Islamic banks generally try to minimize their exposure to exchange rate fluctuations in long-term transactions. Some of the key mechanisms they use include:
1. Currency Hedging: Islamic banks may utilize Islamic hedging instruments like currency forwards, options, or swaps to lock in exchange rates for the duration of a long-term contract. This helps mitigate the risk of unfavorable exchange rate movements.
2. Index-Linked Pricing: Instead of fixing the price in one currency, Islamic banks may structure long-term contracts with prices linked to a foreign exchange index. This allows the pricing to adjust automatically with exchange rate changes.
3. Risk Sharing: In some cases, Islamic banks may share the exchange rate risk with their clients by agreeing to split any gains or losses resulting from currency fluctuations over the life of the contract.
4. Shorter Tenors: Islamic banks may prefer to engage in shorter-term transactions rather than very long-term contracts to limit their exposure to exchange rate volatility.
5. Invoicing in Stable Currencies: Islamic banks try to denominate long-term transactions in relatively stable and predictable currencies to reduce exchange rate risk.
Islamic banks adopt mechanisms such as Sharia-compliant hedging instruments (e.g., Islamic forward contracts, currency swaps), profit-sharing agreements, and risk-sharing contracts (e.g., Musharakah and Mudarabah) to manage exchange rate changes in long-term transactions while adhering to Islamic finance principles.
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