ETHICAL OPTIONS IN ISLAMIC FINANCE
MOHAMAD OBAIDULLAH
An option implies a right without obligation. A conventional financial option is often traded as a separate contract in itself. The contract involves a right to purchase or sell an underlying asset at a stipulated price within or at the end of a specified time period. Transactions in options take place through organised markets. The underlying assets may be in the nature of various commodities, or financial assets, such as stocks, bonds, currencies, or various market indices.
At times financial options are not contracts in themselves, but embedded in complex products of financial engineering. In view of the massive growth of organised markets in options, as well as the ever-increasing range of new and complex financial contracts, this study undertakes an Islamic evaluation of such products and also examines their role in the Islamic system of financial contracting.
Part I of this study identifies the norms of Islamic ethics generally applicable to financial contracts and undertakes an assessment of various option-based financial contracts that are created and transacted in the conventional markets in the light of these norms.
Part 2 examines the notion of options (al-Khiyar) forming part of the theory of contracting in Islamic jurisprudence (Fiqh) and discusses the possibility of designing financial instruments incorporating such options.
Part 3 discusses some real-life examples of options in use by Islamic financial institutions.
Part 4 provides a summary of the entire discussion.
Islamic Evaluation of Conventional Options
Islam provides a basic freedom to enter into transactions. The Holy Qur’an says: “let there be among you traffic and trade by mutual goodwill” (4:29). This is at times misconstrued as a fundamental freedom to trade in options as separate contracts. An overwhelming majority of scholars, however, do not agree with this contention. Th e basic norm does not imply unbridled freedom to contract. A contract involving the exchange of unlawful assets is itself unlawful and a contract must be free from Riba, Gharar, and Jahl and conform to other norms of Islamic ethics, to be permissible.
1. Riba – Prohibition & the Underlying Asset
Options as separate contracts may be in the nature of a call (or a put), providing the holder with a right, without obligation, to purchase (or to sell) an underlying asset at a known exercise price. On e primary requirement for such contracts to be permissible in Islam is that the underlying asset is lawful. In the case of commodity options, the underlying commodity must not be in the forbidden category. As far as financial assets are concerned, one may examine the case of interest-rate options or bond options, currency options, equity options, options on other Islamic contracts, and the more complex ones, such as options on options, or options on futures, by subjecting the underlying assets to scrutiny.
Any security that involves Riba is not permissible. The need to eliminate Riba in all forms of exchange contracts is of utmost importance. Riba in its Sharia context is generally defined as an unlawful gain derived from the quantitative inequality of the counter-values in any transaction purporting to effect the exchange of two or more species (anwa), which belong to the same genus (jins) and are governed by the same efficient cause (ilia). Riba is generally classified into Riba al-Fadl (excess) and Riba al-Nasia (deferment) which denote an unlawful advantage by way of excess or deferment respectively.
Prohibition of the former is achieved by a stipulation that the rate of exchange between the objects is unity and no gain is permissible to either party. The latter kind of Riba is prohibited by disallowing deferred settlement and ensuring that the transaction is settled on the spot by both the parties. Another form of Riba is called Riba al-Jahiliyya, or pre-lslamic Riba, where the lender provides an option to the borrower to swap the earlier debt for a new and increased debt (the interest on the initial debt is included in the principal of the new debt). The borrower may exercise the option on the maturity date or settle the earlier debt.
There is a general consensus on the view that the entire range of debt securities involves Riba and is considered un-Islamic. Hence, options to purchase or sell such securities are also not permissible.
Currency options pose some challenges for scholars and researchers and there are divergent views on the issue of the prohibition of Riba in currency exchange. The divergence is due to the process of analogy (qiyas) in which efficient cause (ilia) plays an extremely important role. The process of analogy (qiyas) is needed, since gold and silver, which performed the functions of money in the early days of Islam, have been replaced by paper currencies. It is a common efficient cause (ilia), which connects the object of the analogy with its subject in the exercise of analogical reasoning.
The appropriate efficient cause (ilia), in the case of currency exchange contracts, has been variously defined by the major schools of Fiqh. Accordingly, some jurists equate currency exchange with Bai-sarf, in which spot settlement, or qabd, by both the parties is insisted upon. Hence, options are automatically ruled out. Some others, primarily belonging to the Hanafi school, permit deferment of obligation by one party, or Bai-salam, in currencies and thus admit the possibility of options.
Considering the case of equity options, the underlying equity stocks must meet some additional criteria to conform to Islamic norms. All business activities of the company issuing the stocks should be Halal and permissible. Accordingly, options on stocks of companies belonging to the breweries, entertainment industries, interest-based banking and finance, hospitality and other similar industries where the major line of business is Haram, fall into the forbidden category. An issue on which some difference of opinion exists among Islamic scholars relates to the permissibility of stocks of a company that is engaged in Halal business, but which also finances part of its assets through interest-bearing debt.
Various Islamic certificates are obviously permissible, as these have been created with the explicit purpose of meeting Sharia requirements. These are not supposed to violate the norms of Islamic ethics. However, in reality, the existence of specific features may render the security un-lslamic and hence, not permissible. For example, a popular form of Islamic certificate permits the shareholder to participate in the earnings; but the downward risk is not shared, as the nominal value of these securities is guaranteed.
Such securities naturally invite objections from Sharia experts and hence, options on such securities are also considered un-lslamic. In the case of some complex options, the underlying asset may itself be an option or a future. The validity of these contracts would depend on the validity of the simple option or future contract. Th e latter is prohibited according to a majority of Sharia scholars.
2. The Issue of Gharar and Speculation
Permissibility to conventional options is generally denied by a majority of Islamic scholars on the grounds that these involve Gharar and are primarily transacted for speculative gains.
Gharar, unlike Riba, does not have a consensus definition. In broad terms, it connotes risk and uncertainty. It is useful to view Gharar in a continuum of risk and uncertainty, wherein the extreme point of zero risk is the only point that is well-defined. Beyond this point, risk or Gharar becomes a variable, and the Gharar involved in a real-life contract would lie somewhere on this continuum. Beyond a point on this continuum, risk and uncertainty or Gharar becomes unacceptable. Jurists have attempted to identify such situations involving forbidden Gharar. A major factor that contributes to Gharar is inadequate information (Jahl), which increases uncertainty. This is when the terms of exchange, such as price, objects of exchange, time of settlement etc., are not well-defined. Gharar is also defined in terms of settlement risk or the uncertainty surrounding delivery of the exchanged articles.
Islamic scholars have identified the conditions that make a contract uncertain to the extent that it is forbidden. Each party to the contract must be clear as to the quantity, specification, price, time, and place of delivery of the contract. A contract, say, to sell fish in the river involves uncertainty about the subject of exchange, and about its delivery, and hence is not Islamically permissible. The need to eliminate any element of uncertainty inherent in a contract is underscored by a number of traditions.
Traditionally, an overwhelming majority of Sharia scholars have defined Gharar in terms of a possible failure by the parties to deliver the goods exchanged. In the organised and free markets of today for commodities, stocks, and currencies, the probability of failure to deliver the same on the maturity date should be no cause for concern. Further, the standardised nature of options contracts and transparent operating procedures on the organised markets is believed to minimise this probability.
Some recent scholars have opined in the light of the above that the probability of failure to deliver, leading to Gharar, was quite relevant in a simple, primitive and unorganised market. It is no longer relevant in the organised options markets of today. Such a contention, however, continues to be rejected by the majority of scholars. They underscore the fact that options contracts almost never involve delivery by both parties. On the contrary, the contract is settled in price difference only.
An outcome of excessive Gharar, or uncertainty, is that it leads to the possibility of speculation of a variety that is forbidden. Speculation in its worst form is gambling. The Holy Qur’an and the traditions of the holy prophet forbid games of chance and all forms of gambling. The term used for gambling is maisir, which literally means getting something too easily, getting a profit without working for it. Apart from pure games of chance, the Holy Prophet also forbade actions that generated unearned incomes without much productive effort.
Here it may be noted that the term ‘speculation’ has different connotations. It always involves an attempt to predict the outcome of an event. But the process may or may not be backed by collection, analysis and interpretation of relevant information. The former case is very much in conformity with Islamic rationality. An Islamic economic unit is required to assume risk after making a proper assessment of risk with the help of information. All business decisions involve speculation in this sense. It is only in the absence of information or under conditions of excessive Gharar or uncertainty, that speculation is akin to a game of chance and is reprehensible.
Do conventional options involve excessive risk or uncertainty (Gharar) and are they used for speculation of a variety akin to a game of chance? Let us consider the case of a simple option, such as a call option.
For example, a call option on stock X provides a right to individual A to purchase the stock at a price of $50 three months from now. The call itself is purchased at a price of say $5.
If, as per his expectations, the price of X increases to $60 on the maturity date, then the buyer of the call has a net gain of $5 (on an investment of $5). This is what the seller or the writer of the call would lose.
If the buyer would have purchased the stock itself (say at a price of $50) instead of the call on the stock in order to benefit from the expected price rise, then he would have made a profit of $10 on an investment of $50. Thus, a call option enables the buyer to magnify his returns if his expectations materialise. Now contrary to his expectations, if the price of the stock falls below $50 on the maturity date, say to $40, the buyer would allow the option to expire without exercising it, since he can buy from the market at a lower price.
His losses would amount to $5 or 100 per cent with the call. This $5 would be what the seller of the call would gain on zero investment. It may be noted that losses for individual A are also magnified with options (losses would have been $10 on the investment of $50 with purchase of the underlying stock). In the game, the buyer and seller must have diametrically opposite expectations. The possibility of risk and return is magnified, the gains of the buyer being equal to the losses of the seller, and vice-versa. Thus, the purchase and sale of options is a risky zero-sum game.
This possibility of such gains encourages economic units to speculate on the future direction of the price of the underlying asset. Since prices of such assets fluctuate randomly, gains and losses are random too, and the game is reduced to a game of chance.
There is a vast body of literature on the forecast ability of stock prices, currency exchange rates etc., and a large majority of empirical studies have provided supporting evidence on the futility of any attempt to make short-run predictions. Prices and rates are volatile and remain unpredictable at least for the large majority of market participants. Needless to say, any attempt to speculate in the hope of the theoretically infinite gains is, in all likelihood, a game of chance for such participants. While the gains, if they materialise, are in the nature of maisir, or unearned gains, the possibility of equally massive losses does indicate a possibility of default by the loser and hence, Gharar.
The economic rationale of conventional options is believed to be their potential use as a hedging device. Hedging, or risk transfer, adds to planning and managerial efficiency. In the context of asset markets that are characterised by volatile prices and rates, such contracts are believed to enable the parties to transfer and eliminate risk arising out of such fluctuations.
For instance, individual A plans to buy (or sell) stock X after a time period of three months. He may be adversely affected if the price moves up (or down) during this time period. The risk due to price movement could be hedged by purchasing a call (or put) with a given exercise price. The price paid for the options would be in the nature of the cost of insuring against adverse price fluctuations. While this is true, the fact remains that an overwhelming majority of transactions are speculative and not for hedging. And hedging alternatives that are not speculative do exist in the Islamic framework.
Some jurists grant permissibility to options subject to the condition that the obligations implicit in the contract for both parties cannot be transferred to a third party. This would effectively curb the possibility of speculation. However, at the same time, this stipulation would also kill the organised market in options.
The general view of Sharia scholars is that an option is a promise to sell or purchase a thing at a specific price within a stipulated time and that such a promise in itself is permissible. The promise is also binding on the promisor. However, this promise cannot be the subject matter of a sale or purchase. Therefore, an option cannot have a premium or price, contrary to the prevailing practice. The objection to options by some Islamic scholars is also based on the tradition forbidding Bai-al-Arboon.
These scholars find purchase of a call option similar to Bai-al-Arboon. The difference is that in the case of the former, if the option is exercised the option premium is not adjusted in the sale price. The seller benefits by the amount of premium irrespective of whether the option is exercised or not. However, it may be noted that though a majority of the schools of Fiqh find Bai-al-Arboon unacceptable, the followers of Ibn Hanbal find this kind of transaction Islamically permissible. M A El Gari (1993) argues in favour of transactions in call options using the framework of Bai-al-Arboon. As far as a put option is concerned, there seems to be little support in its favour.
3. Embedded Options in Contracts
There has been a proliferation of financial instruments in developed markets with complex features, including embedded options. An assessment of this wide range of products of financial engineering is beyond the scope of this paper. However, most of these instruments are un-Islamic because they are Riba-based and also involve Gharar and Jahala.
Islamic scholars are of the opinion that a transaction must be free from jahala, or misrepresentation, to be considered Islamic. The institution of a transparent market is, thus, quite important and transactions should be executed within the market after taking into account all relevant information. It also follows that a contract should be simple and not unduly complex, so that both parties to the contract fully understand the implications of contracting. The importance of information has also been highlighted in the context of freedom from speculation. It is information alone that draws a line of distinction between ethical and unethical speculation.
It may be noted here that a large majority of conventional securities, including and incorporating options, are excluded from the permissible category. However, it is also true that an explosive growth in the range of financial instruments in world markets has not necessarily added to the efficiency of the system. In most cases, the complexity of the innovations has made it impossible on the part of the investors to make an assessment of risk and return and, consequently, of their worth.
Ethical Options (AI-Khiyar) in Islamic Jurisprudence (Fiqh)
The theory of contracting in Islamic jurisprudence discusses the notion of options within the framework of al-Khiyar in exchange contracts. Within this framework, the parties may hold a right either to confirm or to cancel the contract within a stipulated time period. Options for either or both the parties apparently violate a Sharia norm that a valid contract comes into existence with the acceptance of the terms of contract by both the parties.
Permissibility of options is, however, justified on the grounds of larger benefits to the society. Through options, the parties to the contract are granted a ‘reassessment’ or ‘cooling off period during which they can rationalise their decisions or reverse them. Thus, the possibility of conflicts between the parties because of abrupt, irrational and wrong decisions are minimised.
Another important reason may be that under conditions of excessive Gharar or uncertainty regarding the article of exchange, price etc, options for the parties are provided to reduce Gharar and bring it within Islamically acceptable limits. The rationale for options may also be to undo a wrong committed on a party. For example, Islam attaches great importance to the role of information in the market. Release of inaccurate information is forbidden. The concealment of vital information (ghish) also violates the norms of Islamic ethics.
According to the traditions of the Holy Prophet, the informationally disadvantaged party at the time of entering into the contract has the option to annul the contract. The traditions refer to price information in the market as well as other information relevant to valuation of the commodity.
We discuss below the various types of options that find a mention in the Fiqh literature, as also the views of the four major schools of thought on them. Of the various options, the one that is potentially more promising in designing new financial instruments seems to be the option as a condition (Khiyar-al-Shirt). Hence, this particular option has been examined in greater detail.
1. Option of Acceptance (Khiyar-Al-Majlis)
This may be defined as the right of each of the parties to the contract of withholding their acceptance, after the offer has been made by the counterparty, until the meeting (majlis) breaks. This directly follows from several traditions of the Holy Prophet. There is, however, a divergence of views among scholars on whether the option remains in force until the contract is consummated, or until the meeting breaks (which may last longer than the time of offer and acceptance by both parties).
According to the Hanafi school of thought, the option of acceptance (Khiyar-al-Majlis) would remain in force till the meeting breaks only if such a condition is stipulated in the contract. The absence of any such stipulation would imply that the option remains in force till the contract is consummated. The option would expire the moment both the parties accept the terms of the contract. The option of acceptance would, in effect, mean the option of one party to change the terms of offer before the counterparty accepts them.
According to the Shafii school, the option of acceptance (Khiyar-al-Majlis) would continue to remain in force even after the terms have been accepted by both the parties and the contract is complete, till the meeting breaks, as the same is directly inferred from the traditions. (In fact, if the contract contained a stipulation that there would be no options for either party, then the contract itself would be null and void).
All contracts would contain the option of acceptance, provided the following conditions are met. First, there must be a consideration for both parties to the contract. Second, there would be no option in contracts that do not become null and void because of illegality of consideration (say, when it does not belong to the party exchanging it).
Third, the contract must involve exchange of countervalues or benefits from both ends. Hence, this would exclude Musharaka, Qard, Ijara and Rihn from having the option of acceptance (Khiyar-al-Majlis), since these contracts involve delivery of value from one end only.
Fourth, contracts without any identifiable consideration, such as Hawala, are also excluded from this framework. It is thus possible to enumerate the financial contracts that may contain an option of acceptance. These are contracts of pure Bai or exchange, Salam, and Bai Ribawi or Bai susceptible of Riba. The option ceases to exist when the parties voluntarily depart (not by force).
The Hanbali view is similar to the Shafii view and asserts that the parties to the contract have the option of acceptance (Khiyar-al-Majlis) till they physically and voluntarily depart, irrespective of when the contract is consummated. Contracts which contain such options include Bai Sarf, Bai Ribawi, and Salam, where Qabd or taking delivery by both parties is a prerequisite, and all similar forms of Bai.
Hanbalis also rule out options in the following financial contracts: Mudaraba, Musharaka, Hawala, Aariyya, Wadiyya, Rihn, etc. Unlike the Shafii view, Hanbalis hold that any such condition which negates the existence of option of acceptance, is itself invalid and does not nullify the contract per se.
According to the Maliki view, there is no such thing as option of acceptance (Khiyar-al-Majlis). There are broadly two kinds of options (Khiyar): option as a condition (Khiyar-al-Shirt) or option to reassess and revalue (Khiyar-al-Tarwih), and option from defects (Khiyar-al-Naqisa). In this way, their position is similar to the Hanafi view that there is no option of acceptance (Khiyar-al-Majlis) once the contract is concluded. However, unlike the Hanafis, the Malikis assert that the contract would become invalid if the parties stipulated a condition of option of acceptance (Khiyar-al-Majlis).
2. Option as Condition (Khiyar-Al-Shirt)
These options are in the nature of conditions in the contract that provide a right to the parties to confirm or to cancel the contract within a stipulated time period. In essence, this implies that the concerned party gets some time period for reassessment of the benefits and costs involved, before giving final assent or ratification to the contract. There is a consensus among jurists that such conditions providing options to either or both the parties are Islamically valid.
The permissibility of such options is inferred directly from the tradition of the holy Prophet asking a person (who was cheated on some earlier occasions) to retain an option for three days. There is also a general agreement on the question of granting this right to a third party when, for instance, individual A purchases a commodity from individual B subject to the condition of ratification of the purchase by individual C. There is, however, some difference regarding the modalities of stipulating the condition providing the option to a third party.
It is generally permissible to have conditions in a contract which provide options to either of the parties, or both, or even to a third party. The requirement, however, is that the identity of the party to possess the option should be clear at the time of offer and acceptance of the terms of contract. Such conditions can also be stipulated by an agent acting on behalf of a principal with his permission.
According to the Hanafis, all such contracts involving exchange of countervalues either from one end or both, and which are inherently cancellable at any later date, may contain these options. Deposits and loans (Wadiya and Aariya) do not fall under these categories as these are not in the nature of exchange contracts.
It may be noted that such contracts always provide the option to the depositor or lender to call back their deposits or loans at any time. Hence, providing any further option makes no sense. Various financial contracts which may contain such options include, leasing (Ijara), debt transfer (Hawala), and sale (Bai) etc. The contracts which cannot contain such options include Bai-Sarf, and Bai-Salam, etc. The Hanbali view is also generally in conformity with the above.
2.1. Maturity of Options
There is a general agreement among all jurists that the options would continue for a known and finite time period. A contract providing a perpetual option or an option valid for an uncertain time period (for example, an option till company A starts generating profits) is not permissible. There is considerable difference of opinion about the maximum permissible time period over which the options would continue.
According to Imam Abu Hanifa and also Imam Shaffi, the time period during which the condition of option remains in force cannot exceed three days. However, according to Imam Muhammid and Imam Abu Yusuf, prominent jurists of the Hanafi school, such stipulation may continue for any length of time, for three days may be too short a period under certain circumstances for the parties involved to take a decision.
According to the Malikis, the nature of the object of transaction would determine the maximum permissible time period. For example, the same can be as high as 36 days for properties. The jurists of this school have considered a wide range of commodities and accordingly, stipulated the maximum permissible time period. According to the Hanbali school the time period must be finite, free from any uncertainty and known to both parties at the time of contracting and there is no limit on the maximum permissible time period.
2.2. Ownership and Possession During Option Period
The issue of ownership and possession of the article of exchange during the option period is quite important. Another pertinent question relates to the liability of buyer and seller in case the article, which may be in the possession of either party, is destroyed or suffers a diminution in value. Again, there are divergent views on these questions.
The Hanbalis assert that ownership of the exchanged article is transferred to the buyer during the option period in the case of both kinds of options (Khiyar-al-Majlis and Khiyar al-Shirt), whether the option is with either the buyer or the seller or both. While the buyer becomes the owner of the article of exchange during the option period, the seller becomes owner of the countervalue (Thaman, equivalent to price of the article).
The buyer holding the option is permitted to take possession of the article of exchange, but with the consent of the seller Further, if the buyer has possession of the article of exchange, it is permissible for him to put the same to use, though such use would result in cancellation of the option for the buyer The seller holding the option has a right to take possession of the Thaman during the option period. And when the seller has not taken possession of Thaman from the buyer, the latter is forbidden to put it to use.
In case the article of exchange is destroyed, or suffers a diminution in value during the option period, then the liability of the buyer and seller would depend on whether or not the article is weighed or measured at the time of exchange. In the case of an article of weight or measurement, the party in possession of the article would compensate for the loss. In the case the exchange does not involve any weight or measurement, the buyer would be liable for the loss if he had taken possession of the article. He would be liable even when the seller was in possession, but at the same time, the seller had not explicitly refused to switch possession of the article. In the event of refusal, however, the seller is liable. This implies that change of ownership should be accompanied by transfer of possession in favour of the buyer.
As long as there are no constraints on transfer of possession, and the same is not affected, the article would remain with the seller in trust (Amanah). And there is no compensation in trust (Amanah) unless the loss is due to deliberate negligence and destruction. And when the buyer causes the destruction or diminution in value, any option with him would automatically be cancelled and he would be liable for the value of the article (not the contracted price).
The Shafiis have different views on the issue of ownership of the article during the option period. If the seller holds the option, its ownership continues. If the buyer retains the option, then the ownership is transferred in favour of the buyer. And if both have the option then the ownership remains suspended during the option period.
Subsequently when the contract is ratified the article would be assumed to remain in the ownership of the buyer since the time of contracting. And if the same is annulled then it would be as if the ownership had always been with the seller. The benefits flowing from ownership (for instance, dividends, warrants or other possible benefits for a stockholder) would accordingly accrue to the buyer or seller as the case might be.
The Shafiis are of the view that when one party is allowed possession of either the article of exchange or the thaman, the other party is allowed possession of the countervalue. When the seller holds the option, the article of exchange remains in his ownership. Hence, the buyer cannot demand possession of the same. At the same time, the buyer owns the thaman and hence, the seller cannot demand the thaman from him during the option period. When the buyer holds the option, the article of exchange is in his ownership. Hence, he can demand possession of the same from the seller. In such a case, the seller too is the owner of the thaman and hence, can demand the same from the buyer.
It is possible that the article of exchange may be destroyed during the option period owing to some unforeseen or uncontrollable factors. If this happens before the transfer of possession by the seller then the contract will be annulled irrespective of whether the option is with the buyer or seller or both. If the destruction occurs after the buyer takes possession, then the contract will be annulled in case the seller holds the option without any liability for the buyer. The thaman is returned to the buyer. However, when the option is with the buyer or both, then the option remains in force. Subsequently, if the contract is ratified, then the buyer is liable for the thaman. And if the contract is annulled then the buyer is liable for the value of the article only.
The Hanafi view on this issue can be discussed under three possible scenarios: when the seller holds the option; when the buyer holds the option; and when both the buyer and seller hold the option.
When the seller holds the option, the consensus view is that the ownership of the article of exchange continues with him. There is also a consensus on the view that in this case, the buyer ceases to be the owner of the countervalue or thaman. However, there is a difference of opinion on whether the ownership of the thaman shifts to the seller or not.
Under the circumstances, the liability of buyer or seller in case of loss or diminution in value of the article during the option period would depend on whether the buyer had taken possession of the article or not. In the case of the former, then the buyer would be liable for the value of the article as on the date of possession (not the date of destruction or loss). The liability of the buyer would be the same irrespective of whether the contract was subsequently ratified or annulled by the seller holding the option.
In fact, with the seller having the option, and the article in the possession of the buyer, if the seller exercises the option and cancels the contract within the option period, then the buyer has to pay the value of the article irrespective of whether the same is in proper condition or ceases to exist.
If any defect is observed in the article while in possession of the seller, then its value would be accordingly adjusted downwards and the option of the seller would not be affected, provided the same were not due to his negligence. And under these conditions, the buyer would get an option, either to take delivery of the article in exchange of the contracted price or cancel the contract.
However, if the defect occurs due to the action of the seller, then he is held responsible for the diminution in value and the contracted price would be adjusted downwards by the amount of the loss. And if the article is completely destroyed in the hands of the seller holding the option, then the contract is cancelled without any liability for either the seller or the buyer.
When the buyer or any third person holds the option, the consensus view is that the ownership of the countervalue or thaman continues to remain with the buyer. There is also a consensus on the view that in this case, the seller ceases to be the owner of the article of exchange. However, there is a difference of opinion on whether the ownership of the article shifts to the buyer or not.
Imam Abu Hanifa asserts that if the buyer becomes the owner of the article, this implies ownership of both the countervalues in the exchange, which is inequitable and unjust. (The other proponents of this school, Imam Abu Yusuf and Imam Muhammad are, however, not very comfortable with the possibility that the article will remain without any owner during the option period.)
Imam Abu Hanifa opines that even if the buyer does not become the owner of the article, he will be held responsible for the same in the event of taking possession of it. And if the article is destroyed in his possession, he will be liable for payment of the contracted price (thaman). (This is in contrast to the case of the seller holding the option, where the buyer is liable to pay value only.)
There are, however, qualifiers to the above. If the cause of destruction of value is such that this would have forced the seller (holding the option) to cancel the contract (such as natural destruction of the article during the option period) then, under these conditions, the buyer is liable for the value and not the contracted price.
There is a further divergence of views under the following conditions. If the defect is caused by the seller’s actions with the buyer having the option, then according to Imam Muhammad, such option continues with the buyer who has now two alternatives – either to ratify the contract subject to compensation of loss by the seller; or to cancel the contract. According to Imam Abu Hanifa and Abu Yusuf, the contract would be deemed confirmed (option with buyer would expire) and the buyer would be required to pay the diminished value for the defective article to the seller.
The third possibility is that both the buyer and seller hold options. In such a case, there would be no change in the ownership of the countervalues. If either of them cancels the contract within the option period, then the contract ceases to be in existence. And if either of them ratifies, then his option ceases while the other party continues to have the option. If neither party ratifies or cancels within the option period, then the contract automatically comes into force. And if either party ratifies while the other party cancels then the contract remains in force only during the time interval between ratification and cancellation, irrespective of which occurs earlier. And if the article is destroyed before the buyer taking possession, then the contract stands annulled. Similarly, if the countervalue (thaman) is destroyed before the seller taking possession of the same then the contract stands annulled.
As far as benefits flowing from possession are concerned, these remain in a state of suspension during the option period. If the contract is subsequently ratified, they accrue to the buyer and if cancelled, accrue to the seller.
The Hanafis assert that in an exchange with options, the seller is permitted to demand payment of the thaman only after expiry of the option period. Similarly, the buyer is not permitted to demand possession of the article of exchange during the option period. However, if the buyer delivers the thaman, then the seller is forced to shift possession of the article of exchange, and when the seller holds the option, he has a right to refuse transfer, but then he must return the thaman. When the seller takes possession of the thaman or the buyer takes possession of the article of exchange, neither is permitted to put these to use. However, when the seller puts the article to use or the buyer puts the thaman to use before possession of these by the counterparty, then they are permitted to do so, though the contract stands cancelled.
Further, the holder of the option may annul the sale with the knowledge of the counterparty or confirm it without his knowledge. Annulment without informing the counterparty is not permissible according to Imam Abu Hanifa and Imam Muhammed. Imam Shafii and Imam Abu Yusuf, however, do not see informing the counterparty as a requirement for annulment. Confirmation, however, may not require informing the counterparty. The criterion here is whether keeping the counterparty uninformed would result in any loss for him.
The Malikis assert that the ownership of the article of exchange does not shift during the option period, irrespective of who holds the option. The confirmation of the contract transfers the ownership to the buyer. When the seller holds the option, and the buyer takes possession of the article and subsequently claims loss of the same, the compensation to be borne by the parties is largely decided by a legal process that would examine the veracity of the claims.
If the buyer is able to substantiate its claim, then the loss borne by the seller. Otherwise, it would have to compensate for the loss. And there are further details on how to determine the quantum of compensation.
When the buyer holds the option and claims loss of the article in his possession, then he is entitled to the thaman, and when both the seller and the buyer hold the option, it is treated in a manner similar to the seller holding the option. When the article is in the possession of the seller and he claims loss of the same, then he is responsible for giving back the thaman to the buyer. As far as the benefits flowing from the article of exchange during the option period are concerned, they accrue to the seller if they can be separated from the article of exchange. Or else, they accrue to the buyer
According to the Malikis, the seller has no right to demand the thaman from the seller during the option period. And if the seller specifies a condition of spot payment of the thaman by the buyer, then the contract becomes invalid. This is because, if the contract is subsequently annulled, then the thaman delivered by the buyer would amount to a kind of lending, which is forbidden.
However, if the buyer voluntarily pays the thaman, and this is not in the nature of a condition to the exchange, then it is permissible. As far as taking possession of the article of exchange is concerned, this is permissible for the buyer. And the seller cannot be forced to transfer possession except when the buyer specifies an explicit condition in the contract to that effect.
3. Option of Determination (Khiyar-al-Tayeen)
This implies a right that a buyer of multiple homogeneous articles may hold to stipulate a time period before making a choice of one of these. This is a case of option under uncertainty about the subject of exchange.
According to the Hanafis, such an option is permissible if it involves a choice out of not more than three articles. The maximum option period according to Imam Abu Hanifa is three days. Imam Abu Yusuf and Imam Muhammad do not accept an upper limit on the option period, as discussed earlier. The Shafiis do not find such an option permissible because of uncertainty about the subject of sale. The limited flexibility provided by the Hanafi scholars is on grounds of necessity (darura). It may be noted that only one of the articles taken into possession by the buyer is the subject of sale, the other two would be deemed as deposits (amanah) and would be governed by the law of deposits.
4. Option of Inspection (Khiyar-al-Ruyat)
This refers to the right of a buyer of an unseen commodity to reject the same on inspection. This option is justified by the Hanafi scholars on the basis of a saying of the Holy Prophet, “Whosoever purchases a thing without seeing it, has the liberty of rejection after sight of it”.
The Shafiis, however, do not find it permissible on the grounds of uncertainty about the subject of sale. The liberal position of the Hanafi scholars is also due to a belief that the uncertainty is not a source of potential conflict between the parties. Such options are relevant in contracts, such as Istisna, or Bai-Ghaib.
5. Option from Defect (Khiyar-al-Ayb)
It refers to the right of a buyer on discovery after taking possession of the article, of a defect in the purchased article which existed at the time of the sale. The buyer has the option of either retaining the article on payment of the full contracted price (thaman), or of cancelling the contract. The buyer does not, however, have the right to retain the article and exact compensation from the seller owing to the defect.
Compensation can be demanded only when the defect is discovered subsequent to any alteration in the article so that the same is not returnable in its original condition to the seller Further, anything that causes a decrease in the value and consequently in the market price, is deemed to be a defect and the mode of ascertaining the existence of a defect is by consulting with the valuation experts.
Cases in Financial Contracting with Islamic Options
From the above discussion it is clear that the primary considerations underlying the prescriptions of various jurists are: benefit of both the parties to the contract and avoidance of any potential conflict or litigation between them. One may also discern a distinct possibility of designing innovative financial instruments by adding option-related features to a contract within the framework of options as conditions (Khiyar al-Shirt). It follows from the analysis of this framework that a majority of jurists find an option period of more than three days to be permissible. Further, under certain conditions, settlement of the transaction at a value different from the contracted price is also permissible. This opens up the possibility of designing contracts aimed at managing price risk.
Though the potential for use of Islamic options is vastly untapped, a few Islamic financial contracts have options as features. These vary in the degree of complexity. For instance, a current account deposit, similar to Wadiya, with an Islamic bank has an inherent option for depositors to withdraw their deposits at any time. Option may be in the nature of a condition in the contract whereby a depositor in the investment account of an Islamic financial institution which operates as a Mudaraba may be provided a right to withdraw or break-off the contract at any time or after a certain time period.
Options may be more complex, as in the case of a recent sale of stocks by the Dar A1 Maal A1 Islamic Group. The purchaser of stocks of A1 Faysal Investment Bank Limited (AFIBL) holds an option under which it can sell the stocks back to a DMI subsidiary at a specified price at the end of a stipulated time period (end of the year 1998). The option would be cancelled if the stocks purchased appreciates by more than twenty per cent for twenty-one consecutive days during the last two years prior to the expiry of the option.
Another interesting case is that of Istijrar, a new financial contract introduced by the Muslim Commercial Bank, Pakistan, which is currently being used for commodity financing. The contract has embedded options for both the buyer and seller which are activated if the market price pierces an upper or lower bound respectively, during the financing period. The option provides a right to a party to fix the sale price at a predetermined level. If the options are not activated or are not exercised, then the price is settled at the average of the market prices prevailing during the financing period. Both the firm and the bank agree on a public undisputed source of price information and also a sampling interval for observing prices. The average price is calculated from these observations.
Bai Istijrar in its basic form implies a contract in which the price is paid by the buyer at the time of contracting, while the delivery of the commodity by the seller takes place in stages over a period of time. Since the purchase of raw materials and other intermediate goods needed for manufacturing, or of the commodities needed for trading, is a continuous process, the Istijrar contract may be suitable for financing such working capital requirements of a client-firm by an Islamic bank.
The bank may enter into a contract with the client for delivering the commodities. However, the requirement of spot payment of price by the buyer (in need of financing) may be problematic and make the contract devoid of any practical utility. Another problem relates to price volatility. Price increases subsequent to the time of contracting would adversely affect the seller. Similarly, price decreases subsequent to the time of contract would not be in the interest of the buyer.
Another alternative for the bank is to finance the same transaction under Murabaha, that is, charge a predetermined profit above the purchase price and sell it at the cost-plus price on a deferred payments basis. Since the payment to be made to the bank is known with certainty, there is obviously no element of Gharar. This arrangement reduces price risk to zero and minimises overall risk for the bank, that can be reasonably certain about the return on its investment. However, this alternative may not be very practical for working capital financing, which may be of a repetitive and continuous nature and comes very close to Riba-based financing.
In the modified Istijrar contract, both the problems are taken care of in the following way. When options are put as conditions in the contract, the financing period is equated with the option period, since the contract would now be settled at the end of an option period with payment of the price (thaman) or value, as the case may be, by the buyer.
Further, price is taken to be the average of market prices prevailing during the financing period, the source of information on prices being undisputed and commonly agreed upon. When delivery of the goods occurs in stages, such pricing is quite realistic. A possible argument against such an arrangement may, however, be on the ground that the bank or seller is exposed to too much risk.
The risk in this case is price risk. Islamic law provides for stipulation of the price at which the deal is executed in the contract. Absence of a known price in the contract would apparently involve Gharar, or uncertainty. The amount of risk associated with Istijrar is not as high as it appears initially. Istijrar provides for a process of averaging of prices prevailing during the financing period which would reduce this uncertainty to a considerable extent. The element of uncertainty is further reduced by the options that are activated when market prices become too volatile and cross the price band from either side. When the options are exercised (to close or rescind the contract), the outcome is similar to that under Murabaha, that is, the sale price is fixed at a known and predetermined level which allows for a predetermined normal profit to the seller (reflecting value in an otherwise volatile market).
Conclusion
Islamic scholars and economists are involved in a continuous process of designing and developing new financial instruments and finding innovative solutions to financial problems within the Islamic framework. Islamic financial products must be free from Riba, Gharar, and Jahl. Unfortunately, however, these are present in most of the traditional financial engineering products, such as the conventional options or products with embedded options.
These products are often justified in terms of the need to hedge or manage risk. A problem that confronts every participant in various markets, such as the commodity, securities and currency markets, relates to management of risk arising out of volatility in prices. While this need might have led to the development of various hedging tools that involve the use of options, and other derivative contracts, most of them can be, and are, actually being used for speculation.
The need to reduce risk also exists for an Islamic organisation or individual participating in the markets (though an Islamic participant may not seek to reduce risk to zero). And while risk reduction is very much in conformity with Islamic rationality, the conventional solutions are not Islamically permissible.
An analysis of the framework of options (Al-Khiyar) in Islamic jurisprudence reveals exciting possibilities. While the primary considerations underlying the prescriptions of various jurists are to benefit both the parties to the contract and avoid any potential conflict or litigation between them, one may discern a distinct possibility of designing innovative financial instruments by adding option-related features to a contract within the framework of options as conditions (Khiyar-al-Shirt).
It follows from the analysis of this framework that a majority of jurists find an option period of more than three days to be permissible. Further, under certain conditions, settlement of the transaction at a value different from the contracted price is also permissible. This opens up the possibility of designing contracts aimed at managing price risk. Options can actually reduce Gharar or uncertainty to acceptable limits and thereby make the contract Islamically acceptable.
Though the potential for use of Islamic options is vastly untapped, some innovative Islamic contracts have appeared on the scene. Istijrar, which is now being used for commodity financing, is one such Islamic tool for managing the price risk of commodities. Under this arrangement, risk arising from moderate price movements within the barriers remains with the parties to the contract (though it is further reduced by the process of averaging). Both the parties have a hedged position relating to price movements beyond the barriers. Th e contract thus provides a variety of risk management possibilities. The challenge before the Islamic financial researcher is to explore additional uses of this contract, as also to design new innovative contracts incorporating options that conform to Islamic norms.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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