Istijrar Contracts – An Untapped Gem in Hedging Price Risk in Commodity Accumulators

Abstract

Derivatives continue to play an integral role in hedging several types of risk in conventional as well as Islamic finance. While there has been, and continues to be, a lack of consensus from Islamic scholars regarding the complete permissibility of the usage of derivatives in risk management, efforts have been made in order to develop and innovate Shariah-compliant equivalentsto conventional contracts in order to ensure that Islamic Financial Institutions (IFIs) and Shariah-compliant clients have prudent risk management tools to minimize their risk exposure on several fronts. This study proposes a Shariah-compliant Istijrar Accumulator model to hedge against price and commodity risk by using Murabaha-based Istijrar contracts as a way to set a price mechanism for the supply of commodities during a long time period. A binomial option pricing model, Cox, Ross & Rubenstein (1976), is used to determine the intrinsic value of the contract, adjusted for the Ribawi factor (interest factor) by replacing risk free rate with the AAA sukuk return. The proposed Shariah-compliant model is also compared with the conventional KODA structures model as a test for fairness between each party involved in the contract. The results of the model show that the proposed Islamic Istijrar Accumulator limits the downside risk that is observed in the conventional commodity accumulators (dubbed as ‘I’ll kill you later” contracts). Risk is shared rather than transferred between both counterparties in the Istijrar accumulator model which confirms that the payoffs to each party is fair and therefore, a better alternative as an accumulator structure than the conventional model.