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Forward contracts: Islamic Salam versus conventional call options.

INTRODUCTION

Like call options, Salam in Islamic finance gives the holder the right to buy the underlying asset by a certain date for a certain price. Salam is more like the European option, because it can be exercised only on the due date using the predetermined exercise price. It should be emphasized that Salam is an Islamic financing contract based on exchange of goods for money (loans) with the intention of securing possible returns within the restrictions of Islamic Law (Sharia). It is also a contractual investment because the intent of both the buyer and seller of the Salam contract is to finance productive activity and to hedge against future losses (Boyle, 1980; Dillman & Harding, 1985; Galai, 1983; Figlewski, 1989). Hedging with Salam is Shariacompliant as reported by the Imam AL Nasafi in his interpretation of the Mudayna Quranic verse as translated by Ibn Abbas who explained the equivalence of Salam and Salaf. Salam is intended to alleviate productive financing to manufacturers, product traders, farmers and other businesses who need liquid capital and are capable of repayment.

The agricultural sector represents the mainstay of most developing economies. But the existence of many uncontrollable factors and the length of agricultural season make it risky for commercial banks to advance agricultural loans. As such, Salam advances become more of a necessity, especially for food production. Salam contracts can be made under the conditions that they are based on legitimate food items and that the Salam principle loan should be paid within the period of time specified in the contract. Also, the Salam loan contract has to allow for a possible profit margin over and above the expected cost of production. Thus, it is preferable for Salam contracts to be issued through specialized financial institutions with well-trained employees in agricultural finance and marketing to underwrite sound and fair contracts that minimize exploitation of farmers.

By way of contrast, call options are issued to hedge against various assets while monitoring their volatility through the volatility index (VIX). Salam contracts are issued to promote economic growth in agriculture and industry for short-term, medium-term or long-term operations and capital investments. Because agricultural production is vulnerable to uncontrollable conditions, the financier may have to create monitoring indexes similar to VIX or equity swaps to mitigate the possibility of production losses. Note that whereas options are essentially paper transactions, Salam loans extending over the short and long term can be deposited with the financing source and gradually finance the agricultural or industrial operations as they come due. As such, Salam bolsters liquidity.

In Salam, full advance payment is made for goods to be delivered on a future date. The seller promises to supply the specific product(s) to the buyer on a specific future date. The buyer provides the full funds in advance. This upfront payment is the key difference between Salam and a conventional call option. In principle, Sharia discourages forward contracts to avoid Riba Nassia (deferred delivery). Per Sharia, the product must physically exist, the seller must have ownership of the product, the product is at least in the seller's control and full payment must be made in advance. Hence, Salam is allowed only under specific conditions: (1) The seller legally possesses the product to be delivered, (2) The contract specifies the date and time of the delivery and (3) The product's quality and quantity has to be specified in the contract. Much like a covered arbitrage, to mitigate risk, Islamic banks often engage in parallel Salam contracts. That is, the bank enters a Salam contract with a seller for a certain product and makes full payment in advance for a specified future delivery. The bank then enters another parallel Salam contract with a purchaser for the same good for a higher price. When the good is delivered to the bank, the bank delivers it to the parallel Salam buyer.

THE MODEL

In terms of the payoff to the trader at maturity, the initial cost of the option is then included in the calculation. If X is the strike price and [S.sub.T] is the final price of the underlying asset, the payoff from a long position in the European call option is: max ([S.sub.T] - X, 0).

Options will be exercised if [S.sub.T] > X and will not be exercised if [S.sub.T] [less than or equal to] X. The payoff to the holder of a short position in the European call option is: -max([S.sub.T] - X, 0) or alternatively, min (X - [S.sub.T], 0). The payoff to the holder of a long position in a European put option is max(X - [S.sub.T], 0) and the payoff from a short position in a European put option is -max (X - [S.sub.T], 0) or min([S.sub.T] - X, 0). The call options can be displayed graphically as:

[FIGURE 1 OMITTED]

[FIGURE 2 OMITTED]

Figures 1 and 2, respectively, show the payoffs for European call options and Salam. For conventional options, if X is the strike price and [S.sub.T] is the final price of the underlying asset, Figure 1 shows that the option will be exercised if [S.sub.T] > X.

The holder of a short position (has sold or written the option) wishes to have a final price higher than the strike price, otherwise he exercises his put option. Likewise, the holder of a long position (buyer of the underlying asset) as depicted in Figure 1, exercises the call option if the final price (ST) is lower than the strike price (X), i.e., [S.sub.T] < X. Thus, conventional call options attempt to shift risks from the buyer to the seller. By contrast, in Salam (Figure 2) there is no stipulation that the exercise price be less than (call option) or greater than (put option) the final price. Salam deliberately forces its buyer and seller to be equally vulnerable to risk taking.

As shown by Hull (2000), Salam and conventional options would have the same probability distribution for the underlying asset at time, T, in two cases: (1) The stock starts at S0 and pays a continuous dividend yield at rate, q and (2) The stock starts at price [S.sub.0][[bar.e].sup.qT] and pays no dividend yield. Thus, the current underlying asset price can be reduced from [S.sub.0] to [S.sub.0][[bar.e].sup.qT] and then value the option or Salam as though the asset pays no dividends. Note that Salam or a call option gives the holder the right to buy the underlying asset for a certain price. The call option can never be worth more than the underlying asset. Therefore, the asset price is an upper bound to the call option price: C [less than or equal to] [S.sub.0].

Comparatively, since risk is distributed between the buyer and the seller, the Salam contract can be worth more or less than the underlying asset: C > [less than or equal to] [S.sub.0].

THE ISSUES

Although Salam is similar to the European call option as a hedge against future price fluctuations, it, unlike options, does not stipulate the exercise price be less than the expected future price. That is, the exercise price is one that the Salam buyer is willing and able to pay. The price can be more, equal to, or less than the actual future price. Thus, in Salam no underwriting costs are incurred. In that sense, Salam encapsulates the idea of spreading risk between the buyer and the seller based on profit and loss contracts. Additionally, the buyer (financier) of a Salam contract is not seeking an interest charge. Rather, a Salam contract is conditioned on future receipts of a good or service. Also, the principle or initial capital does not have to be monetary. It can be in the form of a service such as housing or transportation. Furthermore, if for some reason a delay of delivery of the product exists, there is no premium or discount penalty as in the interest-based system. Besides, Salam is based on profit/loss for the financier with no premiums or discounts expected. Profit and loss are naturally sector-specific and market-determined. Some sectors are more profitable than others. Thus, whereas speculators in financial markets look for higher returns on financial investments, Salam investments are directed toward investing in productive activities in sectors such as agriculture and manufacturing. Also, all Salam stipulations are predetermined and, as such, late delivery is not penalized with interest payments.

Although Salam is a hedge against future price surprises, it is Sharia-compliant as both parties are equally vulnerable to the risk of profit and loss, with no risk premium attached as in the case of call options and interest-based lending. By contrast, in conventional call options, the option buyer protects against future losses. The most the buyer can lose is the premium on the option in case prices rise. Thus, the risk falls more on the option seller.

Salam specializes in financing industrial sectors producing tangible goods, mainly agriculture and manufacturing, unlike call options which are intended to protect against all possible future price changes in financial markets, including credit markets. That is, call options are subject to speculative attacks, whereas Salam is mainly a financing tool subject to the market profit/loss contracts. The purpose of conventional call options is to protect against the loss of money value rather than the finance of the actual productive process.

Importantly, call options are not backed by some evident collateral or sponsorship. The Salam's main collateral is the harvested crop or manufactured product. Salam also allows for sponsorship by a third party to ensure repayment in case of production failures. To be sure, although the predetermined value of future prices of the product underlying the Salam contract may end up being less than the expected market prices, profit (money value) protection is not really the main purpose of a Salam contract. This allows the Salam seller to sell the prospective product at competitive prices that minimize the possibility of loss.

It is noteworthy that the main purpose of Salam is to provide the necessary finance for future production of goods, not to protect the future value of money as in conventional call options. For one thing, the collateral of Salam is the prospective physical product to be harvested or produced in the future or obtained from the market. This special feature of a Salam contract allows for the Salam issuers to organize their business and production, to avoid interest rate payments and to obtain the necessary liquidity to run their business without getting into unnecessary partnerships with others. Moreover, availability of Salam contracts provides continuous support for expanding productive capacity size and capital creation.

Salam contracts can also act as a financial instrument. Islamic banks or investment banks can issue Salam-backed securities (Sukuk). Investors may purchase these Sukuk or choose another set of goods and services. This type of Sukuk is likely to buttress diversification of the bank's portfolio and spur financial deepening. This way, not only do the Salam contracts bolster agricultural and industrial production, but they also expand the Sukuk market as the market for the underlying products expands. As such, Salam and Salam-backed securities are likely to stimulate the production of the necessary agricultural and industrial products and, in the process, boost up economic growth and employment.

Thus, one main difference between Salam contracts and derivatives like call options is that, unlike options, the Salam price is predetermined at the time of the signing of the contract. The Salam seller's profit/loss depends on the future actual price of the underlying good. The Salam seller does not have the option of exercising the option or letting it expire. Thus, in a Salam contract, both the seller and buyer share the profit/loss risk. Furthermore, the underlying good or service in the Salam contract is tangible and specified. In a call option, the options are intangible and the underlying product is tangible, which makes the option contract vulnerable to "Nasa Riba" in the Islamic sense. Islamic finance requires that the products exchanged must be of the same quality and marked-to-market. The only way that the Salam and option contract can be similar is if the product bought and the product sold are one and the same, or alternatively have the same market price.

Although options are intended to protect against future price changes in trade deals, they are likely to encourage speculative behavior and, unlike Salam contracts, are not restricted to productive activity. As such, options might lead to allocative inefficiency. Salam contracts are specialized only in providing the necessary financing of agricultural and industrial activities and expanding productive capacity of the economy.

It is clear that Salam contracts are conducive to productive and allocative efficiency. Call options are mainly intended to protect existing or expected profits and capital gains. This, besides the Salam contracts, gives the Salam investor guarantees of reimbursement of the principle in kind or cash. The Salam is required to deliver the underlying product in a way that ensures the investor the principle amount, irrespective of the actual productivity and level of production. As such, the Salam contractor is more likely to utilize the Salam amount in a way that maximizes his profits. For the investor, it is a win-win situation, because reimbursement of the principle is the minimum to be received.

It is, therefore, abundantly clear that Salam contracts offer diverse ways of setting the contract. The principle can be tangible as a good or intangible as a service or as cash payments. This flexibility of the contract makes Salam a good financial instrument that can help promote productivity and economic growth.

Thus, if Islamic banks and investment companies focus on financing agricultural and industrial projects through Salam contracts, their competitiveness with conventional financial institutions of attracting more efficient projects will be significantly enhanced. This way, conventional institutions will be forced to adopt Islamic financing, but that would depend on the share of national savings acquired by Islamic banks. Furthermore, Salam is more likely to maintain the sustainability of purchasing power and minimize inflation since the contract investor (lender) receives goods at the end of the contract whose prices are likely to adjust themselves to fluctuating market prices. In this regard, Salam helps in protecting against inflation by providing the necessary finance to bolster more supply of the product. Other advantages of Salam include its direct benefits to society by specializing in financing of necessary agricultural and industrial production, increasing productive efficiency and continuous supply of goods, as both the buyer and the seller of Salam try to target prices that match with the expected market price; as output goes up with regular Salam, unemployment declines, among other things.

Salam can be used in support of monetary policy. Ali (1982) argued that if Salam leads to deflation (as a result of higher supply), a moratorium should be imposed on Salam. Others have argued that instead of stopping Salam contracts, they can be slowed down by restricting the conditions for approval of the Salam by the Islamic bank.

CONCLUDING REMARKS

Both Salam and call options are intended to hedge against future price changes. Unlike call options, Salam makes both parties equally vulnerable to the risk of profit and loss. Salam does not attach a risk premium as in the case of a conventional call option. Conventional call options deliberately attempt to shift risk from the buyer (the long) to the seller (the short).

Also, Salam specializes in financially productive industrial sectors (tangible products) and promotes productivity and economic growth. Conventional call options, by contract, protect against all possible future price fluctuations in the broader financial markets, including credit markets. Thus, call options are subject to speculative attacks, whereas Salam is only subject to the normal (fair) changes in the market for tangible industrial products.

Osman Suliman, Millersville University of Pennsylvania

REFERENCES

AL Nasfi, Abdalla Bin Ahmad Bin Mahmoud (undated), Tafseer AL Nasfi, Dar Ihia AL Kutub AL Arabia. Beruit.

Ali, A. M. (1982). AL siyasa al nagdiaf al iqtisad al Islami. MSC Thesis. University of Um Gura, Mecca AL Mukharama.

Arabi, H. (1982). AL alam ila ayan wa arab ila ayan. Munshurat Shirkat Tuhama. Jeddah.

Boyle, P. P., & Emanuel, D. (1980). Discretely adjusted option hedges. Journal of Financial Economics, 8, 259-82.

Dillman, S., & Harding, J. (1985). Life after delta: the gamma factor. Euromoney, 14-17.

Figlewski, S. (1989). Options arbitrage in imperfect markets. Journal of Finance, 44, 1289-1311.

Galai, D. (1983). The components of the return from hedging options against stocks. Journal of Business, 56, 45-54.

Gasim, H. et al. (1979). AlIqtisad al sinai. Dar al kutub lil tiba wa nashr, 31-36.

Hull, J. C. (2000). Options, futures, and other derivatives. Upper Saddle River, NJ: Prentice Hall.

Jamaldin, F. (2012). Islamic finance for dummies. New York: John Wiley and Sons, Inc.

Omar, M. A. H. (1992). Al-Itar AL-Sharie Wa Iqtisadi Wa AL Muhasbi Li Bai AL-Salam. AL-Bank AL-Islami Lil Tanmia. Jeddah.
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Author:Suliman, Osman
Publication:Competition Forum
Date:Jan 1, 2015
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