Difference Between Islamic and Conventional Derivatives

Abstract

Financial derivatives have been used by investors to make a profit for centuries. Contracts made under financial derivatives are often risky and based on uncertainty. The use of financial derivatives is increasing with time. More than 20 percent of the total population of the world is made up of Muslims. Because of the risky nature of conventional financial derivatives, many Muslims are reluctant to use them because charging interest and taking risks in business to make a profit is prohibited in Islam. Keeping this issue in mind, the Islamic financial institutions of the world decided to introduce Islamic derivatives which can be used by Muslim investors to make a profit.

There are many differences between the Islamic and conventional financial derivatives because the principles of which they were built are completely different. This report identifies these differences in the literature review and explains the reason why these differences are present. The principles on which these derivatives are built are also discussed. The paper accepts the hypothesis that there is a significant difference present between the two and the claim is supported by primary data which was collected by conducting research identifying the differences.

Introduction

Background

Financial derivatives are risk management structures that are used to manage assets on which financial agreements can be made, such as money, jewelry, property, etc.

Financial derivatives make use of many concepts such as risk factors etc. The definition of financial derivatives thus varies as there are different variable risk factors concerned with financial derivatives. Many financial institutions have proposed definitions for elaboration on financial derivates. Another definition that briefly describes financial derivatives is that financial derivatives are essentially documents or agreements that govern two or more parties in a financial agreement. Financial derivatives normally have an underlying value determinant which may depend on many factors such as currency, stocks, price of gold, silver, and even factors such as the weather condition (Paxford, 2010).

In simpler words, it could be said that financial agreement is determined by the prevalent future values of a given asset which may be shares or currencies; whichever the agreement may be. Financial derivatives must be undertaken when the assessment of risk factors had been done thoroughly. By focusing on different risk factors concerning financial derivatives, it comes to our understanding that financial derivates can be numerous concerning different kinds.

According to some of the investigators, financial derivatives might be denting the equilibrium of market efficiency which would directly affect financial institutions. Different financial institutions have been observed to make use of such financial derivatives to considerably reduce risk factors from their financial transaction within the state or across the border. The negative impact of financial derivatives is that uses interest rate and swapping which could greatly trigger an economic crisis within the state with the potential of affecting the global business market. Overall, if we talk about financial derivatives then it’s true that the amount of financial institutions is increasing by large.

The existence of financial derivatives is as old as the trading history in the world. It could be said based on researches and investigations which have been conducted in the same field that financial derivatives have been positively and stably used in the earlier years of trading. Nowadays different kinds of financial derivatives are being used in either original form or amended in a form of a mixture of combinations of financial derivatives.

The existing kinds of financial derivates have varied. Commonly used kinds of financial derivatives are swaps, futures, and options (Paxford, 2010). Swap is a bilateral type of financial derivative which is undertaken by two parties namely buyer and seller of protection. Swap financial derivatives are controlled by International Swaps and Derivatives Association (IDSA) which can be further amended as per requirements (Das, 2003).

The second most widely kind of financial derivative in the future is undertaken by a buyer and seller when the risk of uncertainty is required to be reduced. This type of financial derivatives helps in the hedging of risks (Redhead, 1996). The third type of financial derivatives is options that allow the owner to use the rights over an asset but do not allow him to buy or sell the asset. Options are financial derivatives that are time-limited (Kwok, 2008).

The use of financial derivatives is diverse because almost every type of business dealings require financial security and thus financial derivative is being used globally in business transactions and dealings. In a broader view, financial derivatives could be understood as agreements that are especially founded for financial dealings provided the dependence is over the future underlying factors. The reason behind the growth of financial derivatives is the increased volatility of assets in the global financial market. Following the integration of domestic financial institutions in international institutions has given rise to the use of financial derivatives.

The global business market needs financial derivatives because, in actuality, financial derivatives are potential enough to transfer the risk of the party to a risk-oriented party. Some investigators have also posed their statement that financial derivatives help increase the number of savings because, through such contracts, it becomes easy to predict the future cost of assets (Wilmott, Howison, & Dewynne, 1997). Hedgers, speculators, and arbitrageurs are those business participants which make use of derivatives the most in the international business market.

The concept of financial derivatives is entirely different in Islamic financial institutions and conventional financial institutions. It is important to study the difference between financial derivative structures in conventional banking and Islamic banking. More investigations and researches have been conducted to evaluate financial derivatives of Islamic banking and conventional banking separately (Courchene & Neave, 1994). Unfortunately, there is a limitation of investigations regarding financial derivatives about both Islamic and conventional types of financial derivatives.

The need for investigation in the context of financial derivatives is because intense globalization is creating major changes in global business. The phenomenon of globalization had evolved the concept of a global financial system that requires financial institutions such as banks, monetary funds, etc. to cross borders (LiPuma & Lee, 2004). In current global banking, more and more investment and agreements are being undertaken between different states. Problems are likely to be occurred when conventional financing institutions invest and interact with Islamic banking based institutions.

The research regarding difference between the financial derivatives of conventional banking and Islamic banking is required. The need of research in the specific field is required for the purpose of educating conventional financial institutions regarding financial derivatives of Islamic banking. By educating with thorough assessment, it can be possible that problems which may occur in the collaboration of dealings between Islamic and conventional banking might be solved. Effective decisions could be taken by financial institutions by understanding the difference between financial derivatives of conventional banking and Islamic banking.

There are considerable differences between Islamic financial derivatives and conventional financial derivatives. The biggest difference between both types of banking is that Islamic financial system is based upon the Shariah Law and conventional financing system is modelled by the English common law (Hunt & Kennedy, 2004). Researchers and investigations which have been conducted in the field of financial derivatives claim that Islamic financial system rejects conventional financial derivatives. There is an ongoing debate in Islamic Banking regarding financial institutions. Some of the Islamic scholars believe that financial derivatives are acceptable while others pose a controversial attack that it is not at all allowed in Islamic Shariah.

Thus it is required that conventional financial institutions evaluate the differences in the Islamic financial system regarding financial derivatives. Informed decisions must be taken in business and finance so that there are less possibility of illegal charges and losses (International Monetary Fund, 2000). The study is helpful for the institutions in carefully implementing their strategies for investment in Islamic Finance based institutions. Through the context of this research report, major differences between conventional financial derivatives and Islamic financial derivatives are being evaluated.

Objective

The objective of the current research is to identify and analyze the differences between Islamic and financial derivatives.

Project Aim

This research report purely aims to provide a thorough different literature that is designed to help conventional financial institutions understand the differences between Islamic and financial derivatives. In this way such financial institutions would be able to undertake informed decisions. It is also predicted that by learning the difference between Islamic and financial derivatives, many financial institutions can get away from the risk of experiencing financial crisis.

The conclusion of the report is being conducted on the basis of the extensive literature being reviewed in this report. Financial derivative is not a new element in finance and there is a great deal of research and investigation that have been carried in the field of financial derivatives. The research aims to provide broader evaluation which is new to the financial instructions. The project aims to assess the differences between Islamic and financial derivatives on the basis of banking elements.

Financial derivatives are now being used in various forms and other factors such as globalization have intensely increased the need of research in the field of financial derivatives. The project aims to provide clear understanding regarding Islamic banking and how financial derivatives are observed in the field of Islamic banking. The study is intended to provide a brief background of the financial laws in Islamic banking with the overview of institutions of Islamic banking. The current study examines the structure of financial derivatives along with different kinds of financial derivatives which are vastly being used in the international business market today. This is more likely to help in concluding differences in Islamic and financial derivatives.

Research Hypotheses

There is a vast distinction between conventional financial derivatives and Islamic derivatives which is mandatory to assess in order to collect evidence regarding the following research hypotheses set out for this study:

• There are many differences between the Islamic and financial derivatives based on interest and debts.
• There is a vast difference between the options contract and Islamic derivatives.
• There are differences between the concept of al-Arbun and conventional financial derivatives and between al-Arbun­ and Islamic derivatives.

Research Questions

The study focus on investigating different areas related to the research topic to find suitable answers for the following research questions:

• How Islamic Shariah distinguishes Islamic and financial derivatives?
• What are the differences between Islamic and financial derivatives in terms of interest rate and debt?
• What are the differences between Islamic and financial derivatives in terms of option contracts?
• What are the differences between Islamic and financial derivates in relation to the concept of Arbun?

Significance of Research

The significance of this research is that it takes a different approach to describe financial derivatives. The difference between this research report and conducted investigations is that it helps in determining the difference between Islamic and financial derivatives. Changing patterns of global banking have given rise to the possibilities of financial crisis due to uninformed decisions that conventional financial institutions may undertake. This research may prove significant for the conventional financial institutions because it helps such institutions in taking informed decisions regarding their business transactions.

This research also provides a thorough understanding of Islamic financing and its elements that are being used in the global business market. The research has been conducted in the context of Islamic banking and the use of financial derivatives in the business transaction with institutions based upon Islamic banking. The research had allowed the research to evaluate the differences in the implication of contacts in conventional banking and Islamic banking. Financial derivative is not a new phenomenon but its nature is increasing day by day thus it is predicted that this current study is determined to be helpful in assessing the contemporary form of financial derivatives. The significance of this research can be observed in the area of lack of literature regarding differences in Islamic and financial derivatives.

Structure of Report

A structure of report have especially been designed in order to conduct a broad and successful research regarding the difference between Islamic and finance derivatives. The structure of the report to be prepared for the research work is summarized as follows

• Chapter 1: Introduction
  • This is the first chapter of the report which provides an introduction to the aim of the report. The highlight of this chapter is basically the context to background of the topics. Furthermore, this chapter also includes research questions, scope and overall idea of the research.
• Chapter 2: Literature Review
  • The in-depth and thorough literature section had been structured in chapter this chapter. The literature review includes and analyzes previous research done in the area of financial derivatives. Literature review includes all the previous investigations which help us understand Islamic banking.
• Chapter 3: Research Methodology
  • Research methodology is a very important chapter of this report because it includes the methodology that has been designed to get the result. Research methodology is considered most important. This chapter covers the relevant research methodologies available and explain the research methodology applied to the current research for collection of data from various sources.
• Chapter 4: Observation and Findings
  • This chapter is basically an observational chapter that closely studies the relation of symbols and variables used in the previous chapter. The chapter presents the findings and observations of the researcher through analysis of primary and secondary data.
• Chapter 5: Conclusion
  • The conclusions derived from the current research are discussed in this chapter. Along with the conclusion, certain recommendations for future researches and projects are also proposed.

Ethical Consideration

It is hereby declared that the research on the subject is being carried out after the approval of my instructor. All the copyright laws during the preparation of the report and is not being plagiarised any material and is also be respected. The participants of the research are only approached for research questionnaires after the written permission of the instructor and if any personal information is obtained from the participants are is kept confidential. All the information acquired during the process is being used for research purposes only. There is no intention of making this research exclamatory.

The researcher takes the responsibility to prepare the report but it is not recommended to use the results or conclusions of this report as a basis for any decision-making process. The distribution of this report is subjected to the condition that the report is not in any way being used for business or other means to be sold, lent out, or circulated commercially without prior approval of the researcher and instructor.

Literature Review

Introduction

Financial Derivatives are often used by investors to make as much profit as possible in a short period. Conventional financial derivatives usually aim at making a profit by charging interest on loans and debts. Both of these practices are unacceptable according to the teachings of Islam and Shariah. Muslims make up almost 20 percent of the total population of the world. Muslims around the world are reluctant to make a deal using conventional financial derivatives because of their use of Interest and their risky nature. This was changed when the Islamic banks and other Islamic financial institutions introduced the Islamic Financial System.

This paper aims at discussing the differences between conventional financial derivatives and Islamic financial derivatives. The chapter begins with a discussion on conventional financial derivatives and hedging. A detailed discussion on different kinds of contracts used as financial derivatives is also included. Then the chapter gives a brief explanation of the market growth of these derivatives. After that, the growth of the Islamic financial system in the market is discussed. The chapter then includes a discussion on the concept on which the Islamic derivatives are built along with an explanation of Islamic financial derivatives. The chapter is concluded with a discussion on the differences between Islamic and Conventional financial derivatives.

Assets and Derivatives

According to the Merriam-Webster dictionary, a derivative is “a substance that can be made from another substance” in the field of chemistry (Merriam Webster, 2010). Financial derivatives are also similar as they as derived from the value of something else (Stulz, 2005). This value may be referred to as an asset and is usually a rate or a financial asset (Stulz, 2005). In simple words, a financial derivative is an asset, the value of which is dependent on the financial value of another asset, which is the underlying (Almgren, 2001). Markus Brunnermeier et.al define a financial derivative as “a contract entered between two parties, in which they agree to exchange payments based on the performance or events relating to one or more underlying assets” (Brunnermeier, et al. 2009 pp.2).

All types of financial assets are operated in the financial markets such as stocks and stock indices, foreign currencies, agricultural products, the energy present in different forms, loan contracts with different interest rates, etc, and the prices of these assets often fluctuate, becoming extremely volatile at times (Almgren 2001 pp.1). This trading of financial assets is usually done by people to either “reduce their exposure to risk” or to get more profit from increased leverage by exposing themselves to extra risk (Ware 2005 pp.12). These financial derivatives help the investors to adjust their exposure to the financial market risk, so they can make more profit with small investments (Almgren, 2001).

Financial Derivatives and Hedging

According to Warren Buffet “derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal” (Buffet 2010 pp.2). Because of the high risk involved in the financial market, investors usually use hedging as a risk management strategy. In hedging, the traders hold positions of the same amount in both, underlying and derivatives markets, which reduces the potential risks by combining the risks (Kolb & Overdahl, 2003). Even though there are many dangers and risks associated with financial derivatives, they have been able to provide much value to the modern economy (Stulz, 2005). The most simple and commonly used derivatives are the following:

Forward or Futures Contract

A forward contract between two parties makes it mandatory for the buyer to purchase the underlying on a particular day in the future at the fixed price while the counterparty is obligated to sell the underlying on that price (Stulz, 2005). Because of the volatility of the financial market, there is no guarantee of what the exchange rate or commodity price will be, even shortly. The forward contract is used by companies to protect themselves from future exchange rate uncertainties (Broll & Echwer, 1996). If the expiration date of the futures contract is T, the price fixed for the asset is K, and the price of the asset in the market is S on the expiration date, then the contractor will make a loss or profit of S – K (Almgren, 2001).

Options

Options may be defined as “a contract the gives the right, but not obligation, to buy…or sell…an asset at a given price…on, or up to, a given future date” (MacKenzie and Millo 2003 pp.111). Following are the types of options based on the buying and selling of an asset: call option; put option; European option; and American option (Qureshi, 1945). Options also allow their holders to adjust their resources and limit their risk at the same time (Stulz, 2005). It provides the contract holder the opportunity to not execute the final transaction, eliminating all chances of loss (Almgren, 2001).

Swaps

The era of swaps began in the 1980s (Chance, 2010). Swaps include contracts that allow the two counterparties to “exchange payment streams, typically a floating interest rate stream for a fixed interest rate stream or a stream in dollars for a stream in marks or yen” (Miller 2010 pp.3).

Background – The Market Growth of Derivatives

The financial market of the world has been through many changes in the past three decades. The history of financial derivatives can be traced back to the 1600s, when standardized contracts were made in the Yodaya rice market in Osaka, Japan, but a more significant event in the history of the financial derivative occurred in 1848 with the creation of the Chicago Board of Trade (Chance, 2010). Shortly after its creation, the Chicago Board of Trade soon became a place for storage of grains and through it, all the grains were moved, sue to its location on Lake Michigan (Gray & Peck, 1981).

The board noticed that it was not able to store all the grain in the season while its services were not fully utilized when the grain season was gone, this also had a great influence on the price of the grain (Chance, 2010). A contract was formed by a group of traders according to which they were to lock the price of the grain and deliver them later while farmers stored the seasonal grains on their farms or a storage facility until they were delivered to the Chicago’s storage facility (Chance, 2010). This contract is the first known kind of futures contract in history.

Sixty years after the merchants first traded grains among themselves, to hedge the risk of price change of grains, Federal Regulation was introduced in these markets, making Commodity Exchange Act (CEA) law in the 1930s (Gensler, 2010). From the 1930s onwards, all the trading contracts and derivatives were strictly monitored by the Federal Regulators to make sure that the trading was fair until 1980 (Gensler, 2010).

The futures contract was also banned in the United States in 1936 and other countries from time to time (Chance, 2010). By 1972, futures contracts were being traded on currencies by the Chicago Mercantile Exchange and the Chicago Board Options Exchange was established in 1973 for the trading of the stock options (Stulz, 2005). By the early 1980s, the swap markets started becoming very popular and discussion began regarding the regulation of swaps as the futures (Gensler, 2010).

The first batch of students who graduated from business schools with exposure to derivatives came out in the 1980s and soon many corporations were “using derivatives to hedge, and in some cases, speculate on the interest rate, exchange rate and commodity risk” (Chance 2010 pp.3).

Since then the use of financial derivatives has been increasing. These derivatives help banks and firms to manage their business effectively at a low cost and minimize the financial risk that they face in the future (Miller, 2010). However, because of the recent events in the world economy, conventional financial derivatives have been criticized and held responsible for the recession and bankruptcies (Paxford, 2010). It is because of this criticism that the attention of the financial elites has shifted to Islamic finance (Paxford, 2010).

Market Growth of Islamic Finance

Islamic finance first emerged in the 1960s with the creation of the Mit Ghamr Saving Project in Egypt (Masmoudi & Belabed, 2010). Even though the concept of Islamic finance has been around for centuries, it wasn’t until the 1970’s that the new Islamic financial system came to the limelight in the business world (Nagaoka, 2010). The first Islamic banks, the Dubai Islamic Bank and Albaraka Banking Group, were founded in the 1970s, but their growth did not accelerate until the 1990s (Ringrow, 2010).

The Islamic finance that is still considered to be in its infancy stage only constitutes one percent of the global capital assets as of the year 2008 (Ringrow, 2010). As of 2010, the worldwide assets have reached USD 260 billion, having 276 existing Islamic financial institutions, and an average growth rate of 23.5 percent (Gassner, 2004). It is believed that the growth of Islamic finance resulted from the rise of the oil industry which accelerated the growth of Islamic finance by at least 10 to 15 percent a year (Solé, 2007).

This was because the increasing oil prices resulted in increased capital, investment in infrastructure and real estate development projects in all the Gulf Cooperation Council (GCC) states including Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and United Arab Emirates (Ringrow, 2010). [T1] This, in turn, increased the demand for Sukuk and Islamic loans which resulted in rapid growth in Islamic financing.

Concept

Islamic finance is very different from the conventional finance. Many concepts of the conventional finance are considered to be haram in finance. Islamic finance maintains ethical standards and moral values in the banking sector, eliminating risks and increasing economic prosperity. Islamic banking is based on the principles and the teachings of Islam and is mainly concerned about conducting contracts (Fiqh Muamalat) in accordance with the moral objectives (Maqasid Shariah), of achieving the well-being of both the parties while avoiding evil and any risk which may harm the concerned parties in the future (Gassner, 2004). The main reason why the investors are attracted to Islamic finance is because it is based on the principles of

small leverage, transparency, and no speculation (Ringrow, 2010). It should be noted that Islamic derivatives are distinct from contemporary financial derivatives because Islamic derivatives are intertwined with faith. Recent developments observe an increasing capitalization on debts through interests. However, Islamic derivatives prohibit this motive and acts for the common good of all the parties. The legal principles and codes of Islam are in accordance with Shariah, which prohibits all the financial institutions from charging interest even on the deposit accounts and it prohibits them from applying conventional hedging and derivative instruments (Ringrow, 2010).

Many countries have now recognized the ability of Islamic finance to become one of the most rapidly growing sectors and its significance in the economic growth of a country (Ibrahim, 2010). The essence of Islamic finance was captured in the following statement made by Anwar Iqbal Qureshi in his book Islam and the Theory of Interest: “Islam prohibits interest but allows profits and partnerships. If the banks, instead of allowing loans to the industry, become its partners, share the loss and profit with it, there is no objection against such banks in the Islamic system” (Qureshi 1945 pp.158-159). It is not possible to understand Islamic finance without developing knowledge of the concepts on which it is based. The principles on which Islamic financial system is built are as follows:

Gharar

Gharar when translated into English simply mean risk. According to the Islamic financial system, contracts that require taking high risks and faces future uncertainty is deemed null or void (Paxford, 2010). Under this law, the forward and the futures contracts are considered to be haram (prohibited by Islam). In fact, most of the financial derivatives involve taking high risks, making them unlawful.

Riba

Riba refers to the interest paid by the borrower to the lending party. According to the Shariah, bonds and bank loans are considered to be unlawful because they are based on interest on money lending. The option contract is therefore deemed unlawful according to the Islamic principles since it involves giving interest in the form of premium which is paid by the client (Paxford, 2010).

Maisir

Even though Islam encourages trade, it prohibits maisir (gambling) (Gassner, 2004). In financial derivatives, many contracts are made on the gambling since neither of the parties have any knowledge of the future, making those contracts haram (Paxford, 2010).

Zakat

Zakat refers to the social tax which made mandatory by the Islamic law. Zakat constitutes of 2.5 per cent of the total wealth of an individual annually and it is farz (mandatory) on all Muslims. Another advantage of Zakat is that it does not allow money to be hoarded which is invested in the society without pulling it out of the fear of an economic downturn (Gassner, 2004).

Islamic Bond Issues (Sukuk)

Sukuk is derived from the Arabic term Sakk which means “check” in English (Masmoudi & Belabed, 2010). Sukuk are Islamic bonds issues under the principles of Islamic Shariah. It involves giving certificate which represents “partial ownership in certain assets accepted by Shariah” (Gassner 2004 pp.2). What differentiates Sukuk from ordinary bonds is that it is backed by assets, guarantee stable income, are tradable, and are only issued when the assets for which it is giving ownership exists on the “balance sheet of the government, the monitory authority, the corporate body, banking or financial institution or any entity which wants to mobilize the financial resources” (Tariq 2004 pp.20).

According to the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) Shariah standards of Sukuk, fourteen different types of Sukuk can be issued under the Islamic financial system (Sukor, Muhamad, & Gunawa, 2008). These Sukuk include Pure Ijarah Sukuk, Hybrid/Pooled Sukuk, Variable Rate Redeemable Sukuk, Embedded Sukuk, etc (Tariq, 2004). These bonds are very successful in the GCC states and in Malaysia, where they are used very frequently and their success is now attracting the attention of many non-Islamic issuers (Masmoudi & Belabed, 2010).

There has been a significant growth in the Sukuk markets and it is estimated that $70 billion Sukuk bonds have been issues globally, with Bahrain and Dubai holding a large number of buyers (Ainley, Mashayekhi, Hicks, Rahman, & Ravalia, 2007). Sukuk can be issued in many ways based on different Islamic contracts such as Mudarabah, Murabahah, Musharakah, and Ijarah (Sukor, Muhamad, & Gunawa, 2008).

Islamic Financial Derivatives

According to the principle of Zakat, any profits made should be for the interest of the whole community, though contemporary financial derivatives are exclusive to the benefit of the party and do not go further to explain how the profits should be used. The contemporary financial derivatives are developed to make a profit because there is the possibility of doing so. Under Islamic derivatives, this could be equated to hoarding which is considered to be Haram. Under Islamic derivatives, this money should be used for community developments like building a factory, school, hospital, or such like community development structures (Kolb & Overdahl, 2003).

However, the liberty of contemporary financial derivatives in this regard is considered selfish and sinful. There have however been arguments that the profits made under contemporary financial derivatives can be used to benefit the community but Islamic derivatives still cannot agree with this opinion because the profits can be easily transferred to a third party which would essentially translate to Gharar, which is prohibited in Islam. Islamic financial derivatives are completely different from conventional financial derivatives because according to the Islamic Shariah, conventional financial derivatives are considered to be unlawful.

Since Maisir (gambling), Gharar (uncertainty), and Riba (interest) are prohibited in Islam, many conventional derivates automatically get eliminated since most of them include taking risks and interests. Even though Islam prohibits taking an interest, it encourages profit allowing partnership contracts in Islamic finance (Tariq, 2004). It is also important to take risks to progress in the economies and certain situations; it is not possible to avoid taking risks. The Islamic financial system also includes principles according to which risk management can be handled and trade can be done by Shariah. The two main types of partnership contracts that are allowed by Islam include Mudarabah and Musharakah. In musharakah contracts, the concerned parties make some investments and a separate musharakah muntanqisah is set for each investment (Paxford, 2010).

Then these parties enter into the Mudarabah contract with Islamic financial institutions willing to finance each musharakah and when all the Mudarabah agreements are satisfied, these parties then buy shares from other partners under musharakah (Paxford, 2010).

The Murabaha can be applied in several ways but is mostly used as a tool of financing arrangements such as working capital financing and receivables, while the Musharakah structure is usually used for mortgages and the development of financing (Schoon 2007 pp.21). Murabaha has been the most popular contract used to replace short-term loans on interest in the Islamic financial system since the 1970s (Nagaoka, 2010). These differences are also identified by the Standard Charted bank, which is the first international foreign bank that offered Islamic banking in 1992 and established its global headquarters in Dubai in 2003 (Standard Charted Bank, 2010).

Options Contract

In conventional financial banking, the options contract is an important “tool of financial engineering” which is widely used by investors (Obaidullah 1998 pp.73). The conventional option contract provides the shareholders their right without posing any obligations on them by allowing them to buy or sell a specific price during or at the expiration of the given period (MacKenzie & Millo, 2003). The conventional option contract is based on Gharar, which is prohibited by the Islamic Financial System. The option contract involves taking a lot of risks since neither of the parties knows what the future may hold. Uncertainty is like an options contract since both call and put options are mutually exclusive, rewarding one party, increasing Gharar in the contract (Tariq, 2004).

Under the Islamic faith, brotherhood is highly advocated for and the empowerment of everyone in the society and is given much emphasis. Charging interest on loans is therefore excluded from Islamic derivatives. This is mainly because a loan is taken when a person does not have enough resources, charging interest on loans will put the person, who is already running out of resources, in more debt, which will increase with time, making it more difficult to pay it back. Islamic derivatives keep in mind the fact that one party can easily make a windfall at the expense of another. The gain in derivatives is purely a matter of chance and is influenced by Maisir and Qamar.

The option contract is an example of Maisir and Qamar, especially enforced in contemporary financial derivatives. The option contract is based on future profitability; for example through the appreciation of a currency concerning asset purchase. Under Islamic derivatives, options contracts are prohibited and are considered haram (Iqbal, 2010). The reasoning behind this prohibition is that option contracts are undertaken based on possibility and chance while no meaningful commodity is transferred between the two parties. Buyers, therefore, base their decisions on future possibilities and may even end up not affecting the transaction; especially when the odds are against them.

The options contracts are said to possess the elements of matter. It is completely dependent on chance and luck because it encourages making a profit without putting in any arduous effort or labor. It is this attitude in Islam that is looked down upon. While the Islamic Financial System eliminates riba, gharar, Qamar, and Maisie making all the conventional financial derivatives unlawful, it understands the need for taking risks to progress and provides hedging options that are by the teachings of Islam and Shariah. These two options are known as Arbun and Bai Salam.

The concept of Arbun

The concept of al-Arbun in the Islamic Financial System is close to the option contract in the conventional financial system. The glossary on Islamic banking provides the following definition of album: “Down payment; a non-refundable deposit paid by a buyer retaining a right to confirm or cancel the sale”. It is similar to the American option in the sense that an agreement is made between the buyer and seller on the price and date, but if the buyer decides to cancel the agreement, he loses his deposit (Ayub, 2010).

The American option contract allows the execution of the agreement anytime before the expiration date, where as the European option contract allows execution on the given date only (Gassner, 2004). In a contract made under al-arbun, if the buyer does not revoke the agreement and receives the asset, then the down payment which was given in the beginning of the contract, become a part of the total agreed price which is to be paid for the asset (Schoon, 2007).

The concept of arbun is very similar to the concept of call option in the conventional financial system, and its validity is much debated. Many schools of thoughts argue that the use of arbun is unlawful because the arising uncertainty from the contract for the seller amounts to gharar (Tariq, 2004). However, al-arbun cannot be used for unspecified assets because it “hinders its possibility to fully replicate the functions of conventional contracts that are on unspecified underlying assets” (Tariq 2004 pp.65).

On the other hand, the use of arbun is allowed with an approach that is more liberal allowing the use of revocation options [T1] provided by the Hanbali School of Saudi Arabia [T2] (Gassner, 2004). The concept is still criticized by the other three schools of law, on the basis of the sayings of the Prophet which dismiss down payment i.e. arbun (Gassner, 2004).

Interest and Debt

There is a wide difference between the Islamic derivatives and conventional financial derivatives. All the conventional derivatives and dependent on making profit from interest and uncertainty, both which are considered to be haram according to the Shariah. Financial derivatives include forward or futures contract, swaps, option contract, etc. All of these derivatives include gambling since contracts made under these derivatives are based on future, of which the counterparties have no knowledge, which increases the uncertainty and risk.

The principles of Islamic financial institutions clearly state that Riba, Gharar, Qimar, and Maisir are unlawful and should be avoided. Riba may be defined as “any contractual increment in a loan or debt due to the time element” (Kahf 2006 pp.5). This definition exactly fits the definition of interest, which is often charged on loans and debt by the conventional banking system. Under Islamic derivatives, the provision of interests (riba) is prohibited because it seeks to empower one party at the expense of the other.

The main difference between conventional interest financing and Islamic financing is that the increment on loans is increased with time increasing the debt and that is exactly why it is prohibited in Islamic finance (Kahf, 2006). Many individuals wanted to relieve themselves from riba, which is why there was a rapid growth in the Islamic financial industry since the Islamic banks and other financial institutions made it clear that the riba in the conventional banking is unlawful and established alternative contracts (Usmani, 2010).

Islamic financial institutions provide derivatives which are equity based and not interest based, such as Mudarabah and Musharakah. In these contracts, the debt which is to be returned is fixed which is in accordance with the Shariah. Other derivatives too are being designed which are free of interest and debt. The main aim of conventional financial derivatives is to get as much profit as possible, without any restrictions, using interest and debt while Islamic derivatives not just aim to maximize interest but promotes risk sharing along with it (Rahman, 2007).

Another major difference between the conventional and Islamic derivatives is that in conventional derivatives, the relationship between the parties is that of a creditor and debtors, while under Islamic derivatives, the relationship of the parties concerned is like that of investor and trader; buy and seller; which in turn increases the feasibility of the agreements (Rahman, 2007).

Research Methodology

Introduction

Today research is impossible without a research methodology. Research methodology defines the steps that ought to be involved while solving the problem stated in the research. The methodology contains a variety of techniques that a researcher adopts to come up with an authentic conclusion. A research methodology consists of elements such as studying the problem in dept, gathering data, analyzing and experimenting on it until a conclusion or a numerical hypothesis is derived out of it (Kumar, 2008).

The data collected forms the basis of every research methodology. It can be either in primary form or secondary form depending upon the problem highlighted in the research. Also, the type and amount of data collected again depend upon the type of research being done (Blaxter, 2006).

Often research methods are confused with research methodology. They both are different. Research methods are a part of research methodology. The researcher needs to know this difference before he starts with the research. Also, the researcher should have sound knowledge of all the techniques of research methodology, only then he will be able to solve the problem of the research (Kumar, 2008).

Research Methodology Approaches

Today researcher has the option to choose from many types of research methodologies still it has been observed that quantitative and qualitative are the most used research methodologies. Both the methodologies over time have proved their worth by giving out valuable conclusions and valid hypotheses. In the initial steps, these research methodologies are carried out in similar patterns but when it concludes both the methodologies apply their own set of strategies. Quantitative research methodology gives the conclusion in numerical hypothesis while qualitative research methodology is based upon researcher’s ideas (Panneerselvam, 2004).

Quantitative Research

Quantitative research is conducted in a highly systematic manner to create a valid conclusion. The best aspect of quantitative research is that it creates a relationship between two elements and supports its phenomenon through numerical analysis. The concrete element of quantitative research is the statistical and mathematical models which are used to create theories leading to the hypothesis. Quantitative research is most used in physics and other similar subjects which are supported by mathematical derivatives and other statistical theories (Hunter & Leahey, 2008).

Quantitative research can be only carried out by the researcher who has full and complete knowledge of statistical and mathematical data. The procedure of carrying out a research in quantitative data is very simple. The first step is to recognize the problem, identify relevant means to collect data that will help in solving the problem, collect data and finally analyze it till the researcher derives a conclusion (Creswell, 2009).

Qualitative Research

Qualitative research is used when human behavior is analyzed in any particular event or situation. It is also used when analyses of an organization or a market structure is done. Qualitative research is also known for answering the decision making questions what, why, when, where and how quite well (Denzin & Lincoln, 2005).

The conclusions of qualitative research are not numerically supported in fact they are based upon personal ideas and opinions of the researcher. They are biased in nature often leading to further debate and analyses (Marshall & Rossman, 1998).

Qualitative research is further divided into two kinds

Inductive approach

Inductive approach is best used for research which is based upon unorganized data. The elements of inductive approach make it possible for the researcher to identify the variables regardless of the size of data. Manage it, analyze it and then extract a valid conclusion from it (Thomas, 2003).

Deductive approach

When conclusion derived from inductive approach is further analysed or is used in a new research then deductive approach is used. Deductive approach is very concise in nature and does not use any more data apart from what is already present in inductive approach. Another name for deductive approach is water approach because of the highly systematic manner in which it works (McMurray, Pace, & Scott, 2004).

Kinds of Data used in Research Methodology

Every research methodology is either based upon secondary data or primary data.

Primary Data

Primary data is raw data which has never been gathered before. The major characteristic of primary data is that once it is collected it is put into immediate use (Patzer, 1995). There are several ways to collect primary data such as interviews, mailed questionnaires, semi structured interviews, structured interviews, case studies and social networks (Singh & Bajpai, 2007).

Secondary Data

When primary data is brought into use again it is called secondary data. Primary data takes shape of secondary data when all the irrelevant data is eradicated. It is more like a sample which consists of data relevant to research only. Means of collecting secondary data are not as vast as primary data but there is rarely any need for more data apart from what found in primary data. Secondary data can be collected from resource inventories, budgets, social indicators and economic indicators (Patzer, 1995).

Adopted research methodology

The research methodology adopted in this paper is qualitative based because it will be studying the differences existing between Islamic and conventional financial derivatives. The research methodology uses both primary and secondary sources for collecting data. Also the research has taken the basis laid in literature review forward building a stronger research which ends with a logical conclusion based upon the views of the researcher. Literature review is a very important part of this research; it will tell the reader about the ideas that have been created keeping the main theme of the topic in view. The literature review has put together several elements of research together that has never been discussed before. These elements have been further defined in the research by using primary data as the base.

Primary Research

Utilizing several means of collecting primary data, different organizations which use both contemporary financial derivatives and Islamic derivatives have been targeted and the change in their outcome after the adoption of Islamic ways of banking has been analyzed.

The primary sources also sketch customer’s reaction to the changing current trends.

Also, the research has made more use of inductive approach starting with collection of data through survey questionnaires and then analyzing them to come to a conclusion as to what is the basic difference between the two methods and which one is better. Amongst many means of collecting primary data survey questionnaires were opted as the best resource.

Primary Research Source – Survey questionnaire

Written survey questionnaires turned out to be very useful for this research as they were based upon standardized questions which led to the generation of more objective responses. In a typical survey research a sample of respondents from a huge population is selected and a standardized questionnaire is given to them. The questionnaires can be in a variety of types from online questionnaires to face to face interviews and telephone interviews. Initially, surveys were only done in the fields of psychology and anthropology however today the field of survey has much expanded and is also used to study the changes in organizational life and working patterns (Writing at CSU, 2010).

The advantages of survey questionnaires are several due to which this particular method was chosen. Survey questionnaire is not only cheap but it can also be distributed in a wide geographical area through emails and faxes. The best aspect of survey questionnaires is that respondents feel free to reply to questions which might otherwise become a source of embarrassment for them (Writing at CSU, 2010).

Structuring of Questionnaire

The usage of both open ended and closed ended questions has been done in the survey to extract more useful information from the representatives. The questions have been designed to meet the objective of the research which is to identify the difference between Islamic financial derivatives and conventional financial derivatives. Firstly, categorical close ended questions have been used by asking a question and then giving limited options for the respondent to choose from. Once the respondent answers then he is asked to explain as to why he chose the particular option, which brings the element of open ended questions in the survey (Knowledge Base, 2005).

The questions are also demographic based as they majorly concentrate on attaining opinions and views of representatives working in Al-Rajhi Bank of Saudi Arabia or Saudi Hollandi Bank of Saudi Arabia regarding the differences existing between interest and debt, options of contract and concept of Al- Arbun. Different aspects of both the banking systems have been focused upon to get a more clear idea about them such as through the question if conventional financial derivatives make profit through interest it has been aimed to find out about manner in which conventional banking system operates. The later questions have concentrated more on Islamic financial derivatives by discussing the interest levied on Shariah and contract options available.

Sampling

Webster in 1985 defined a sample as a part of a population that can give information about the entire population. When people are selected from a large population they are called respondents. Sampling on the other hand is a procedure adopted in which a sample is taken and examined to arrive to achieve the main objective of the research (Mugo, 2010).

This research mainly revolves around identifying the differences that lie between conventional and Islamic financial derivates to arrive at a conclusion that is better than the two. The two representatives chosen are legal officers and representatives of Al-Rajhi Bank of Saudi Arabia or Saudi Hollandi Bank, also located in Saudi Arabia. Both of these banks offer Islamic as well as conventional banking to their customers, which became the core reason for choosing these two banks. The participants chosen hold perfect information on both the banking systems and therefore are in the right position to point out the important differences allowing the researcher to arrive at accurate reasoning and conclusion.

Limitations

The main limitation of qualitative research is the specific skills needed to conduct proper research. The researcher or whoever is conducting the interviews or analyzing the survey questionnaire should have good observational skills so he can extract the right information from the collected data. If the investigator is unable to observe, analyze and interpret properly the entire research goes wrong. Another disadvantage of qualitative research is that it largely depends upon the data collected. So if the resources giving the data are dishonest it cripples the main objectivity of the research. The selection of respondents should be done very carefully. This is why for this research those representatives were chosen that had perfect knowledge of both conventional and Islamic banking derivatives (Writing at CSU, 2010).

Findings and Analysis

Introduction

This chapter includes the findings of the primary research in detail. The chapter begins with an explanation of the demographic questions and subject findings. The differences between the Islamic and conventional financial derivatives are then discussed in detail according to the findings. The explanation of answers to each question is given. First, the questions related to the differences in interest and debts are discussed followed by differences in options contract and al-Arbun. The analysis of the result is given at the end of the chapter.

Primary Research Findings

Demographic Questions

The individuals who were asked to fill the questionnaire either belonged to Al-Rajhi Bank of Saudi Arabia or Saudi Hollandi Bank, also located in Saudi Arabia. Both these banks provide Islamic as well as conventional banking to their customers. All of the participants had prior knowledge of Islamic and conventional financial derivatives and are qualified to point out the differences between the two banking systems.

Subject Findings

The questionnaire was designed to find out the differences between Islamic and conventional derivatives. The questionnaire revealed that there is a vast difference between the two. The differences were to be established especially about interest and debt, options contract, and concept of al-around. The findings of the research are divided into the following three parts accordingly:

Differences in Interest and Debt

Do you think that most of the conventional financial derivatives rely on making a profit through charging interest?

It was found from the questionnaire that most financial derivatives do rely on making a profit by charging interest. Most of the participants pointed out in the explanation of question 5 that options contract, forward or futures contract, and swaps, which are the most widely used financial derivatives, were highly dependent on interest rates. These answers were similar to the literature review which also revealed the high use of interest in financial derivatives. One participant also revealed that without charging interest in the contracts made using conventional financial derivatives it was not possible to make a profit at all.

Is it allowed to make a profit using interest by Shariah?

The participants agreed that it was not allowed to charge interest according to the teachings of Islam and Shariah. The participants explained that even though it was haram to charge interest on loans or debt in Islam, trading and exchange of goods was encouraged. The participants also explained why charging interest was considered to be unlawful in Islam. The answers revealed that interest is prohibited to improve the overall growth of the economy and to prevent hoarding of money. One participant suggested that interest increased hoarding of money which is one of the main reasons why recessions occur. Some participants also suggested that contracts made under Islamic derivatives were more fruitful because interest rates did not increase with time.

Options Contract

Are the options contract made for all kinds of assets, specified or unspecified?

All of the participants agreed that options contracts could be made using all kinds of assets whether they were specified or unspecified. Some of the participants mentioned that the contract was made on an underlying asset, the price of which was difficult to determine, such as stock prices, which was often used to make an options contract. Two participants also expressed that this was not always the case and that sometimes tangible assets were also used at times, but the use of unspecified assets dominated the use of tangible assets.

Is it allowed to make contracts on unspecified assets in Islam?

It was observed that all of the participants believed that it was not allowed to make contracts on unspecified assets. They revealed that Islamic derivatives only allowed the use of tangible assets and the contract was deemed unlawful otherwise. All the participants confirmed that the use of unspecified assets was haram according to the Shariah.

Is the holder of the options contract obligated to carry out the agreement according to the specified terms?

The participants explained that the contract holders of the options contract were not obligated to carry out the agreement according to the specified terms but had the right to proceed. The participants revealed that the options contract can be canceled at any time by the holder without giving any reason. Two of the participants pointed out that the options contract gave all the rights to the contract holder and put the seller at a lot of risks.

Is there high risk and uncertainty involved in the options contract?

It was observed that most of the participants agreed that there was high risk and uncertainty involved in the options contract because it gave the contract holder the right to terminate the contract and was not obligated to fully comply with the contract. The participants explained that it was this fact which increased risk and uncertainty for the counterparty that had to put up with the decision of the holder. The seller in turn can face loss while the holder did not have to risk anything.

Are the options contract allowed in Islam?

All the participants agreed that the options contract was not allowed according to Shariah. Different reasons were given for this by different individuals. Most of the participants said that the options contract was haram because of its risky nature. They elaborated that Shariah did not allow contracts that involved high risk and uncertainty since transparency is encouraged in Islam and according to Shariah all the rights and obligations should be settled before entering the contract. The options contract, on the other hand, is made under uncertain conditions and neither of the parties knows about the future of the contract that they are getting into. One of the participants expressed that the options contract was unfair to the seller.

Some of the participants said that options contracts were unlawful because of the unspecified underlying assets. The answers revealed that the options contract was made on all kinds of underlying assets such as stock, money, papers, etc, and even when the assets have not been specified the contracts remained intact.

The participants agreed that making contracts on unspecified assets was prohibited in Islam, which made the options contract haram.

Another reason why the options contract was considered unlawful was that of risk-sharing. Participants believed that there was no way to share the risk between the parties entering the options contract. They said that it puts one party at risk while the other party makes a profit without taking a risk at all. This, according to them was not allowed by the Shariah as Islam encouraged the sharing of risks and losses by the parties and sought to benefit the whole of humankind and not just one person. One participant expressed that financial motives were the basis for the options contract which is looked down upon by Shariah.

According to the results both interest and uncertainty are looked down upon in Islam which made options contract very different from Islamic derivatives since it included risk and interest, both of which are prohibited in Islam. The participants from both the banks expressed that they believe minimizing risk and banning interest increased transparency in the banking system which was much appreciated by the customers.

Concept of al-Arbun

Are options contracts similar to the concept of Al-Arbun?

While answering this question, the participants agreed that there were some similarities between the options contract and the concept of al-around. According to most of the answers, the concept of al-Arbun is similar to that of options contracts because they both allowed the holders to revoke the contract on or before the expiration date. Participants expressed that the concept of al-Arbun­ was close to the American and European options contract in particular.

How are the contracts made under al-Arbun different from conventional contracts?

Several differences were pointed out in the answer to this question. The most prominent of these differences was that of down-payment. The participants explained the contracts made under al-Arbun required the holder to give the down-payment to the seller when the contract was entered. This down-payment was then the property of the seller and was non-refundable. This reduced the risk for the seller. If the holder decided to revoke the contract in the future, the seller is not expected to return the down payment. The participants expressed that this was one feature of al-Arbun which differentiates it from conventional contracts.

Another difference point out was that of underlying assets. The participants explained that the contract of al-Arbun could only be made on tangible assets and unspecific assets such as stock could not be used. One participant also said that the risk-sharing nature of the contract made it different from the optional contracts. The participant expressed that because of the down-payment, the seller was not exposed to risk because it guaranteed a certain amount of money to the seller.

Is the concept of al-Arbun by Shariah?

This question was given to explore the differences between the concept of al-Arbun and Shariah. However, the participants were not able to provide any specific answer to this question and remained confused about its authenticity. One of the four participants explained that the concept of al-Arbun was by Shariah because it increased risk sharing and did not allow contracts to be made on unspecified assets. Another participant believed that the concept was haram because down-payment was not allowed in Islam and was against the teaching of the Prophet. He explained that because of the doubtful nature of the contract, three schools of thought did not allow the contract and it was accepted by only one out of four schools of thought.

The other two participants remained confused about its validity. They explained that even though the concept of al-Arbun was close to the options contract it did increase sharing of risk which is encouraged by Islam. They also expressed that since the contract was based on tangible assets only, it was not wrong. They said that even though down-payment is looked down upon in Islam, the concept is accepted by the Hanbali school of thought. These two participants could not decide whether the concept of al-Arbun was acceptable or not and remained unsure of what they believed.

Findings Analysis

The purpose of the questionnaire was to find out the differences between the Islamic and financial derivatives about interest and debt, options contract, and al-Arbun. The results confirm these differences. The answers to the first two questions verify that there are differences between the Islamic and conventional derivatives based on interest and debt. The following objectives were to be achieved by this research:

To establish the difference between Islamic derivatives and contemporary financial derivatives about option contracts

The results confirm that there is a high use of interest and debt in the conventional derivatives whereas interest is prohibited in Islam. As mentioned in the literature review, any kind of increment on loans with increasing time is prohibited in Islam (Kahf, 2006). The participants confirmed that interest on loans and debts is used to make a profit by the banks. The participants also mentioned that charging interest is considered to be unlawful in Islam. The findings are consistent with the literature review according to which interest on loans and debts is haram (Usmani, 2010). As the previous studies confirm that interest is highly used by banking systems and that financial derivatives involve a high amount of risk (Obaidullah, 1998), it can be concluded that most of the financial derivatives are considered unlawful by the Shariah.

To investigate the differences between Islamic derivatives and contemporary financial derivatives about interest and debts

The results show that there is a vast difference between the options contract and Islamic derivatives. The participants pointed out several reasons in the questionnaire. These differences included the ambiguity of the underlying assets, charging interest, and risk-sharing. These three differences are also mentioned in the literature review. Interest (Riba), and Uncertainty (Gharar), as mentioned in the literature review, are strictly prohibited according to Shariah (Paxford, 2010).

The answers of the participants are similar to the previous studies mentioned in the literature review. It is mentioned in the literature review that Islamic derivatives promote sharing risks and discourage charging interest (Rahman, 2007). The primary research findings support the literature review and prove that the options contract is completely against the teachings of Islam and Shariah.

To establish the difference between Islamic derivatives and contemporary financial derivatives about the concept of Arbun

The participants remained confused about the issue of al-Arbun and could not decide whether it was by the principles of Shariah or not. Their answers revealed that they did say a similarity between the options contract and al-Arbun since both of them allowed the holder to revoke the contract on or before the expiration date of the contract. It is also mentioned in the literature review that al-Arbun is similar to the American options contract (Ayub, 2010).

The participants also pointed out the differences between al-Arbun and conventional financial derivatives, such as risk-sharing and tangible assets. This is consistent with the literature review which also mentions that al-Arbun only allows contracts to be made using tangible assets (Tariq, 2004). The differences of opinion came to the surface when the answers to the last question were analyzed, which was designed to find out whether people accepted al-Arbun as an Islamic derivative or not. One of the participants agreed and one did not. The other two could not reach any conclusion. These differences are also mentioned in the literature review which discusses the issue in detail. It is mentioned in the literature review that three out of four schools of thought did not accept the use of al-Arbun (Gassner, 2004).

Conclusion

The objective of the current research is to identify and analyze the differences between Islamic and financial derivatives. The research carried out in this report suggests that there are many differences between Islamic and conventional financial derivatives based on interest and debt which cannot be bridged. The research also suggests that there are differences between al-Arbun and conventional financial derivatives on the matter of tangible assets and risk-sharing and between al-Arbun and Islamic derivatives on down-payment.

The findings of the research are in confirmation with the literature review which identifies these differences between Islamic and conventional derivatives in detail, supported by several previous studies conducted on a similar topic. The research carried out in this report accepts the following three hypotheses based on the reasoning provided for each hypothesis.

• H0: There are many differences between Islamic and financial derivatives based on interest and debts.

This hypothesis is accepted because the research confirmed that all of the conventional financial derivatives involve one or more of the following: Interest (Riba); Uncertainty (Gharar); Gambling (Maisir); and Speculation (Qamar). The participants also confirmed that all of these three ways of making a profit are prohibited according to Shariah. All the participants agreed that making a profit by charging interest on loans and debts was looked down upon in Islam proving that there are many differences between Islamic and financial derivatives on interest and debts. This is consistent with a previous study carried out by Usmani (2010), Obaidullah (1998), and Kahf (2006).

• H1: There is a vast difference between the options contract and Islamic derivatives.

This hypothesis stands verified because several differences between an options contract and Islamic derivatives were identified while conducting the research. The differences identified in the research are mainly on interest, assets, and sharing of risk and losses. The research confirmed that the concept on which the options contract was based is completely against the Shariah which makes its use haram (unlawful). This proves the hypothesis that there is a vast difference between the options contract and Islamic derivatives and these differences are also identified by all the Islamic financial institutions (Gassner, 2004).

• H2: There are differences between the concept of al-Arbun and conventional financial derivatives and between al-Arbun­ and Islamic derivatives.

The research proves that there are many differences between al-Arbun and conventional and financial derivatives. The differences between al-Arbun and conventional financial derivatives are present on the matter of risk-sharing and tangible assets while the differences between al-Arbun and Islamic derivatives are present on the concept of down-payment which is considered to be haram according to the Shariah. It was also found that differences of opinion among the people were also present regarding the authenticity of al-Arbun just like these differences were present between different Islamic schools of thought.

Recommendations for Future Studies

This report contributes to the existing literature review on the topic. The nature of this report is more theoretical and discusses differences between Islamic and conventional financial derivatives from an ethical point of view. It is suggested that if any future research is to be conducted on the same topic, it could extend to gathering market data to measure the market performance of both Islamic and conventional derivatives offered by banks. If data is available on the differences in principles, implementation, and market performance of both conventional and Islamic derivatives, a better comparison can be made between the two.

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