Salaf contracts are classified as debt instruments and are one of the most innovative financial instruments being used in Iranian market. These contracts provide short term and long term financing for corporates to meet their financing requirements and to promote industrial growth in Iran’s market. An investor who holds typical Salaf contract is not able to engage in transactions prior to the time to maturity of the contract. Therefore, typical Salaf contracts are similar to European options such that an option can only be exercised at its maturity.

However, this issue has been resolved by introducing Parallel Salaf Contracts (SPC). These contracts are trading in Iran’s energy and merchantile exchanges since 2015 and provided a great opportunity for investors to benefit from these financial assets. Individual investors are able to trade these contracts in the secondary market. SPC has two main benefits which are:

1) Provide financing for corporates 2) Trading opportunities for investors.

The mentioned benefits are subject of the discussion for this article. It is important to note that the existing article reviews the trading mechanism of paper-based SPC contracts. However, reviewing the physical market is beyond the scope of this report and will be further investigated in another article.

 

In a typical SPC, an investor buys a contract similar to futures contract, which represents a small percentage of the underlying asset such as fuel oil. A contract holders need to close the contract at the time of the maturity.

Investors who hold the primary SPC can sell it to other investors in the secondary market. These SPCs also are tradable in the secondary market. The value of each contract represents a small percentage of the value of underlying asset.

 

SPC investors enjoy daily compounding returns. Each SPC lasts for one year and each contract size is equal to one ton (this unit apply for Fuel Oil) of the underlying asset. Similar to futures contract, the value of SPC tracks the value of underlying asset and investors are expected to monitor the value of the underlying asset on a daily basis. The trading in secondary market commences 10 days following the initial offering of the contract. The settlement date for each contract is 10 days prior to contract expiry date.

 

The main trading mechanism of SPC has been reviewed in the below:

 

  • The exercise price for SPC at the time to maturity is equal to 123% — the initial value of the underlying asset at contract opening day (Spot price). If the value of the underlying asset at the time to maturity (settlement date) is less than exercise price, then an investor has the right to sell the contracts to contract issuer at exercise price and gain at minimum 23% return over one year.
  • If the value of the underlying asset at the time to maturity (settlement date) is greater than exercise price, then contract issuer has the right to buy back the contract from contract holder. As such, investors are expected to gain maximum of 24% return over one year.
  • The realized profits for contract holders are only distributed at contract settlement date with no payment being made during the course of the contract.
  • SPC are exempted from taxes.
  • The money raised by companies through bond and debt instruments in Iranian market can only be used for specific projects as defined to investors at the time of the purchase. However, money raised through SPC are within the full ownership of the SPC issuer and it can be used for multiple purposes such as financing of various projects, short and long term investments.
  • The SPC issuer is the guarantor of the contract, which gives the company full authority in exercising the contracts.

Table below provides a review of SPC contracts in Iran energy and mercantile exchange:

Energy Exchange:

Salaf

 

Mercantile Exchange:

 

Salaf Given the volatile nature of Tehran’s Stock Market, we assessed the relative performance of market return (TSE index) and Fuel oil SPC contract in the below chart. While Fuel oil SPC contract grew consistently and significantly outperformed market return over the second half of 2015, Tehran Stock Market experienced rapid growth over the first 3 months of the year (2016). As such, SPC can also be used as hedging instrument for active participants of the market as it enables them to recover potential losses they could have incurred in equity market through SPC.

 

 

Salaf

 

 

It is important to note that the content of the article is only a high level introductory to Salaf contracts trading mechanism in Iran, which aims to provide a background view for readers. As such, the information shall not be considered as advice or a recommendation to investors.