Risk Management in
Islamic Financial Instruments
5
Exchange launched an S&P BSE 500 Shari’ah index. Islamic banking is also beginning to be
integrated in the more developed banking sectors of Hong Kong, Singapore, and the United
Kingdom (EY 12).
1.3. CURRENT STATUS OF THE ISLAMIC CAPITAL AND SUKUK MARKET
Well-functioning capital markets require sufficient legal, regulatory, accounting and tax
frameworks, established standards, market depth, and liquidity. Such conditions exist to an
extent in the IFSI, but they are underdeveloped in this relatively nascent field, and the IFSI has
the potential to further develop and strengthen its capital markets.
Over the past decade, the Islamic capital market has developed in terms of both sophistication
and size. Increased demand for diversification using Shari’ah compliant investments has
fostered innovations in the Islamic capital market. With the development of Islamic debt
(sukuk), Islamic indices, and equity, a vibrant Islamic capital market is facilitating cross-border
capital flows and funding economic activities. At this time, the Islamic capital markets consist
of Shariah compliant stocks, the Global Dow Jones Islamic Market Index (DJIMI), sukuk, other
Islamic alternatives to conventional debt instruments, and a fledgling legal and tax framework.
For conventional stock markets, stocks are screened based on debt-to-asset, liquidity-to-asset,
and receivables-to-asset ratios. Shariah compliant stocks are similarly screened, but require an
additional step. In order for stocks to be Shariah compliant, they must be screened based on
the principles of Shariah. Islamic stock exchanges include: the Dow Jones Islamic Market
Indexes, the FTSE Global Islamic Index Series, Global’s GCC Islamic Index, the Kuala Lumpur
Shariah Index and the Jakarta Islamic Index ( 10 Year Framework 37-38).
As mentioned previously, Islamic capital markets are relatively young and underdeveloped,
compared to more conventional capital markets. As such, several types of instruments
currently do not exist in the Islamic capital market. These include Islamic versions of primes
and scores, warrants, synthetics, index-linked securities, convertibles, swaps, commodity
futures, and financial futures. Other financial instruments are currently in development:
preferred stock, bonds, floating-rate bonds, securitized loans, and options (10 Year Framework
41).
Most of the development of Islamic financial instruments and products has focused on
leveraging the efficiencies and profit-making effectiveness of conventional financial
instruments. Therefore, most Islamic financial instruments are seen to be derivatives of
conventional instruments. However, according to the report by the Islamic Development Bank,
IFSB, and Islamic Research and Training Institute, engineers of financial instruments should
focus more on creating independent products based on Shariah principles, instead of simply
being substitutes for conventional financial products.
Another weakness of the Islamic capital markets is the limited use of Shariah screening
mechanisms. One of the reasons people choose to use Islamic finance is that their religious
values exclude them from the conventional finance market. As such, a priority for Islamic
finance participants is transparency. The users of Islamic finance desire to know with certainty