An overview of FX risks

Currencies fluctuate based on various factors including (but not limited to) monetary policy, inflation, political environment and trade balances. Companies conducting business globally face foreign exchange (FX) risk in three forms:

a) transcation exposure from individual deals in foreign currencies;

b) translation exposure when converting foreign subsidiaries’ financial statements into the reporting currency; and

c) economic exposure where currency fluctuations affect future cash flows and market value.

Conventional FX risk management employs financial instruments like forwards and options. Forwards lock in future FX rates while options provide the right but not the obligation to transact at a specific rate. However, Forwards violate Shariah principles of currency trading and physical possession while options trade in rights, incorporate speculation, and involve debt swaps. Thus, both are prohibited in light if Shariah principles and rulings

Shariah Compliant Alternatives for FX Risk Hedging

Shariah compliant alternatives exist. Back-to-back interest-free loans in different currencies provide a simple hedge. Trading in foreign currency by creating offsets and settling transactions in foreign currency is another practical solution. Another common method is the use of Commodity Murabaha that are structured to cover the FX risks. The wa’d (unilateral promise) method is most common – a single wa’d where one party promises or double wa’d where both parties promise to transact in the future if conditions are met.

In conclusion, FX risk is an inherent challenge for global businesses. While conventional instruments are not Shariah compliant, Islamic finance has developed permissible alternatives based on interest-free lending, trade, and promises that allow companies to hedge risk in a Shariah compliant manner. With the growth of Islamic banking, Shariah compliant hedging mechanisms are becoming more robust and sophisticated, providing tools to manage currency volatility in a way that meets both economic and Shariah principles.

Download the paper to learn more about hedging currency risk

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