As the name suggests, a derivative is a contract which “derives” its value from the performance of an underlying entity such as a stock, a tangible asset, interest rate, etc. The derivative and its mother instrument are traded separately even though they are linked. Common usage of derivatives includes for purposes of hedging to minimize risk for one or both parties in a contract while simultaneously offering a potential for high returns for the other party. They are touted to effectively minimize various risks such as fluctuations in equity, debt, commodity or index prices; changes in foreign exchange market, interest rates, weather conditions (in case of agricultural commodities), etc.

Engaging in trading, by default, incurs risk. The more trading positions are assumed, higher the risk and by extension the potential for reward. Derivatives help both ends of the equation by either reducing the price or assuming the risk with the possibility of a fitting reward. Ironically, this beneficiary characteristic itself has been the crux of its nefarious public perception in recent years. Since derivatives implicitly encourage speculative positions by both counterparties, derivative trading has de-facto relegated to the dark art of betting on the future price of an asset. This speculation stems from the assumption that the other party keen to shield itself from price fluctuation has wrongly forecasted the future market price. This being said, derivatives are not intrinsically evil. In fact, they serve an essential purpose for many companies who seek insurance from price volatility and ensure profits in uncertain conditions. In a nutshell, derivatives are the capital market equivalent of insurance.

Conventional derivatives have come about as a consequence of financial engineering. Reacting to continually complicating needs of the business environment, financial institutions innovated with new and sophisticated products to cope. The age-old rationale that every new innovative product must contribute to the value addition of existing products is also applicable to derivatives.

For example:

i. The evolution from forward to futures has reduced
a. Liquidity risk
b. Counterparty risk
c. Pricing bias

ii. The evolution from futures to options has reduced

a. Lack of flexibility incurred by standardized contracts
b. Inability to profit from conducive price movements
c. Ineffective management of contingent liabilities

It is worth noting that in today’s parlance derivatives is a wide umbrella term which houses a myriad of financial instruments. This term paper, however, is constricted to the most popular ones: forwards, futures, options and swaps.

The discussion in preceding tabs delineate the integral role played by derivatives in managing risk. Risk, in itself, is defined by financial dictionary as the uncertainty associated with any investment. Thus, risk stands for the possibility that the actual return on an investment will differ from its expected return. It is quantified usually as the standard deviation of the return on total investment. Risk management, therefore, entails the techniques employed to mitigate risks associated with investment activities. It encompasses 3 basic steps:

i. Identification of the source of risk
ii. Quantifying the magnitude of risk
iii. Deciding the correct measure to counter risk (both on and off balance sheet)

From an Islamic perspective, we know that “no risk no gain” is a legal principle which means returns are justified by taking risks. Thus, risk management is a tricky subject because of risk-return tradeoff. Since risk and returns are invariably positively correlated, offsetting risk also means diminished profit potential. Thereby, the challenge of risk management techniques lie in insulating the expected returns while reasonably reducing the risks. The measures in risk management, as alluded earlier, include on and off balance sheet techniques.

On balance sheet technique:

To demonstrate this, let’s assume a Malaysian businessman exports palm oil to Japan and is thus exposed to foreign exchange rate risk in MYR-JPY pairing. He has 3 ways of reducing this inherent risk:
a. Quoting Palm Oil only in MYR (home currency strategy)
b. Increasing the quoted price in JPY to compensate for foreign exchange risk (pricing strategy)
c. Enter into a bilateral currency risk sharing agreement (easier said than done)

Pros:
i. Structured in a way which manages the inherent risk
ii. No change needed in operational parameters of a business
iii. Customer convenience
iv. No sacrifice of competitive advantage

Cons:
i. Quoting only in home currency will dissuade foreign buyers since they too are just as weary of foreign exchange fluctuations
ii. Increasing the home currency rate reduces competitive edge

Off Balance sheet techniques

For our hypothetical example above, the same objectives can be achieved by the Malaysian exporter by engaging in the following contracts:

a. Forwards (Short JPY forward contracts)
b. Futures (Short JPY futures contracts)
c. Options (Long JPY put options)
d. Swaps (Enter a swap agreement between JPY paying importer and MYR receiving exporter)

Pros:
i. Convenient to businesses
ii. Flexible in executions
iii. No disturbance caused to customers
iv. Potentially increases competitiveness by allowing to lock-in profits

Despite the soaring popularity of these off-balance sheet techniques in recent years, not all Islamic Jurists have approbated such practice.