Commodity risk hedging through risk sharing: reengineering Islamic forwards

ABSTRACT In this paper, we study the possibility of using Islamic forwards, which are commonly known as salam contracts, to hedge commodity risk, while respecting the principle of risk sharing. Results show that this can be achieved by considering a stochastic forward price. In addition, splitting the deal into many salam contracts that have the same characteristics with regard to size and delivery date almost removes the zero-sum structure of salam's payoffs. To compute the number of needed contracts, we use a Monte Carlo simulation. The estimated number is large and increases with price volatility. Nevertheless, when this volatility exceeds a certain threshold, keeping one contract becomes the optimal solution for risk sharing. The relatively large number of needed contracts renders the splitting impracticable. Therefore, it is reduced to a number that both parties of the deal can agree upon. Finally, this hedging strategy is only possible within a mutual risk-sharing arrangement, because the price in salam must be specified; otherwise, the contract is void.