Permissibility and use of options for hedging purposes in Islamic Finance

• Published in: Thunderbird international business review 2006-05, Vol.48 (3), p.425-443
• Main Authors: Smolarski, Jan, Schapek, Michael, Tahir, Mohammad Iqbal
• Format: Article
• Language: English
• Subjects: Analysis; Finance; Hedging; Ideology; Islam; Islam and economics; Islamic countries; Islamic financing; Islamic law; Options (contracts); Options markets; Put & call options; Risk; Stock options; Studies; Study and teaching
• ISSN: 1096-4762; 1520-6874
• DOI: 10.1002/tie.20103

The debate concerning permissibility and use of options in Islamic finance is ongoing, and the issue is far from settled. Current analyses on this issue appear to focus on taking of unnecessary risks ( gharar), the perceived lack of a physical asset in an options contract, and the possibility of exploitation of the ignorant. To the extent that these factors are involved, options are not permitted under Islamic teachings (the Shariah). In this article, we investigate whether options may be permitted for hedging purposes in Islamic finance. We use equity options as an example in our analysis. After providing a brief overview of options markets, we review the existing literature and critically examine other work such as the religious decrees (fatwas). We also provide two examples, one each of call and put options, to illustrate the managerial issue of use of options for hedging purposes. Our analysis shows that options may be permitted for hedging purposes in Islamic finance as long as the underlying economic activities are themselves permissible (halal) from an Islamic point of view. The analysis also indicates that one of the key issues is related to unnecessary risk taking. The avoidance or reduction of such risks in hedging situations is largely dependent on the settlement and clearing function of the exchanges trading options, which effectively provides a guarantee of delivery. Mutual consent for entering into or canceling contracts and the issue of intangible assets also play a role in determining if options are permissible under the Shariah. We conclude the article by urging experts of Islamic jurisprudence to understand the theory and mechanics of options and use group ijitihad (consensus opinion of Islamic scholars) in conjunction with academics and experts in financial markets and instruments on this vital issue in contemporary finance for the benefit of the Islamic world as well as those trading with the Islamic world. © 2006 Wiley Periodicals, Inc.