenge is how Islamic derivative structure can be approved across jurisdiction and in term of internationalization of products. The second challenge is to understand the product regulations and market mechanisms. Nowadays, all financial products that is offered in the market is regulated by the regulatory bodies such as Bank Negara Malaysia and Securities Commission. In the global system, there are also global financial regulatory bodies to ensure the regulation of these products. Our understanding of Islamic financial products should be consistent with the product regulations and market mechanisms. The third challenge is due to the small size of Islamic financial institutions. In general, derivatives mean distributing the risk between other institutions. Unfortunately, due to small size of Islamic financial institutions, many of them may encounter difficulties to find counterpart to take up the risk. As a result, most of the Islamic banks still rely on the conventional banks as well as conventional tools due to inability to accept high risk exposures. For example, Maybank Islamic Berhad do derivative with a customer who have exposure of RM 10 millions of currency risk. In order to square off their position, Maybank Islamic Berhad will do the derivative with Maybank Berhad since Maybank Islamic Berhad cannot take that risk due to RM 10 million is a huge amount to them. In addition, Islamic derivative will encounter difficulties since the connection of Islamic banks is not strong....