Archive for Urbun
‘Urbun’ in Islamic Finance is a down-payment paid by the buyer to the seller giving the right (option) to the buyer to settle the remaining outstanding payment within a prescribed period of time. The investor can choose not to pay the remaining amount in the prescribed period of time, however, the ‘urbun’ or down-payment is then forfeited. However, the forfeited down-payment may be less than the decrease in the price of the investment and therefore the ‘urbun’ has the effect of mitigating the loss incurred by the investor in investments. ‘Urbun’ is accepted in many Sharia’h standards of Murabahah, Ijarah, and Istisna.
For example, Without ‘Urbun’, an investor in stocks/commodities must pay the full payment price or must have agreed to pay a certain fixed price to the seller to obtain the ownership rights to the stocks/commodities. If the market price decreases, the investor’s loss is proportionate to the market price decrease.
An Investor in a fund purchases a basket of shares at USD 1,000,000.00 in anticipation that the value of the shares would increase in the future. Without ‘urbun’, if the value of the shares decreases to USD 900,000.00, the Investor in the fund will incur a loss of USD 100,000.00.
However, if Urbun is used, the Investor in the fund can limit the exposure of her loss. In order to obtain the right to purchase these shares with the value of USD 1,000,000.00, the Investor in the Fund only needs to pay, for example, USD 20,000.00 up front as a down-payment and the remaining USD 980,000.00 within for example one month or the prescribed time period. Suppose the value of the shares goes up to USD 1,100,000.00 in one month. The Investor may exercise the right to obtain the shares by paying the agreed upon amount of USD 980,000.00 within the prescribed period of time and then sell the shares at the market rate of USD 1,100,000.00, thereby making a profit of USD 100,000.00.
On the flip side, if the market value of the shares goes down after the Investor has made the USD 20,000.00 down-payment, the Investor may choose to not exercise her right to purchase the basket of shares for USD 1,000,000.00 and incur a loss of USD 100,000.00. If the Investor backs out, the Investor then forfeits her USD 20,000.00 down-payment, however, the loss the investor incurs at USD 20,000.00 is less than the decrease in the market price of the basket of shares which was USD 100,000.00. Therefore, through ‘urbun’, the investor has limited the scope of her loss in the investment while preserving her ability to make a profit from the investment scheme. This is a brilliant risk mitigation concept! (AMANIE)
Sharia’h Parameters of Islamic Derivatives
Sharia’h Compliant Swaps and Hedging to Mitigate Risks
Management of Risk by State Bank of Pakistan
Parallel drawn by Adam Lewis of Melbourne, Australia that this is the same or similar to a call option in conventional western finance.