Islamic forex contracts

1. Foreign exchange (FX) is an important activity in modern economy. A foreign exchange
transaction is essentially an agreement to exchange one currency for another at an agreed
exchange rate on an agreed date, it provides protection against unfavorable currency exchange
rates and helps businesses associated with activities in a foreign currency to set a form of
currency risk exposure. And when using techniques such as foreign exchange hedging
capabilities, businesses can protect against adverse currency movements at a future date. FX
transactions cover foreign currency payment transactions and fund transfers involving different
currencies and countries and transactions such as travelers’ cheques, foreign currency cash,
foreign currency drafts, foreign currency fund transfers/remittances, investments and trade
services.
Regarding the comparison with Riba, some jurists compare paper currencies with gold and
silver; which were universally acceptable as principal means of exchange in the early days of
Islam. They refer to hadith of the holy prophet (peace be upon him) "Sell gold for gold, silver for
silver... in same quantities on the spot; and when the commodities are different, sell as it suits
you, but on the spot." However, the case of exchange involving paper currencies belonging to
different countries, the intrinsic value or worth of paper currencies cannot be identified or
assessed unlike gold and silver which can be weighed. Hence, the Shari’ah injunctions for Riba
prohibition are not applicable to paper currencies. Such exchange would be permissible as long
as it is free from any injunction regarding the rate of exchange and the manner of settlement.
Regarding Gharar and speculation, the prohibition of futures and forwards involving exchange of
currencies is justified by the fact that such a contract involves sale of a non-existent object or of
an object not in the possession of the seller. Some recent scholars have opined that futures, in
general, should be permissible, because the efficient cause, that is, the probability of failure to
deliver was quite relevant in a simple, primitive and unorganized market. However, this should
be no longer cause for concern in today’s organized futures markets where the standardized
nature of futures contracts and transparent operating procedures on the organized futures
markets are believed to minimize this probability of failure. Nevertheless, such contention
continues to be rejected by the majority of scholars; they underscore the fact that futures
contracts almost never involve delivery by both parties. On the contrary, parties to the contract
reverse the transaction and the contract is settled in price difference only. In addition, regarding
the forecastability of exchange rates, they are volatile and remain unpredictable at least for the
large majority of market participants. And any attempt to speculate in the hope of the
theoretically infinite gains would be a game of chance for such participants.
Hedging tools

2. Today’s currency markets are characterized by volatile exchange rates. In a volatile
market, the participants are exposed to currency risk and Islamic rationality requires that
such risk should be minimized in the interest of efficiency if not reduced to zero. Islamic
FX hedging mechanisms are designed to achieve the objectives of the conventional
currency hedging contracts while being in conformity with the Islamic commercial
jurisprudence principles. This implies the need to ensure that the contract is free from
Riba, Gharar and Maysir. Some these mechanisms are:
• A forward contract involving currencies allows one currency to be sold against
another, for settlement on the day the contract expires; it eliminates the risk of fluctuating
exchange rates by fixing a rate on the date of the contract for a transaction that will take
place in the future.
• A futures contract involving currencies is an agreement to buy or sell a particular
currency for delivery at an agreed-upon place and time in the future; however, these
contracts very rarely lead to the delivery of a currency, because positions are closed out
before the delivery date.
• A foreign currency option is a hedging tool, similar to an insurance policy that
allows one currency to be exchanged for another on a given date, at a prearranged
exchange rate, without any obligation to do so; foreign currency options eliminate the
spot market risk for future transactions.
• A swap contract involving currencies is an agreement to exchange one currency
for another and reverse the exchange at a later date; it is based on a notional principal
amount, or an equivalent amount of principal, that sets the value of the swap at maturity
but is never exchanged; Currency swaps are used to gain liquidity.
• Currency arbitrage aims to take advantage of divergences in exchange rates in
different money markets by buying a currency in one market and selling it in another
market to take benefit of the differing interest rates.
From the Shari’ah viewpoint, the problem with the above structures arises when the
parties involved want to exchange currency sometime in future but already fixing a rate
which is fixed today while the contract is sealed today. This contravenes to the basic
Shari'ah rules governing the exchange of currency (Bai` Sarf). In Bai` Sarf, it is a
requirement for an exchange which involves two different currencies to be transacted on
spot basis. Hence it is prohibited to enter into forward currency contracts whereby the
execution of a deferred contract in which the concurrent possession of both the counter
values by both parties does not take place. Nevertheless, in order to minimize the risk of
uncertainty of prices in the future, forwards, futures, options and swaps markets for
currency-trading have also emerged for Islamic banks although the general ruling of
Shari'ah scholars is that hedging is not permissible. Yet, these objections may be
arguable, since hedging helps to eliminate Gharar by enabling the importer to buy the
needed foreign exchange at the current exchange rate, since Islamic banks only invest the
foreign currencies purchased by them in a Shari'ah-compliant manner as far as is possible
and since the principle of protection of wealth is respected. In addition, genuine

3. speculation is allowed in Islam, as opposed to professional speculation, where the
speculator is not a genuine investor. Most of the Islamic financial contracts provided by
Islamic banks will be exposed to foreign exchange fluctuations arising from general FX
spot-rate changes in foreign operations and the resultant foreign currency receivables and
payables. Islamic banks can charge fees based on various Islamic contracts and to curb
speculation and misuse, hedging could be confined to foreign exchange receivables and
payables related to real goods and services only.
Islamic FX Swap
The swap introduced by Islamic banks, based on concepts such as Wa’ad, Murabahah,
Musawamah and Tawarruq is deemed by scholars as permissible as long as it is free from
elements that contravene the Shari’ah, and for the purpose of fulfilling the need for
hedging.
Therefore Shari’ah parameters in structuring and executing swap are very important to
ensure market practitioners truly fulfill and adhere to the requirement outlined by
Shari’ah. Two broad categories of Shari’ah parameters on Islamic FX Swap are
suggested, namely the guidelines on combining various contracts in one single
transaction and the other is on guidelines of how to demarcate Islamic swap purposes
either to hedge or to speculate. The two commonly offered structures of Islamic FX Swap
in the market are based on the contract Bai` Tawarruq or the concept of Wa’ad
(promise/undertaking). The arrangement based on Tawarruq it is structured with the
application of two sets of Tawarruq (at the beginning) to enable the same effect as FX
Swap to be achieved. While the second structure based on the concept of Wa’ad involves
exchange of currencies at the beginning, and promise or undertaking (Wa’ad) to carry out
another Bai` Sarf at the future date based on the rate determined today. At the expiry
date, the second Bai` Sarf will be implemented to get back the original currency.
Tawarruq
Tawarruq is the mode through which Islamic Banks are facilitating the supply of cash to
their clients. The method consists on buying an asset and immediately selling it to a
client, either directly or indirectly, on a deferred payment basis. The client then sells the
same asset to a third party for immediate delivery and payment, the end result being that
the client receives a cash amount and has a deferred payment obligation for the marked-up
price to the Islamic Bank.
Islamic Banks use Tawarruq in the form of reverse Murabaha Reverse where the client
requires a cash lump sum. The client buys an asset from the Islamic bank as in Murabaha,
but rather than retaining the asset for use in its business, sells it to a third party.
Generally, banks deal with brokers who provide agency services and the commodity
always remain in the same place without transfer of ownership from the seller to the

4. buyer; thus a number of conditions of a valid sale may be lacking in such transactions.
Furthermore, by way of Tawarruq a person can obtain cash without taking an interest
based loan. In fact, Tawarruq is different from Bai al Inah that involves the sale and
instant ‘Buy-back’ of an asset for a price higher than that for which the seller originally
sold it. Bai al Inah is not valid according to vast majority of the Muslim Jurists and the
mainstream theory of Islamic finance, as the goods are sold back to the same person from
whom these were bought. Whereas Tawarruq is considered a hilah to get cash in the garb
of trade using two contracts when the bank is really the financier and not the seller. Trade
profit is permissible because the parties undertake commercial risks and add value in
terms of facilitating the clients. Therefore, there must be a known time-gap between the
sale of the commodity by the bank to the client and the resale of the same commodity in
the market by the banks as agent of the clients. Otherwise, the Shari´ah conditions for
sale and purchase of goods such as possession, offer and acceptance, etc. would not be
fulfilled. If the sale and purchase are conducted in a single session and place at pre-agreed
prices without any time-gap, the element of risk would be eliminated; this would
contradictory to Shari´ah principles. Tawarruq is allowed by contemporary Shari´ah
scholars on the basis of Necessity provided the commodity purchased is sold to any third
party. If sale and purchase are conducted under two separate contracts, legally the
transaction would not become usurious. However, resale to the same person is not
approved by majority of the Muslim jurists and Shari´ah scholars as it would deemed as a
“buy-back” arrangement prohibited under the Shari´ah rules. Another cautious condition
could be required by some jurists for a valid Tawarruq is that the process involved should
not be pre-agreed among the three contracting parties. However, in general, Islamic banks
involve pre-agreement on purchase, sale and resale of goods giving a fixed rate of return
for banks without any commercial risk. In fact, what happens, basically, is that the client
makes the bank its agent to resell the asset for cash in the market from where the bank
had made the purchase.

5. Musawamah
Musawamah is a different form of Murabaha, in which parties bargain over the price of
goods to be traded without any reference to the price paid or cost incurred by the seller
and where the seller is not obliged to disclose the cost price. While the seller may or may
not have full knowledge of the cost of the item being negotiated, they are under no
obligation to reveal these costs as part of the negotiation process. This difference in
obligation by the seller is the key distinction between Murabaha and. All other conditions
relevant to Murabaha are valid for Musawamah as well. Musawamah can be used where
the seller is not in a position to ascertain precisely the original cost of the commodities
being offered on sale.
Musawamah can also be either cash or a credit sale, but it is generally used as a credit
sale, in which banks negotiate with clients on the price of assets to be sold by the bank,
and paid by the client later. Banks add their profit margin to their cost but are not
required to disclose the details of their cost price and their profit margin in any
transaction.
Musawamah is the most common type of trading negotiation seen in Islamic commerce.
Classical Muslim jurists generally preferred Musawamah over Murabaha for trading. It is
considered as easier because Murabaha implies a trust reposed in the seller and requires
detailed description to the buyer which could include a risk of some false. However,
Musawamah as a financing mode for Islamic banks is a not as efficient as Murabaha.
The absolute prices fixed for goods in the case of Musawamah, may lead to corruption
and mismanagement at a micro level. While, in Murabaha, the Islamic bank managers
price the goods by applying the profit margin or reference rate to their cost. Nevertheless,
banks can Musawamah for large transactions, when it is difficult to determine the original
cost of particular goods or a service, or when the goods to be sold comprise a pool of
products.