262 AN INTRODUCTION TO ISLAMIC FINANCE
the time of contract. However, application of bay’ al - salam to foreign cur-
rency is not permitted simply because Islam treats currency as a medium of
exchange and not as a commodity. There are no other instruments that can
be used to hedge against the volatility of the exchange rate.
The following section demonstrates how a currency forward contract
may be constructed synthetically without a standard forward contract. The
synthetic construction of a forward contract means that the payoffs are
identical to a forward contract, but they are achieved through a set of dif-
ferent transactions executed in a certain sequence. These products can make
signifi cant contributions to risk management in Islamic fi nancial markets,
providing hedging against currency risk.
Take as an example an importer in an Islamic country who wants to
hedge against the volatility of a foreign currency. In the absence of a cur-
rency forward contract, the importer will be exposed to risk arising from
any appreciation in the value of the foreign currency. Assuming that there
are no market frictions such as taxes, capital controls and transaction
costs and that there are fi nancial intermediaries who have access to both
local and foreign money markets, a forward contract can be constructed
synthetically using the murabahah contract, which results in a fi nancial
claim from the sale of a real asset. However, since the margin above cost
(mark - up) is agreed upon in advance, the expected rate of return is pre-
determined. The fi nancial claim created in this fashion is similar to a
zero - coupon fi xed - income security or a certifi cate of deposit (CD) in con-
ventional banking.
Suppose that the importer wants to hedge X amount of foreign currency
obligation for a period of time (T) from today (T 0 ). Current market rates
of return on a three - month murabahah contract in domestic and foreign
markets are Rd and Rf respectively. The importer can approach a fi nancial
intermediary or Islamic bank to arrange for the purchase of X amount of
foreign currency in the future.
The following steps can be taken by the fi nancial intermediary to pro-
vide a currency hedge to the importer by taking positions in assets in foreign
markets in collaboration with a local investor:
On the date of the contract (T 0 ):
Step 1: Importer requests the bank to arrange for a currency forward
contract for maturity T. The banker enters into a jo’alah contract with the
importer to deliver X amount of foreign currency at the foreign exchange
rate at time T. This contract allows the importer to hire the bank to
provide a service; that is, to arrange or deliver currency at time T for a pre-
determined fee.
Step 2: The banker fi nds an investor in the domestic market who is will-
ing to participate in arranging a currency forward contract for maturity T.
Or, the bank may use funds from an existing depositor’s investment account
as well. Let us assume that the expected rate of return in the local market
at time T 0 was Rd.