Source: BURSA MALAYSIA | Published: September 2023
Hedging is a crucial financial concept that enables traders and investors to reduce a variety of risk exposures they encounter.
A hedge is essentially an opposite or offsetting position that is taken. Its value increases or decreases as the value of the underlying position does.
Therefore, a hedge can be viewed as the acquisition of a type of insurance policy on an investment or portfolio. By diversifying or using assets that are closely connected, one can attain these offsetting positions. The adoption of a derivative, such as a futures, forward, or options contract, is frequently the most popular and efficient hedge.
Hedging in Conventional Equity
Alternative investments known as hedge funds take advantage of market opportunities. However, hedging is not limited to hedge funds alone. Broader concepts of hedging exist to mitigate risk in the financial markets, including Shariah-compliant investments and other risk management strategies. Compared to many other investment categories, these funds require a bigger initial deposit and are typically only available to authorised investors.
That is because regulatory bodies, such as the Securities and Exchange Commission (SEC) in the United States or the Securities Commission Malaysia, regulate hedge funds far less strictly than other financial products like mutual funds or unit trust funds. Due to the illiquidity of most hedge funds, investors must keep their money invested for longer periods of time, and withdrawals are sometimes time-limited.
They employ various tactics as a result, allowing their investors to receive active returns. However, prospective hedge fund investors must understand how these funds generate revenue as well as the level of risk they assume when investing in this kind of financial product.
Hedging in Islamic Equity
Due to the prohibition on using traditional derivatives in Islamic finance, hedging creates special difficulties in the context of Islamic equity.
It appears that the noble goal of hedging, which is to manage risk, has been misinterpreted as being just to make money and it seems that there is still no agreement among Islamic scholars as to the legitimacy of derivatives under Islamic financial principles.
The Islamic Derivative Master Agreement (IDMA) was released by Malaysia's central bank, Bank Negara Malaysia, in 2007.
The bank created this first-ever international Islamic regulation for trading in Islamic derivatives in order to promote the growth of Islamic hedging and lower investment risk in the Islamic financial market.
The ISDA/IIFM Tahawwut Master Agreement (TMA), based on the common structure of a commodity Murabahah transaction, was created in 2010 by the Bahrain-based International Islamic Financial Market (IIFM) and the International Swaps and Derivatives Association (ISDA).
The market's demand for a market benchmark for Islamic hedging transactions served as the catalyst for the creation of the TMA, and subsequent developments of the agreement have also been driven by the market.
For example, ISDA established a working group to discuss documentation, legal, and regulatory issues affecting trading in over-the-counter derivatives transactions with corresponding parties in Islamic jurisdictions.
The Sixth Islamic Financial Services Board seminar addressed progress in the field of Islamic hedging. It emphasised the need for international standards to govern transactions involving Islamic hedging instruments.
An appeal was also made for research into Islamic hedging to support the creation of original and imaginative tools.
Bai Al Arbun is an option that adheres to Shariah principles. In this case, the fund business makes a partial payment and accepts delivery of the stock in exchange for a promise to complete the transaction by paying the remaining balance within the allotted time, failing which the stock must be returned and the token down payment forfeited.
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