Financial Engineering an Islamic Approach Islamic Option Engineering

1
Financial Engineering an Islamic Approach
Islamic Option Engineering

• Shahin Shayan Arani
• President Board Member
• Ezam Investment Company

2
Financial System

• The function of a Financial System is to
  optimally channel financial surpluses in an
  economy towards the direction where financial
  deficits exist
• An important requirement for economic
  development, is the existence of a strong
  Financial System

3
Financial System Subgroups

• Financial Institutions
• Financial Markets
• Financial Instruments
• Financial Rules Regulations
• Financial Control Supervision

4
Financial Institutions

• Depository Institutions
• Insurance Institutions
• Investment Institutions
• Credit Unions
• Investment Banks Broker/Dealers
• Financial Advisory Institutions
• Others (Rating Agencies, Trust Co..)

5
Financial Markets

• Organized Exchanges vs. OTC
• Money Markets vs. Capital Markets
• Primary Markets vs. Secondary Markets

6
Financial Instruments

• Equity Based Instruments (Stocks, Preferred
  Stocks ..)
• Debt Based Instruments (Bonds, Loans .)
• Derivative Based Instruments

7
Financial Rules Regulations

• Regulations in relation to the operations of
  financial institutions
• Regulations in relation to the operations in
  financial markets
• Regulations in relation to taxes
• Regulations in relation to foreign investments
• Other regulations (derivative markets .)

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Financial Control Supervision

• Control Supervision of Financial Institutions
• Depository Institutions
• Insurance Institutions
• Investment Institutions
• Credit Unions
• Investment Banks Broker/Dealers
• Financial Advisory Institutions
• Other Financial Institutions

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Financial Control Supervision

• Control Supervision of Financial Markets
• Money Markets
• Capital Markets
• Derivative Markets
• Currency Markets
• Control Supervision of Taxes
• Control Supervision of Foreign Investments

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Islamic Financial InstrumentsCash Based Contracts
Time
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Islamic Financial InstrumentsCredit Based
Contracts
Time
12
Islamic Financial InstrumentsSalam Based
Contracts
Time
13
Islamic Financial InstrumentsQuestionable
Contracts
Time
14
Islamic Financial InstrumentsForward Futures
Based Contracts
Time
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Derivative Based Instruments

• Derivative Instruments are instruments at which
  their values are derived from the value of an
  underlying physical or financial assets
• Derivative Instruments include
• Forward Contracts Futures Contracts
• Salam Contracts Swap Contracts
• Option Contracts (Call Put) Combination
  Embedded Contracts
• Derivative Instruments are mainly used as risk
  management tools
• Participation in risk and reward is an important
  feature of Islamic finance investments
• Management of risk is an integral part of Islamic
  mode of financing

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Call Options

• Call Options are contracts at which the owner of
  the Call (buyer or long position holder) after
  paying a premium (option premium) to the seller
  of the Call, gains the right but not the
  obligation to buy a given asset with a specific
  quality at a specific price (strike price) at or
  until a specific date (strike date).

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Call Options

• A Call Option is not an obligation
• The seller of a Call Option (short position
  holder) has no obligations to sell the asset
  until the Call is exercised by the Option buyer
• When the Call is exercised the seller is obliged
  to sell the asset at the strike price
• Call Option buyer thinks the asset price will
  rise and the seller thinks the opposite

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Call Options

• A Call Option buyer usually uses this instrument
  to insure or hedge the cost of the needed raw
  materials or the maximum price he/she wants to
  pay for the purchase of an asset
• Call Options are mainly traded in the organized
  exchanges and to some degree in the OTC markets

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Long Call Option
Long Call
Value
Break-Even Price
Underlying Asset Price
20
Short Call Option
Value
Break-Even Price
Short Call
Underlying Asset Price
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Put Options

• Put Options are contracts at which the owner of
  the Put (buyer or long position holder) after
  paying a premium (option premium) to the seller
  of the Put, gains the right but not the
  obligation to sell a given asset with a specific
  quality at a specific price (strike price) at or
  until a specific date (strike date).

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Put Options

• A Put Option is not an obligation
• The seller of a Put Option (Short Position
  holder) has no obligations to buy the asset until
  the Put is exercised by the Option buyer
• When the Put is exercised the seller is obliged
  to buy the asset at the strike price
• Put Option buyer thinks the asset price will fall
  and the seller thinks the opposite

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Put Options

• A Put Option buyer usually uses this instrument
  to insure or hedge the income resulting from the
  sale of an asset or the minimum price he/she
  receives from the sale of an asset
• Put Options are mainly traded in the organized
  exchanges and to some degree in the OTC markets

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Long Put Option
Long Put
Value
Break-Even Price
Underlying Asset Price
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Short Put Option
Break-Even Price
Value
Short Put
Underlying Asset Price
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Immunization StrategyLong Call/Long
PutVolatility Strategy
Long Call
Value
Break-Even Price
Underlying Asset Price
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Immunization StrategyLong Call/Long
PutVolatility Strategy
Long Put
Value
Break-Even Price
Underlying Asset Price
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Immunization StrategyLong Call/Long
PutVolatility Strategy
Long Call
Long Put
Value
Underlying Asset Price
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Immunization StrategyLong Call/Long
PutVolatility Strategy
Long Call
Long Put
Value
Break-Even Cap Price
Break-Even Floor Price
Underlying Asset Price
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Immunization StrategyShort Call/Short
PutStability Strategy
Value
Break-Even Price
Short Call
Underlying Asset Price
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Immunization StrategyShort Call/Short
PutStability Strategy
Break-Even Price
Value
Short Put
Underlying Asset Price
32
Immunization StrategyShort Call/Short
PutStability Strategy
Break-Even Cap Price
Break-Even Floor Price
Value
Short Call
Short Put
Underlying Asset Price
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Features of Option Contracts

• Option Contracts can be used on physical assets
  such as agricultural, oil, gas and petrochemical
  products, precious metals or financial assets
  such as equity based, debt based and even
  derivative based instruments
• By using combinations of Call/Put and Long/Short
  positions, very powerful risk management
  strategies can be implemented

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Features of Option Contracts

• Option Contracts can be used in a combination
  form (embedded options) with other assets or
  contracts
• Most corporations use option contracts alone or
  in a combination form to more efficiently manage
  and control income, costs and risks inherent in
  their operations

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Features of Option Contracts

• Most Financial Institutions enter into Option
  Contracts as a mean to manage their financial
  risk or as intermediaries to provide risk
  management services to other institutions

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Features of Option Contracts

• Option Contracts in Islam are analyzed through
  the Al-Khiyar Contracts
• Islamic contracts such as Al-Khiyar Shart,
  Al-Khiyar Ayb and Al-Khiyar Tadlis or Bai Urbun
  all have option features and can be used for
  specific risk management purposes
• Al-Khiyar contracts in Islam all have combination
  or embedded option features

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Features of Option Contracts

• From an Islamic point of view, the viability of
  stand alone Option Contracts traded in the
  international capital markets, needs to be
  reviewed and analyzed in more detail
• Combination or embedded options in Islam are
  valid forms of contracts and should be used more
  effectively, assuming they satisfy other Islamic
  conditions such as the exclusion of
• Riba - a form of usury
• Gharar - a form of deception in trade or trading
  of risk where asymmetric information and risk
  profile exists in a contract
• Maysir gambling

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Features of Option Contracts

• From an economic point of view, Option Contracts
  are very effective and powerful risk management
  tools
• The ability to hedge, insure or transfer risks
  increase management efficiencies and planning
• When dealing in a very volatile environment, risk
  management tools are essential for managing and
  controlling business risks including price risks
• Applications of Islamic option contracts cover
  Credit Risk Management (credit derivatives),
  Value at Risk Management (VAR), Capital at Risk
  Management (CAR).

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Features of Option Contracts

• In the Islamic Financial System, the analysis,
  review and validity of using stand alone Option
  Contracts must be performed and the applications
  of Combination Options (Synthetic or Embedded)
  through the Al-Khiyar Contracts must be enhanced
  and further emphasized
• Islamic Financial Institutions can play a major
  role in this effort

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ExamplesSynthetic Strategy
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Synthetic StrategyLong Asset/Long Put
(Synthetic Long Call Long Put Long Asset)
Long Put
Synthetic Long Call
Value
Break-Even Price
Long Asset
Underlying Asset Price
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Synthetic StrategyShort Asset/Long Call
(Synthetic Long Put Long Call Short Asset)
Synthetic Long Put
Long Call
Value
Short Asset
Break-Even Price
Underlying Asset Price
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Islamic Financial EngineeringIranian Euro Bond
Offering

• Iranian Risk Rating B2
• Settlement Date July 23rd 2002
• Total Principal Amount 500 Million Euro
• Principal Per Security 1000 Euro
• Final Maturity 5 years
• Coupon Rate 8.75 per year
• Coupon Payments Annual
• Selling Price 99.249
• Yield to Maturity at Pricing Date 8.949 per
  year
• Present Value of the Bond at Pricing Date 992.49
  Euro
• Bond Duration at Pricing Date 4.26
• Possible Embedded Derivatives Combined with the
  Bond
• Issuer Long Call Option
• Issuer Short Put Option