Islamic Foreign Exchange Forward
FX Swap is a derivative instrument that has a precise objective of hedging against risk of fluctuation in currency exchange rate. Islamic Foreign Exchange forward is the Islamic substitute to the conventional FX forward. In this context, Islamic Foreign Exchange forwards is based on wa’ad (Undertaking) and tawarruq Islamic principles so as to imitate conventional FX forward but in a way that is complying to Shariah. The IIFM IFX Forward templates are based on the wa‘ad structure (Zahan & knett, 2011). A wa’ad in this case is a promise made by one party (the Buyer) to the other party (the Seller) that, if the Seller decided to exercise the Wa’ad or what’s called undertaking the wa’ad, the Buyer will fulfil the promise, that is in this case: entering into the transaction under which he will buy from the Seller one currency in exchange for another currency on the relevant settlement date. The concept of wa’ad arises at dealing date when the client promises or commits himself for an exchange of a specified amount of money on a specified date. The wa‘ad need to exist in each IFX Forward transaction. If and the Seller decided to exercise the relevant wa‘ad on the relevant Exercise Date (by the Seller sending an Exercise Notice), the Buyer is then required to purchase a specified amount of one currency in exchange for a specified amount of another currency. The terms of the contract are the Offer and Acceptance of the Buyer and Seller.
There are two common IFX structures developed by IIFM which are commonly used as a Shari‘ah compliant hedging tool:
1- Two unilateral and Independent Wa‘ad based structure.
2- Single Binding Wa‘ad based structure.
For the two unilateral and independent Wa‘ad structure, each party needs to execute a Wa‘ad while for the single binding Wa‘ad Structure, only one party needs to execute a Wa‘ad. Below given an illustrative example as per (IIFM/ISDA Islamic Foreign Exchange Forward (IFX) Standard Templates Wa‘ad based Structures, n.d)
Two unilateral Wa‘ad structure.
Scenario 1: on the Exercise Date if USD/GBP Spot Rate is < 1.51, the Customer exercises its rights under Wa’ad 1, so that on the Settlement Date, the Bank buys GBP 1 million in exchange for USD 1.51 million.
Scenario 2: on the Exercise Date, if USD/GBP Spot Rate is > 1.51 (i.e. Forward Rate of 0.66 > GBP/USD Spot Rate), the Bank exercises its rights under Wa’ad 2, so that on the Settlement Date, the Customer buys USD 1.51 million for GBP 1 million.
Single Wa‘ad structure
On the Exercise Date, the Bank exercises its rights under the Wa’ad, so that the Customer buys GBP 1 million in exchange for USD 1.51 million. Although for Shari’ah related reasons the Bank is not strictly under an obligation to exercise its rights under the Wa’ad, given that this is an IFX Forward product the expectation is that it would do so.
Islamic finance as conventional finance is exposed to the risks of market volatility and fluctuation either in currency rate market or interest rate market. Accordingly, Islamic swaps are organized in a way to successfully operate as a hedging mechanism in Islamic finance. Islamic swaps are hybrid contract that are practised in a similar way to conventional swap, thus attaining the same objectives as conventional swap contracts. What is more important is that swaps are structured to be compliant with the Islamic commercial jurisprudence principles: Shariah requirements. This denotes the importance of ensuring that contracts are free from riba (usury), gharar (excessive ambiguity) and any element of gambling in the transactions. There are several types of financial swaps that are commonly used in the conventional financial system. In fact, there are three main instruments of Islamic swaps developed in a compliant way with Shariah laws and principles; those are FX Swap, Cross Currency Swap, and Profit Rate Swap.
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