Currency hedging

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Because of high volatility of foreign exchange markets, the stakeholders undertaking International transactions are exposed
to foreign exchange risk. Islamic rationality requires that the risk originating from foreign exchange rate fluctuations should be reduced to minimum.

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Islamic currency hedging mechanisms have been designed to fully or partially cover any risk of loss related to exchange rates. They use the same principles as conventional mechanisms while being in conformity with Islamic economic principles. This includes the need to ensure that the contracts are free of Riba, Gharar and Maysir. However, these mechanisms remain highly controversial from point of view of Sharia because they contradict the rules of foreign currency exchange (Bai Sarf). The latter state that it is forbidden to conclude foreign exchange contracts where simultaneous possession of values ​​to be exchanged by both parties did not take place. Nevertheless, several Islamic banks use these contracts and consider that the objections of Ulema on these contracts may be debatable. Indeed, hedging contributes to eliminate Gharar while allowing the importer to buy currencies necessary for current foreign exchange rate. In addition, skillful speculation is allowed in Islam, as opposed to professional speculation, where the speculator is not a serious investor.

Among the hedging mechanisms most used by Islamic banks, we can mention:

  • Currency forward is a currency future contract enabling to sell one currency against another, for a settlement on the date of expiry of the contract, it eliminates the risk of foreign exchange rate fluctuation by fixing a rate on the date of the contract for a transaction which will take place in future.
  • Currency future contract is an agreement to buy or sell a currency for a date and place of delivery in the future. However, this type of contract leads very rarely only to the delivery of the currency, because the positions are closed before the delivery date.
  • Currency option is a hedging instrument, similar to an insurance policy that allows a currency to be exchanged against another on a given date, at a preset foreign exchange rate, without any obligation to do so. Currency options enable to eliminate the risk of spot market for future transactions.
  • Currency swap contract is an agreement aiming to exchange one currency against another and reverse the exchange at a later date. It is based on a notional reference amount, or an equivalent principal amount. Currency swaps are generally used to acquire liquidity. Several regulatory authorities have approved the validity of FX swaps based on the concepts of Wa’ad, Murabahah, Musawamah or Tawarruq. However, conventional swaps such as swap that takes place every evening at 23H, are unanimously prohibited.
  • Currency arbitrage aims to take advantage of divergences in foreign exchange rates in different money markets by buying a currency in one market and selling it in another market to profit from different interest rates.