Modeling Prices of Islamic Commodity Swaption

Abstract

Derivatives that manage commodity risk over multiple periods are not Sharīʿah-compliant. This study proposes a Sharīʿah-compliant swaption model (waʿdān or two promises on swap) for hedging commodity risk. The model combines two separate and independent waʿds (waʿdān) on commodity swap through murābaḥah contract. Black (1976) model is used to determine the intrinsic value for the counter-parties involved in the contract. The risk-free rate is replaced with the return on AAA ṣukūk to make Black (1976) model Sharīʿah compliant. The proposed Sharīʿah-compliant model is compared with the conventional swaption model, and with the Islamic commodity option (waʿdān on commodity) for its effectiveness. The tests of the model show that the proposed Islamic pricing model has a higher positive effect than the conventional swaption model. In addition, the proposed Islamic commodity swaption is more efficient than Islamic commodity options. The reliability of the proposed model was established by the Monte Carlo simulation run with 10,000 iterations.