Volume 17, Number 6 (August 2015)
Islamic finance is based on the fundamental principle of fair risk sharing. The industry has grown rapidly over the last decade, especially since the global financial crisis. The volume of sharia-compliant financial instruments and transactions has risen remarkably, reaching US$1.4 trillion in 2014. Islamic finance is based on a set of permissible principles that must be followed (eg, profit-and-loss sharing, ethical investment and asset backing) and prohibitions that must be avoided (eg, interest, speculation and gambling).
Islamic finance so far has the foremost merit of being crisis resistant and intrinsically stable. Indeed, the principles of Islamic finance preach the use of equity investment and the design of equity-based financial innovations that embed risk-sharing designs. Islamic finance seems to engender more stable financial markets than conventional finance. In other words, Minsky's (1974) endogenous instability seems not to apply to the Islamic finance industry. This distinguishing characteristic is corroborated by several theoretical and empirical studies that confirm its ability to connect closely the real and financial sectors, playing the role of circuit breaker in times of financial crisis.
The pivotal feature of risk management in Islamic finance is risk sharing. It can be considered the major factor shaping financial innovations. The critique of conventional finance's risk-shifting technique is that it leads to an unfair outcome. Indeed, Greenspan (1999) argues that derivatives - the standard vehicles for shifting risk - are zero-sum contracts. Although the academic literature in finance and economics is awash with conceptual and narrative papers dealing with risk sharing, there is a real scarcity of quantitative contributions and empirical works in this area. The papers
published in this special issue fill this gap by investigating a variety of theoretical and empirical issues.
In our first paper, "The management of refinancing risk in Islamic banks", Kenneth Baldwin investigates the risk engendered by maturity mismatches. The author studies the risk that an unexpected increase in the cost of refinancing liabilities as they mature will not be offset by corresponding asset returns. Baldwin develops a model that quantifies a reserve that alleviates the variability of net income variability. The model pioneers both the derivation of the optimal size of a refinancing risk reserve and a rule for allocating the reserve to successive reporting periods.
The issue's second paper, "Recursive profit-and-loss sharing" by Walid Mansour, Mohamed Ben Abdelhamid and Almas Heshmati, develops a new type of option, called a profit-and-loss sharing (PLS) option, that is recursively embedded in a threetier partnership. The authors show that the financial design allows simultaneous sharing of risks among the contracting parties and immunizes the project from premature default.
In the third paper in the issue, "Applying the Cornish-Fisher expansion to value-at-risk estimation in Islamic banking", Hylmun Izhar explores the operational risk exposures of Islamic banks. The author uses the delta-gamma sensitivity analysis-extreme value theory (DGSA-EVT) model and the Cornish-Fisher expansion to take account of the value-at-risk (VaR) approach's nonnormality assumption of risk variables. The merit of the latter method is that it alleviates the over- or underestimation of the VaR. One major handicap of over- or underestimation is that it may mislead the Islamic bank's chief risk officer. The advantage of the technique proposed in this paper is that the model can be customized according to the level of sophistication of the Islamic bank in generating its income.
In our fourth paper, "Advanced risk profile analysis of Islamic equity investment: evidence from the American, Asian and European markets", Mondher Bellalah and Zeineb Chayeh investigate the risk profile of three conventional and Islamic equity indexes. The results show that the Islamic Europe and US equity indexes seem to be less risky than their conventional counterparts. The authors attribute their findings to two factors that clearly differ between the indexes: sectors and leverage. Nonetheless, this result does not hold true for the Islamic Asia/Pacific equity index, which indicates
a higher level of risk during the last financial crisis. On balance, this paper finds that Islamic investment can be used as a risk-hedging tool during financial crises.
In the fifth paper in the issue, "Commodity risk hedging through risk sharing: reengineering Islamic forwards", Ali Kafou and Ahmed Chakir study the use of Islamic innovations for hedging commodity risk according to the risk-sharing principle. The authors pioneer the use of Islamic forwards, known as salam contracts. They use Monte Carlo simulation and consider multiple salam contracts with the same characteristics. They show that, beyond a given threshold for the commodity's price volatility, the optimal risk-hedging strategy in the context of a mutual risk-sharing arrangement involves one salam contract.
I hope readers find these papers interesting and that they spur supplementary practical and academic work. Further quantitative papers would help practitioners in the Islamic finance industry to benefit from risk-sharing techniques for various purposes, such as portfolio performance, hedging effectiveness and financial stability.
Guest Editor: Walid Mansour
Islamic Economics Institute, King Abdulaziz University
Papers in this issue
The management of refinancing risk in Islamic banks
This paper investigates the risk engendered by maturity mismatches.
Recursive profit-and-loss sharing
This paper develops a new financial product that allows the profit-and-loss sharing (PLS) principle to be enforced recursively in practice.
Applying the Cornish–Fisher expansion to value-at-risk estimation in Islamic banking
This study deliberates upon a proposed delta–gamma sensitivity analysis–extreme value theory (DGSA–EVT) model that focuses on the assessment of risk exposures represented by the value of value-at-risk (VaR) in three incomegenerating channels: one in…
Advanced risk profile analysis of Islamic equity investment: evidence from the American, Asian and European markets
This paper investigates three Islamic equity indexes, classified by economic hubs (Dow Jones Europe, Asia/Pacific and United States), against their conventional peers from 2003 to 2009.
Commodity risk hedging through risk sharing: reengineering Islamic forwards
This paper studies the possibility of using Islamic forwards, which are commonly known as salam contracts, to hedge commodity risk, while respecting the principle of risk sharing.