Although technically just a repeat sale or 'supply' arrangement, (see, eg., Md Ayub, pg 355), Istijrar is both a very sophisticated contract and in the form most quoted can have elements resembling 'Asianing' in options (i.e., average price), and barrier options, (although note that it is not really an Asian option, but a series of barrier options). See as well Thomas, Cox and Kraty, Structuring Islamic Finance Transactions, pp 71-2.
The modern use of the contract was begun by Mufti Taqi Usmani and this interesting payoff is described in some detail in papers by Md Obaidullah and Obiyathulla I. Bacha. Istijrar: A Product of Islamic Financial Engineering Dr Mohammed Obaidullah (New Horizon, no 68, Oct 1997). We are asking permission to reproduce this article in electronic format as IIBI has not yet finished scanning their back issues (expected time July 2009, Insh'Alah). (Please check this posting again soon to see if we have received permission)
It is also mentioned in some detail in Obaidullah's online book: part 4, p48ff (190). And, this lecture note by O.I. Bacha, Derivatives in Islamic Finance--An Overview, p 21ff or his paper Derivative Instruments and Islamic Finance: Some Thoughts for a Reconsideration, see pp 23ff.
The details of the arrangement are as follows (according supposedly to Dr. Muhammad Imran Ashraf Usmani), see MeezanBank Guide to Islamic Finance, section 19, or Istijrar as well. Please note that although this is a sale, after the execution of the Master Murabaha, no offer or acceptance is issued and sale is concluded merely by posession (bay al-ta'ati or al-mu'atah).
Master Murabaha facility or Istijrar facility agreement is signed between the bank and its client under which various Sub-Murabahas would be extended:
At Time T0:
The Master Murabaha agreement will describe the following formula for the price range an the Murabaha price P*:
- The upper and lower range around the cost price P0 is determined. This price range may be linked to a benchmark such as 'LIBOR+margin'. Hence the price bound would change when the benchmark shifts.
- The Murabaha price P* or the exercise price is set. This is the price which may be applied if the market price of the asset goes above or below the price range during time T0-T90.
- When the Sub-Murabaha or 'Declaration' is signed at T90, the sale is executed.
- The settlement price Ps is determined at this time.
- Avg price of asset during T0-T90
- Exercise price fixed by either party afte the market price of asset during time T0-T90 has gone out of the rice range. This exercise price may be the murabaha price P* or some other price fixed by either bank or customer.
- If a number of Sub-Murabahas have been executed under the Master Murabaha Agreement, then each will be settled according t is own settlement price on the settlement date.
- In order to decrease the price volatility between Declaration Date an the Settlement Date, the duration may be reduced.
T0 - Time when Master Murabaha agreement or Istijrar agreement is signed.
T90 - Time when declaration is signed
Ts - Settlement Date P0- Cost price
P*- Murabaha Price
Declaration -- Offer and Acceptance between Custeomer and Bank to sell the asset back to customer.
- Murabaha Price P* is to be determined at the time of extending the Sub-Murabaha.
- The Murabaha Price P* cannot be fixed as the settlement price Ps by the Bank or the Customer during the tenor of the sub-Murabaha T0-T90
- Ps-settlement price may be the prevailing market price of an average of the price during the Istijrar period.
- The price on the settlement date cannot be changed by either party even if the market price has gone out of the pri range during the tenor of the sub Murabaha.
- Master Murabaha Agrement/Istijrar agreement is signed at T0
- Agency agrement is signed (if required) at T0.
- When the bank purchases the commodity the Declaration (Sub Murabaha) is signed at T90.
- Ps-the Settlement Price (Contract Price) is paid on the Settlement Date.
While the features of this derivative contract/arrangement are described in some detail in these papers, the technicalities and legalities and Shariah aspects are less easily found. But the amazing thing is that this arrangement is merely a set of sales.
Islamic Law of sale is such that Istijrar is not considered a set of strange options, no wa'ad is necessary, no khiyar is needed (although they can apparently also be used). In sales contracts there is flexibility according to the payment and settlement of price. Bay' bi Sirr al-Suqq (payment at market-determined price) is the subject of relatively rich discussion and we will go over this, Insh'Allah, in another post, but this is one area of fiqh which touches upon Itijrar. The fact that Istijrar is a repeat sale makes many scholars feel that this flexibility (delay of payment and price set according to market average) should be afforded to this arangement. Moreover, the embedded derivative elements help to reduce the risk, reducing the gharar of the arrangement to something considered to be 'acceptable'.
Please note as well that Istijrar is extremely flexible and can be used for many other types of contract (e.g., ijara, and mudaraba, supposedly) and can probably allow for a great many other payoff profiles. This, using Islamic Law of Sale, is something that has not been used to its fullest as yet in Islamic Finance, and we should probably expect much more future innovation in Islamic Finance using Istijrar.
As we mentioned above, we hope to write more on the notion of sale at market-determined price (bay' bi sirr as-suq) as well as the more conventional delay in payments and more details on conclusion of sale without offer/acceptance.
This is one of the hidden gems of Islamic Finance.