Islamic investments funds versus hedge Funds

Diploma Thesis, 2008

155 Pages, Grade: Sehr gut



1.1 Background
1.2 Statement of the problem
1.3 Objectives
1.4 Justification
1.5 Structure

2.1.What are Islamic investment funds?
2.1.1 The Shariah
2.1.2 The principles of Shariah
2.1.3 The Shariah board
2.2 Historic and future development
2.2.1 Financing in the beginning of Islam
2.2.2 Islamisation of the economy – Pakistan in its outrider role
2.2.3 The history of the Islamic capital market
2.2.4 Current market environment of Islamic capital market
2.2.5 Further development of Islamic capital markets
2.3 Special characteristics of Islamic finance
2.3.1 Interest in Islamic finance
2.3.2 Risk in Islamic economics
2.3.3 Gharar
2.4 Financial engineering in Islamic finance
2.4.1 Principles of financial engineering
2.4.2 Strategies for product development
2.5 Special characteristics of Islamic investment funds
2.5.1 Shariah principles for Islamic investment funds
2.5.2 Investing in shares
2.5.3 The purification
2.6 Regulation of Islamic investment funds
2.6.1 Difficulties of adopting existing regulations
2.6.2 Unifying regulations
2.6.3 Information disclosure
2.6.4 The Shariah board
2.7 Vehicles of Islamic finance
2.7.1 Murabaha (cost plus financing)
2.7.2 Bai muajjall (deferred payment)
2.7.3 Bai salam (prepaid purchases)
2.7.4 Istisna (manufacturing contracts)
2.7.5 Mudarabah (partnership)
2.7.6 Musharakah (profit and loss sharing)
2.7.7 Ijara (leasing)
2.7.8 Quard hassan (benevolent loans)
2.7.9 Sukuk
2.7.10 Sale and buy back agreement
2.7.11 Islamic accepted bills
2.7.12 Government investment issues
2.7.13 Islamic treasury bills
2.7.14 Islamic negotiable certificates of deposit
2.7.15 Islamic private debt securities
2.7.16 Al rahnu agreement-I
2.8 Principles of Islamic financing techniques
2.8.1 Nature of financing
2.8.2 Role of the investor in the management and use of funds
2.8.3 Risk bearing by the investor
2.8.4 Uncertainty of the rate of return on capital for the investor
2.8.5 Cost of capital for the fund manager/finance user
2.8.6 Relationship between cost of capital and the rate of return on capital
2.9 Types of Islamic investment funds
2.9.1 Islamic equity funds
2.9.2 Ijara funds
2.9.3 Islamic commodity funds
2.9.4 Murabaha funds
2.9.5 Bai-al-dain
2.9.6 Mixed funds
2.9.7 Islamic investment funds companies
2.10 Islamic investment fund databases and indexes

3.1 What are hedge funds?
3.1.1 Historic and future development
3.1.2 Special characteristics and objectives of hedge funds
3.2 What is the difference between hedge funds and alternative investments?
3.2.1 Returns and the role of the hedge fund manager
3.2.2 Risk and regulation
3.2.3 Investment instruments and trading techniques
3.2.4 Incentives and payment structures
3.3 What are the strategies of a hedge fund manager?
3.3.1 Global macro
3.3.2 Event driven
3.3.3 Equity hedge
3.3.4 Relative value
3.3.5 Short selling
3.4 Style drift
3.5 Investing in hedge funds
3.5.1 The alpha factor
3.5.2 Key determinants of return and risk
3.5.3 The hedge fund manager – a crucial driver for return
3.5.4 The life cycle of a hedge fund strategy
3.6 Hedge fund trends
3.7 The opportunities and risks of hedge funds
3.8 Further development of hedge funds
3.8.1 Hedge fund databases and indexes
3.8.2 Performances in comparison
3.8.3 Concerns in performance measurement
3.9 Fund of hedge funds

4.1 Can Islamic investment funds catch up with conventional investment funds?
4.1.1 How costly is Shariah compliant investment
4.1.2 Advantages of Islamic investment funds
4.1.3 What are the barriers to growth?
4.1.4 Conclusion: Can Islamic investment funds catch up with conventional investment funds?
4.2 11Is hedging for Islamic investments possible?
4.2.1 Hedging in Islamic finance
4.2.2 Futures
4.2.3 Options
4.2.4 Swaps
4.2.5 Islamic venture finance
4.2.6 Conclusion: Is hedging for Islamic investments possible at all?
4.3 Can Islamic investment funds appeal to Non-Muslims?
4.3.1 Islamic investment funds’ spread to the world
4.3.2 The problem of the brand “Islamic investment funds”
4.3.3 Conclusion: Can Islamic investment funds appeal to Non-Muslims?
4.4 How to balance an investment portfolio with Islamic investment funds and hedge funds
4.4.1 Advantages and disadvantages
4.4.2 Balancing the portfolio



Adnan Siddiqi
Peter Hrubi


1 Introduction

1.1 Background

Alternative investments represent an “alternative” to traditional investments like mutual funds. However, there is no single definition. A popular Alternative investment is the so called hedge fund.

Hedge funds gained popularity in the 1960s when Alfred Winslow Jones generated a significantly higher profit by using hedge funds than he would have made using traditional investment funds. He tried to optimize the return of his traditional portfolio by selling short and borrowing debt capital. As a result of the short sales, he also benefited from declining share prices and became independent from the general market development. Through the investment in borrowing debt capital, he achieved a leverage effect, as he could apply much more capital than he had equity. In 1986, the value of a Hedge fund increased by 750% in only six years. Most of today’s hedge funds are built on the agreement of a “limited partnership with lucrative incentive-fee structure”.[1]

However, there also has been some turbulence on the hedge funds’ flight to the top. One famous example is the Long Term Capital Management (LTCM) hedge fund, founded in 1994. It began trading with an investors’ capital of $ 1.3 billion, being initially very successful with annualized returns of over 40% in its first years. Although this looks to be a very successful story, the dream ended in late summer of 1998. Due to various reasons, LTCM’s equity fell from $ 4.72 billion at the beginning of 1998 to $ 600 million in September without shrinking the portfolio, which also led to a significant elevation of the already high leverage. Total losses were found to be $ 4.6 billion. This was a disaster for both managers and investors.

Nevertheless, the market recovered and hedge funds continued to be successful. Up until the end of 2007, assets under management worth around $1.5 trillion, spread over more than 10,000 funds (investments including pension funds and university endowments).[2] Recent studies suggest a further increase in volume and number of hedge funds: By 2010, it is predicted that the number of funds will be at the same level (10,000 funds) but the invested capital will be about $ 3 trillion, twice the amount of today’s capital.[3]

Islamic investment funds are a special type of alternative investment funds, which may become more popular than hedge funds in the next years. They can be described as “a joint pool wherein the investors contribute their surplus money for the purpose of its investment to earn permitted profits in strict conformity with the precepts of Islamic Shariah”[4]. The history of Islamic finance goes back to the time of the Prophet Muhammad. However, Islamic investment funds started at almost the same time as hedge funds.

The first Islamic financial institutions were established in the 1960s in Egypt and Malaysia. However, it was not until the oil boom in the 1970s that the industry began to attempt to create financial products in accordance with the Shariah. This growth continued in the 1980s and 1990s. Islamic financial institutions spread to several western countries, which consequently started to establish “Islamic windows” in their commercial banks. Today there are more than 270 financial institutions[5] operating on the basis of non-interest instruments in more than 40 different countries.[6]

The Islamic bank and financial activities are estimated to be about $ 260 billion[7] and $ 350 billion respectively today, which are 40 times higher than the amount of $ 6 billion it reached on the early 1980s.[8] As this growth suggests, there is a lot of movement in the market of Islamic financial institutions which arose from the desire to achieve Islamisation of the economy. The Islamic capital market is still growing. The overall size of the market for Islamic investments and Muslim capital is estimated to be around $ 750 billion. Islamic financial institutions have increased by a factor of 40 since 1982, demonstrating tremendous growth of the Islamic financial market.[9]

1.2 Statement of the problem

The following main issues arise for hedge funds:

- Risk: Hedge funds contain a large portion of risk, due to the applied instruments like short selling or leveraging. Investors have to be aware of the risk-factor when investing in hedge funds.
- Manager: The manager carries two responsibilities, summarized as the “alpha factor”. First of all he is solely responsible for the outcome. Thus, the selection of the manager is essential. Further, there is the problem of asymmetric information, as he can decide which information he wants to forward to his investors and which not. Consequently, there is a huge potential of encountering the problems of moral hazard and adverse selection.
- Regulation: In order to prevent the market from contamination, huge efforts have been made to regulate the hedge fund business. However, these regulations have also narrowed the freedom to manage hedge funds and thus led to decreasing profit opportunities.

In comparison, Islamic investment funds face the following problems:

- Structural issues: As Islamic investment funds need to comply with Islamic law, some business areas like gambling, pork and weapons are excluded and some financial techniques like interest, short selling or leverage must not be applied. This fact reduces the opportunities for these sorts of funds.
- Legal issues: As Islamic investment funds are still “underdogs” in the investment industry, not all countries offer optimal legal structures for them. For example, in some cases, problems of double taxation exist. This implies a competitive disadvantage compared to traditional investment funds.
- Regulation: As for legal issues, Islamic investment funds also face regulatory boundaries. These also imply disadvantages for Islamic investment funds.

1.3 Objectives

Despite these issues, hedge funds and Islamic investment funds offer a variety of advantages, which can not be dismissed. One objective of this thesis is to analyze the advantages and disadvantages to get a better picture of both.

Another important question is how to balance an investment portfolio including hedge funds and Islamic investment funds. In some cases, there are similarities between both, which can be used in a synergetic way. For example, Islamic investment funds enable better hedging against market risks, which may help hedge funds to achieve a better profit-risk relation. Strong differences are born out of the appliance of Islamic law and the short-term actions of hedge funds. Out of the issues raised above, it becomes necessary to consider the special characteristics of each, balancing the investment portfolio. This paper tries contributing to this issue by giving a bigger picture of Islamic investment funds and analyzing the differences and synergies between both.

To reach this objective, the following three questions will be considered to provide a framework for the thesis:

- Can Islamic investment funds catch up with conventional investment funds? o Is hedging for Islamic investments possible at all?
- Can Islamic investment Funds appeal to Non-Muslims?

Through these answers, the conclusion shall then derive a better understanding of

- their advantages and disadvantages, o their differences and synergies,
- and how to possibly balance an investment portfolio including Islamic investment funds and hedge funds.

1.4 Justification

Existing literature mostly discusses alternative investments and Islamic finance separately and rarely provides direct comparison between hedge funds and Islamic investments. This thesis shall contribute in filling this gap, by exploring the characteristics of both in the same paper.

Further it shall provide a first insight for investors, taking hedge funds and Islamic investment funds into consideration for their investment portfolio.

1.5 Structure

While alternative investments like hedge funds, provide tremendous advantages in comparison to conventional investment funds (like hedging, etc…); Islamic investment funds are a bit different. Most of the financial instruments like hedging, options and futures cannot be applied by Islamic investment fund managers, due to religious constraints. Nevertheless, as we show in chapter 4.2, Islamic funds seem to be even less risky than hedge funds while reaching the same or even better profits. There are various other facts that might or might not appeal to investors (e.g. that Islamic investment funds are classified as ethical investments) and in the end of this paper we want to examine Islamic investment funds as a serious alternative to conventional investment funds like mutual funds or hedge funds.

In the first part of this paper we discuss Islamic investment funds. Islamic investment funds are basically investment funds that are compliant with the rules of Islamic law, which is called the Shariah. Islamic investment funds are one part of a larger Islamic finance movement that started to become serious in the first half of the 20th century and continues to gain enormous economic power until today. Islamic finance itself goes back to the beginning of Islam. Due to the colonization of the Islamic countries, it got replaced by western financial systems, but as these countries gained independence, Islamic finance re-emerged.

Islamic banks seem to be the basis for all Islamic finance activities. As Wilson (1999) discussed in his paper, the success of Islamic banks in Europe is accompanied by the spread of Islamic investment funds. A good example for this development is the experience of the bank Al-Baraka.

Al-Baraka International Bank was the first bank to solely offer Islamic banking services in the 1990s. Its major business was with clients from the Gulf region that resided in London, but with the increase in the number of British Muslims, more and more Islamic services were used by British citizens as well. Next to usual banking services, Al- Baraka also offered investment deposits on a mudarabah profit sharing basis (see chapter 2.7.5 for more details on mudarabah). The deposits rose from £ 23 million to £ 154 million within 8 years and soon Al-Baraka could not handle all the funds by itself and had to trade through an affiliate company. Soon investment management became more profitable than banking services and Al-Baraka acted more and more as an investment company than as a bank. Consequently, in 1993 Al-Baraka surrendered its banking license and closed its branches to focus solely on investment activities. The Al- Baraka Investment Company and the Dallah Al Baraka Investment Company were founded shortly after.[10]

The example of Al-Baraka shows how Islamic investment funds are dependent on Islamic banking and the Islamic financial system as a whole. We concluded out of such historic processes that this would also be a perfect structure for our research on Islamic investment funds: first we point out Islamic finance to provide an understanding for Islamic economy, which is essential to understand Islamic investment funds, following this we consider Islamic investment funds themselves.

Since little effort has been made into researching Islamic investment funds until now, we try to utilize the enormous academic work on Islamic banks and finance to derive conclusions for Islamic investment funds. Nevertheless, some academic work has been done on Islamic investments and we tried to include as much as we thought would be useful in serving our purpose for providing a full picture of Islamic investment funds.

After defining Islamic investment funds and discussing the principles and fundamentals of the Islamic finance System (chapter 2.1), we give an overview of the history of Islamic Finance and Islamic investment funds (chapter 2.2). In chapter 2.3 we discuss the special characteristics of Islamic finance, resulting from the Islamic law and the principles and strategies for Islamic financial engineering and product development. In this section, we also take a closer look at the religious constraints, which build the basis for Islamic finance.

After this section on Islamic finance, we turn to Islamic investment funds and start with special characteristics and principles of Islamic investment funds, which are mainly based on the special characteristics of Islamic finance (chapter 2.5). Regulation plays an important role for alternative investment funds and in chapter 2.6 you can observe, why it is even more important for Islamic investment funds.

After these general considerations, we turn to specific investment vehicles that are available for an Islamic investment fund manager in chapter 2.7 and talk about the principles that underlie such investment techniques (chapter 2.8). In contrast to conventional finance, an investment in Islamic finance is always seen as a venture or business set up by parties providing capital and investment experience and expertise. For this, Islamic finance instruments are contracts, closed between the engaging parties. The main contracts will be discussed in this section. We conclude this part with an analysis of various types of Islamic investment funds. The final chapters of our Islamic investment fund section are about the various types of Islamic investment funds that are derived out of the various trading vehicles and techniques (chapter 2.9) and Islamic fund databases (chapter 2.10).

To provide a base for such an analysis, we discuss the archetypal alternative investment fund - the hedge fund – in the second part of this paper. We will define hedge funds in chapter 3.1 and give a short overview of the history of hedge funds in chapter 3.1.1. Since hedge funds are huge players in the investment fund society, we discuss their differences to conventional investment funds in chapter 3.2 to provide reasons for the success of hedge funds and why they appeal to investors to such a huge extend.

In chapter 3.3, we discuss various strategies of a hedge fund manager. As will be seen in our further discussion, most of these tools and strategies are unique to hedge funds and cannot be applied by Islamic investment funds due to specific reasons. After that we talk about the typical investment characteristics of hedge funds (chapter 3.5). For example, an analysis of the alpha factor showed that hedge funds mainly are dependent on the alpha factor and thus of the hedge fund manager himself.

We finish the part about hedge funds with hedge fund trends (chapter 3.6 and chapter 3.7) and further development of hedge funds (chapter 3.8) that show the huge potential for this kind of alternative investment.

The third section of the thesis concludes the chapter by answering the research questions. We start this discussion by looking at Islamic investment funds as a reasonable alternative to conventional investment funds (chapter 4.1). Afterwards, we compare Islamic investment funds to conventional funds and hedge funds (chapter 4.2). In chapter 4.3 we discuss if and why Islamic investment funds appeal to Non-Muslims.

Iqbal and Tsubota (2006) did an extensive analysis of the reasons for the growth of the Islamic capital market. They conclude that both the supply and the demand for Islamic investments will fuel the momentum for the Islamic capital market to become a huge marketplace, especially for emerging market borrowers in the regions of the Middle- East, South-East Asia, South Asia and North Africa. On the supply side, the amount of Shariah compliant Islamic investments is still increasing and evolving into a truly international market. Besides multilateral Development Banks – like the World Bank – even low credit rating countries like Pakistan have raised a considerable amount of funds in their markets. The demand side is also developing. The middle-income countries in the developing world will require more and more investments in infrastructure over the next decade. Their domestic capital markets are often not deep enough to satisfy their huge investment needs and thus they need to access external sources of financing.

Another source for the high growth of Islamic financial markets, as identified by Iqbal and Tsubota (2006), is the increasing demand of Muslim stakeholders that call for more Shariah compliant financing. Due to the growth of oil-dollars and the migration of Muslims all over the world, the voices calling for Islamic investment products get louder and financial intermediaries will pay more attention to the needs of their Muslim clients.[11] However, not only Muslim clients will call for more Shariah compliant products – as we will see in chapter 4.3.

2 Islamic investment funds

2.1 What are Islamic investment funds?

An Islamic investment fund can be described as “a joint pool wherein the investors contribute their surplus money for the purpose of its investment to earn permitted profits in strict conformity with the precepts of Islamic Shariah”.[12] For an investor, it is important to understand that he is participating in a fund, whose profits earned are distributed according to the Islamic law of Shariah.

2.1.1 The Shariah

The Shariah is translated as “the path to the source of water” and concerns theology, practice and legal matters.[13] It means, it is the “source of life for Muslims” and represents the “clear and correct path that one must follow in life so as to be submitting to the will of God”.[14] The Shariah includes laws derived from revelation, wisdom, and consensus and analogy. It is based on six sources:[15]

- The Quran
- The Sunna
- The Hadith
- Ijma
- Qiyas
- Ijtihad

In the Quran, the Prophet Muhammad received the word of God over a period of time (revelation). The Sunna consists of “practices and sayings”, in overall the behavior of the Prophet Muhammad (wisdom). They then built a standard set of behavior for Muslims, which was passed on as a “collection of traditions”, also known as Hadith.[16] Ijma relates to the decisions derived from religious sources taken by religious scholars on issues not faced by the Prophet in his lifetime. Qiyas refers to the decisions taken by analogy on matters not addressed to in the Quran or the Sunna compared with a matter addressed in the Quran or the Sunna.[17]

Still there is one other source for the Shariah, the Islamic concept of Ijtihad, meaning human or independent reasoning/interpretation.[18] This concept is not authoritative like the Quran or the Sunna, but derivative. After the Prophet Muhammad died, his followers tried to interpret the Shariah according to the concept of Ijtihad by finding agreement on decisions and their basis (consensus and analogy).[19] This was also the time, where the four main religious schools were formed, which provide their interpretation of Islamic law on matters that concern life, economics, finance and much more under the Islamic law. These equally orthodox and authoritative schools are the Hanafi, Mâliki, Shâfi’î and Hanbali school.[20]

In order to understand the role of Shariah, Jahn (2006) distinguishes between religion and law in Islam. The religion sets the goals and the law – the Shariah – builds the way, these goals can be reached.

Justice represents the main goal in Islam. For the Muslim, justice builds the centre of the relationship between man and God and also between men. Thus, the Shariah can be seen as the “Islamic corpus juris”, expressed through permissions, called “halal”, and prohibitions, called “haram”.[21] By this, a Muslim knows what he must do, what is allowed and what is explicitly prohibited.

For this, the Shariah represents and protects the interests of the community. Jahn (2006) concludes, that after a long period of interpretation over centuries, the Shariah today contains “detailed rules, covering commercial and penal law, marriage and divorce (family law), as well as devotional matters.”[22]

2.1.2 The principles of Shariah

Islamic finance means using and applying financial methods according to Islamic law.[23] The Islamic law is called Shariah and is based on the Quran and the Sunna, as described above. The most discussed matter in Islamic finance is the strong and explicit prohibition of interest (riba) by Allah in the Holy Quran.[24] The following can be seen as the main principles of Islamic finance:[25]

- Riba, meaning usury is prohibited.[26] This mainly refers to giving or receiving interest.
- Money cannot be invested solely to earn profit. It must have a social and ethical purpose.
- Investments can only be made in businesses allowed by the Shariah. The following businesses are classified as unlawful:[27]
- Manufacturing, packaging or distribution of alcohol or pork products for human consumption
- Gambling casinos or the manufacture of gambling machines
- Movie theatres o Pornography o Hotels
- Financial services including banks, insurance companies, brokerage firms
- Restaurants earning mainly from selling alcohol
- Airlines, as their profits also include duty free sales of alcohol and tobacco.
- Maysir, meaning gambling, is not allowed. These are transactions including speculation or gambling.
- Gharar, meaning excessive uncertainty, is prohibited. It also means risk in Arabic language.[28] It includes uncertainty about the subject or the terms of a contract, as well as selling something that the seller does not own. Returns can only be earned, if the seller is the owner of the good.[29] That means, short selling is not possible in Islamic finance.
- The risk of a transaction and business must be shared between the borrower and the lender.[30]

2.1.3 The Shariah board

In modern Islamic financial institutions, a Shariah board is established. This Shariah board is part of an Islamic bank and supervises and approves the bank’s work. Whenever there is a doubtful situation according to the Shariah, the board must clear it before it can be undertaken.[31] The board members are well known and respected in their profession and possess high knowledge and experience of Shariah teachings. Official statements of the Shariah board are published as fatwa.

Functioning as an independent body, the International Association of Islamic Bankers monitors all the Shariah boards and controls their fatwas by the Supreme Religious Board to make sure they comply with Shariah. As the Shariah offers space for interpretation, there can be different opinions of Shariah. Some issues may be cleared by some boards, but not by others.

2.2 Historic and future development

2.2.1 Financing in the beginning of Islam

Islamic finance came in use for enabling trade and business activities for Muslims. Islamic salesmen were quite active in Spain, the Mediterranean and the Baltic states and were known for their trading activities. Their techniques and instruments were adopted even by European financiers and businessmen.[32]

In the pre-Islamic era, interest was not only a common but also a dominating instrument of financing in Saudi Arabia.[33] Merchant was the main profession in those times, and interest was heavily used by tribes and the Jewish community. According to Khaf and Khan ([1992]), many Jews took over the function of a “bank” in that time and lent money at rates of 12% per annum.

Mudarabah, an Islamic trading instrument which will be described later in more detail, was also applied in that era, even before the rise of Islam. Here, the profit is shared between two parties, where one provides the funds and the other works with it, providing his experience. The Prophet Muhammad was the first to use the mudarabah when trading with a rich woman called Khadijah, whom he later married. Musharakah, an instrument for full partnership, was mainly applied when large commercial enterprises should work according to a profit and loss principle. Another common transaction was sale on credit, permitted by the Prophet to enable “finance of consumption or production without usury”.[34] He further motivated Muslims to give “benevolent loans”, known as Quard Hassan.

Gait and Worthington (2007) stated that after the Prophet Muhammad died, Islam spread very fast over Asia, Africa and Europe and with it the use of Islamic finance. Historical records show that mudarabah and musharakah were used by businessmen. Islamic finance remained the same until the beginning of the 19th century. At this time, the Muslim countries were colonized by Western countries which brought in the capitalistic system and put an end to Islamic finance. After gaining independence at the end of colonization, Islamic finance re-emerged in Islamic countries and began to develop.

2.2.2 Islamisation of the economy – Pakistan in its outrider role

A very good example for the Islamisation of the economy in an Islamic country is the history of Pakistan. In the last 200 years the economic system changed dramatically and one of the reasons for this change was the interest based economic order, spreading all over the world. Islamic countries were no exception to this development, even though interest is prohibited by Shariah (as discussed above).

In the late 1940s, Asian scholars started discussing about an economy compliant with Shariah. In that time, rural landlords created an interest-free credit network. But the experiment was only short-lived.[35]

Nevertheless, Pakistan established its constitution to align the state with the rules of Islam. The Objective Resolution of 1949 states that the sovereignty over the entire universe belongs to Allah Almighty and that people can act independently within the limits prescribed by Him.[36] Thus, the principles of Pakistan claim for the accordance of people’s life with the teachings of Islam and the economy is no exception to that.

Mehmood (2002) stated that it needed three constitutional assemblies until the present one was signed in 1973. However, the Objective Resolution remained an essential part. The provisions of the Constitution of 1973 included the following:

- Islam was declared as the state religion.
- Steps were taken to enable the Muslims of Pakistan to order their lives in accordance with Islam.
- The principles of democracy, freedom and equity, tolerance and social justice had to be fully observed.
- The state had to eliminate riba as early as possible
- The law should be brought into conformity with the injunctions of Islam.

Mehmood (2002) further mentioned that several institutions were established to assist the Islamisation further. Three of them are worth mentioning in more detail:

- The Council of Islamic Ideology

The task of the council is to make recommendations to the parliament and the provincial assemblies as to possibilities of enabling and encouraging Muslims of Pakistan to further order their lives in accordance with Islam.

- Federal Shariah Court

The Federal Shariah Court consists of seven Muslim judges and a Chief Justice who is qualified to be a judge of the Supreme Court of Pakistan or is or has been a permanent judge of the High Court. Its task is to examine and decide, if any law is consistent with Islam. Its authority is limited however by the constitution, the Muslim Personal Law and the law relating to the procedure of a court or tribunal.

- Islamic Research Institute

Its task is to define Islam in terms of its fundamentals, emphasizing the basic Islamic ideals of “universal brotherhood”, tolerance and social justice. Thus, the Islamic Research Institute focuses on research regarding Islamic thought, science and culture.

Although the constitution and the institutions described above were designed to align the life of people with the principles of Islam, the prevention of riba was not much of interest during the first three decades, after the partition from India. Then in 1977, General Muhammad Zia-ul-Haq took first measures.[37]

One of his first actions was to assign the Council of Islamic Ideology to prepare a report with measures of how to eliminate riba. These steps were very progressive and Pakistan became the first country that seriously focused on a full Islamisation of the economy. Another report about the introduction of Zakat and Ushr – also a step for the Islamisation of the economy – was submitted in 1978. In 1980 the Council of Islamic Ideology suggested to eliminate interest from the economy in stages. Further, Pakistan was one of the first Islamic countries that revived Isbah, the office that supervised markets, provided municipal services and settled disputes. However, in its revived form it was only established to protect ordinary citizens from administrative mistakes.

In 1980, Zakat and Ushr were introduced in Pakistan.[38] Zakat was collected from a 2.5% p.a. levy on saving accounts, numerous bank deposits, unit trusts, government securities, corporate shares and debentures, annuities and life insurances. Other comparable assets were distributed through a voluntary system of Zakat board.[39]

Mehmood (2002) indicated that in 1981, the government directed all nationalized commercial banks to open interest free counters next to their existing, interest-bearing counters. In 1984 the State Bank of Pakistan planned to eliminate interest within one year. However, various loopholes remained and no substantial change could be achieved in practice.

The Enforcement of Shariah Act was entitled in 1991. Under this law, the state was required to “take steps to ensure that the economic system of Pakistan is constructed on the basis of Islam economic objectives, principles, and priorities.”[40] To do so, the Commission for Islamisation of Economy was appointed, with the aim to eliminate riba.

The Federal Shariah Court revised various fiscal laws in 1990, including provisions regarding interest. They were confirmed by the Supreme Court of Pakistan in 1999. In order to do so, the government needed to prepare an infrastructure, supporting the elimination of riba from banking and the financial system in the following four subjects: Banking and financial sector, share market, bond/debt market, and government borrowing and lending.[41]

In 2000, a fully empowered commission emerged, entitled “the Commission for the Transformation of Economy”. This commission reported various actions and identified numerous Shariah compliant modes of financing.

In pursuance of the court proposals, the Ministry of Finance set up a task force. It should convert domestic borrowings into project-related financing and further establish a mutual fund that would finance the government on a Shariah-compliant basis.

As Mehmood (2002) stated other steps taken were the licensing of a fully dedicated Islamic bank and the allowance for existing banks to start Islamic Banking subsidiaries.

This short abstract of Pakistan’s attempt for the Islamisation of its economy should emphasize the difficulty of changing a long tradition of interest-bearing economy into a riba-free economic system. Even Pakistan, as one of the first countries that progressed so far, has not yet achieved it.

2.2.3 The history of the Islamic capital market

Although it seems, the main problem in Pakistan was to eliminate riba, describing an Islamic financial system as simply interest-free does not capture the full picture. It also emphasizes entrepreneurship, preservation of property rights, transparency and the sanctity of contractual obligations. Today, the Islamic bank and financial activities are estimated between $ 260 billion[42] and $ 350 billion, which is 40 times higher than the amount of $ 6 billion, which it reached in the early 1980s.[43] As this growth suggests, there is a lot of movement in the Islamic financial institutions market, pushed by the wish to Islamize of the economy, as seen in the example of Pakistan.

The first Islamic financial institutions were established in the 1960s in Egypt and Malaysia. But it was not until the oil boom in the 1970s that fuelled the ambition and attempts of the industry to create financial products in accordance with the Shariah. This growth continued in the 1980s and in the 1990s Islamic Financial Institutions spread to several western countries. They started “Islamic windows” in their commercial banks. Today there are more than 270 financial institutions[44] operating on the basis of non-interest instruments in more than 40 different countries.[45]

Iqbal and Tsubota (2006) stated that the momentum of the 1980s and 1990s was basically fuelled by acquiring funds through deposits invested mainly in trade financing. These activities included:

- Cost-plus-sale or purchase finance (murabaha) o Leasing (ijara)
- Trust financing (mudarabah)
- Equity participation (musharakah)

But the assets of Islamic financial institutions stayed very static and were solely based on short term instruments, because of the market conditions, lack of liquid assets and some other constraints. Thus, one may not wonder that in the end of the 1990s new and more sophisticated products were needed. Areas of concern were mainly:

- Lack of liquidity
- Lack of portfolio and risk management tools o Absence of derivative instruments.

That is when Islamic financial institutions realized that new products were needed, if they wanted to survive or even push further growth. Two essential products then were introduced that really achieved this objective:

- Equity funds compatible with Shariah (as described in chapter 2.1.1) o Sukuk – Islamic asset-backed securities (as described in chapter 2.7.9)

While equity funds mainly attract investors with a healthy risk appetite, Sukuk became more popular with people who sought securities that were more like fixed-income debt securities but also comply with Shariah.

2.2.4 Current market environment of Islamic capital market

The Islamic capital market is still growing until today. The overall size of the market of Islamic investments and Muslim capital is estimated at around $ 750 billion. Islamic financial institutions have increased by a factor of 40 since 1982, denoting a tremendous growth of the Islamic financial market.[46]

Iqbal and Tsubota (2006) carried out an extensive analysis on the reasons for the growth of the Islamic capital market. They concluded that both, the supply and demand side will fuel the momentum for the Islamic capital market in becoming a huge marketplace, especially for emerging market borrowers in the regions of the Middle-East, South-East Asia, South Asia and North Africa. On the supply side, the amount of Shariah compliant Islamic investments is still increasing and evolving into a truly international market. Besides multilateral Development Banks – like the World Bank – even low credit rating countries like Pakistan have achieved to raise a considerable amount of funds in their markets. And the demand side is developing as well. The middle-income countries in the developing world will require more and more investments in infrastructure over the next decade. Their domestic capital markets are often not deep enough to satisfy their huge investment needs and thus they need to access external sources of financing.

Another source for the high growth of the Islamic financial markets, as identified by Iqbal and Tsubota (2006), is the increasing demand of Muslim stakeholders that call for more Shariah compliant financing. Due to the growth of oil-dollars and the migration of Muslims all over the world, the voices calling for Islamic investment products get louder and financial intermediaries will pay more attention to the needs of their Muslim clients.[47] However, not only they will call for more Shariah compliant products – as we will see in chapter 4.3.

2.2.5 Further development of Islamic capital markets

In their paper, Iqbal and Tsubota (2006) write that most likely, instruments providing investors with a predetermined return as well as full recourse to the obligor – like ijara or murabaha – will have more market potential than other instruments. They identified three variables influencing the growth of structures, supporting this evolution:

- Sponsorship from the host country
- Competitive advantage to conventional bond issues
- Shariah scholars

The market development is strongly influenced by the leadership and sponsorship of the host country, especially on legal and regulatory issues. Ijara can serve here as an example. The owner of the operating asset needs to sign a leasing contract. In most cases, the government itself owns this operating asset and it depends on the legal environment, if the government is allowed to lease assets at all. Thus, it is a key requirement for countries and their governments to take further actions in fostering the growth of Islamic financial markets.

The second variable is the competitive advantage to conventional commercial institutions. Islamic transactions often face a competitive disadvantage to conventional bond issues in terms of cost efficiency. Islamic transactions denote often higher legal and documentary expenses and higher distribution costs. There is also no funding cost advantage of Islamic markets, since most terms are derived from more liquid capital markets. Iqbal and Tsubota (2006) show that borrowers need to formulate a long-term strategy to reduce the overall funding costs instead of focusing on a single transaction. On the other hand, investors should express their demand for Shariah compliant services in terms of bid pricing. And intermediaries can contribute to stimulate the growth of Islamic capital markets by further standardizing their processes and thus reducing transaction costs.

And finally Shariah scholars can play an important role: Multi-disciplinary expertise covering topics from the theological interpretation to financial structuring is essential for a further market development. Also, the unification of the laws of the Shariah and their implications on the financial market would represent a huge step in the history of Islamic financial markets. And if such unification would be too difficult to achieve – as it seems – the simple acceptance of differences across borders and schools could stimulate cross-border activities and secondary market trade.[48]

2.3 Special characteristics of Islamic finance

2.3.1 Interest in Islamic finance Prohibition of interest by Islam

Islamic finance is mainly based on one concept: “Avoiding trading directly present for future money”.[49] According to Islamic finance, finance can be interpreted as money being returned for equity or the right to participate in future business profits to a pre- determined share. Further, goods and services can be delivered, while their payment is committed and due at a future date.

In the Quran (2:275) is written:[50]

“…That is because they say: Trade (bai’) is only like interest (riba), but God has permitted trade and forbidden interest…”

Further, it can be found:[51]

- “Those who devour usury will not stand except as stands one whom The Evil One by his touch hath driven to madness. That is because they say: Trade is like usury. But Allah hath permitted trade and forbidden usury. (2:275)”
- “O Ye who believe! Fear Allah and give up what remains of your demand for usury, if ye are indeed believers. If ye do it not, take notice of war from Allah and His Apostle. But if ye turn back, ye shall have your capital Sums: Deal not unjustly and ye shall not be dealt with unjustly.” (2:278-279)
- “The Prophet has condemned both the receiver and the giver of usury. It is claimed that the Prophet said: Sell not gold for gold except in equal quantity, nor sell silver for silver in equal quantity, nor sell anything present for that which is absent. “(Hadith)

As mentioned above, there is a clear prohibition of interest in Islamic finance. Allah has permitted sale and prohibited interest. To understand the functionality of Islamic financial instruments and the prohibition of riba, it is important to know, how interest is defined in Islam. This can be best explained, when differentiating sale from interest. By definition, interest is “a contractual increment received by a lender from a borrower over and above the principal”.[52] This means, that interest mainly refers to money lending. First of all, when lending money with interest, all the risk is shifted to the borrower. In a trade transaction, natural uncertainty is part of the transaction.

Further, Khaf and Khan (1992) cited Quraishi, who pointed out the main difference:[53]

“One, who sells clothes worth Rs. 10 for Rs. 20 does so, believing that the clothes are equivalent to that sum. When mutual agreement has been arrived, the exchanges value become equal with the result that the parties to the transactions all benefit. But if a person were to acquire Rs. 20 for Rs. 10, the additional Rs. 10 does not represent any real benefit. It will not be then admissible for him to say that he obtained the additional sum in exchange nor any such thing which could be pointed out as an exchangeable wealth (1946, p.50).”

According to this explanation, interest is the price paid by the borrower for receiving time. In other words, interest is solely justified by allowing the delayed the payment. In that way the borrower receives a return on capital for borrowing money and carrying no risk at all for any asset. While in a “real sale”, an asset is sold or borrowed and delivers a return with both parties carrying the risk of the asset, as uncertainty is part of the asset’s nature. Here, time has an effect on the profit and loss of the transaction.

So it can be said, that the setup of risk and time differentiate a sale from an interest- based transaction. In a sale, uncertainty and risk appear in relation to time and profits as well as losses can be created over time. Interest-based transactions do not follow the natural conditions of uncertainty and risk. Also the capital can not decrease, but increases automatically with time.[54] The interest separates finance from the transaction and by this, interest becomes the “cost of time, or the cost of pure finance”.[55]

Muslim scholars have questioned this construction in terms of ethics and efficiency.

Khaf and Khan (1992) describe that by citing Maudidi:[56]

“…Which rationale principle, which logic, which cannon of justice and which sound economic principle can justify that those who spend their time, energy, capacity and resources, and whose efforts and skills make a business thrive, are not guaranteed a profit at any fixed rate, whereas those who merely lend out their funds are fully secured against all risk of loss and are guaranteed a profit at a fixed rate? (ibid. p. 214)” The need of a zero interest rate

In the 1950s, the system seemed to work perfectly for everyone. No faults were seen in taking and receiving interest. The rate of interest was seen as a price, more specifically, as the “relative price of present money to future money”.[57] Price was an important instrument for resource allocation. For this, no economist was interested in a zero interest rate.

Some years later, economists declared the instability of the interest-based system in practice.[58] It was then, that Friedman’s monetary rule was discovered, which implies that for optimal efficiency and allocation of resources, a zero nominal interest rate is needed. Al-Jarhi (2003) describes that by adding one marginal unit of real balances in a fiat-money world, which does not cost the community any real resources. If there would be a positive price for the use of money, traders would try to gain profit out of it by using real resources. However, as the interest rate is zero, traders have no motivation in exchanging real resources for money. Instead, they can be used for consumption and investment. This shows that the prohibition of interest by Islam and other major religions like Christianity, Jewish and Hinduism does not violate the economy.

A zero interest rate can only be realized by deflating the economy at the real rate of interest. For this, the money supply is consistently contracted at a “rate equal to the representative household time preference”.[59] Thus, a long-run policy of deflation is necessary, which central bankers would never agree on. They would worry that a liquidity trap could be created by a zero interest rate. Others suggest deflating only asymptotically, when implementing Friedman’s Rule. Further, monetary authorities would lose their mobility.

However, Islamic banks already apply these rules. The prevention of interest-based lending affects the applied monetary policy. First of all the real rate of growth is observed and the rate of monetary expansion can be aligned with the level of price stability and expected real growth. Al-Jarhi (2004) stated that by implementing a 100 per cent required reserve ratio, monetary authorities, instead of banks’ shareholders, gain absolute control over money supply and direct profits from monetary expansion to the government,. As the economy is as close to price stability as possible, monetary growth is optimal and real resources need not to be transferred to monetary use. No problems of deflationary policy arise.

Now, people can execute spot purchases with their cash balances. In case the cash balances are deficient or not enough for their purchases of assets and commodities, they can go back to finance. Instead of interest rates, rates of profit on equity and profit- sharing finance, mark-ups on credit-purchase finance and rental rates on leasing finance are used.[60] Al-Jarhi (2004) points out that as the time value of money is consistent, the interest rate must not be brought down to zero to achieve an optimal allocation of resources.

Profitability and return rates for investments would become the main issues for profit sharing modes of Islamic finance. The most productive investment would receive the financial resources and this optimizes the financing process. In credit-purchases and leasing transactions in Islamic finance, debt obligations are taken for giving commodities. Al-Jarhi (2004) notes that credit-purchase of assets and commodities would be directly associated to higher demand of these, having a direct influence on aggregate supply. This development further shows that credit finance under Islamic finance would be less inflationary compared to conventional banking and finance.[61]

2.3.2 Risk in Islamic economics

The structure of the following discussion is mainly based on Al-Suwailem (2006), as he offers a compact discussion of available literature and topics, which need to be taken into account.

Risk is an issue of Islamic finance and conventional finance in equals measures. It has advantages and disadvantages.62 On one side, it is not possible to grow or gain extraordinary profits without taking risks. Also, by deleting risk out of the equation, no incentives remain and economic efficiency drifts away. However, excessive risk will distract and aggravate investment and growth. Thus, it is important to find a middle course and a compromise to be able to work with risk and to achieve the best results possible. Islamic finance offers such a possibility.

Already in the beginning of Islam, Muslim scholars declared the different “faces” of risk. Ibn Taymiah wrote more than 670 years ago:[63]

“Risk falls into two categories: commercial risk, where one would buy a commodity in order to sell it for profit, and rely on Allah for that. This risk is necessary for merchants, and although one might occasionally lose, but this is the nature of commerce.

The other type of risk is that of gambling, which implies eating wealth for nothing. This is what Allah and his Messenger (peace be upon him) have prohibited. ([2]; pp.700- 701.)”

According to this, Al-Suwailem (2006) differentiates between two types of risks:

- Risk in normal economic transactions, like value-adding and wealth-creating activities.
- Risk with the aim of “eating wealth for nothing”, where no additional wealth is created. Risk-sharing in Islamic finance

Before taking a deeper look at risk itself, it is important to declare one main difference between conventional and Islamic finance: the risk-sharing. Al-Jarhi (2004) explains it painting the following picture:

“Conventional finance can be likened to a spectator’s game where few skilled players stay in the playground and a big crowd is watching from outside. Islamic finance, meanwhile, is similar to participatory sports, where everyone is playing and no one is mere watching.”[64]

Risk can not be taken out of the equation, as it is an essential part of the investment. But Al-Jarhi (2004) holds that the difference to conventional finance is that the investor too carries an essential part of the risk, not only the fund manager. In conventional finance risk is only carried by borrower. Loans are only given with the security that the investor or lender will receive his money back and does not carry any sort of risk attached to the loan and what it is used for.

In Islamic finance on the other hand, investors and managers both share the risk of choosing the right investment and its profitability, engaging in a partnership and not a simple borrower-lender relationship.[65] Investors share the risk with the manager for example for production, distribution and so on. So it can be held that investors and managers (or banks and depositors) both play an important role in the decision-making process. This transforms the simple borrower-lender relationship into a prospering partnership.

Al-Jarhi (2004) states, that the responsibility and taken decisions are carried by all involved people, making all “partners rather than spectators”. But not only the higher involvement is an advantage, it further leads to a better stability of banks. Investors participate with their deposits in firms with whom they indirectly share risk and rely on the banks to observe these firms. By the investor’s participation, the banks could influence the firm’s corporate governance to reduce risk and raise profits. This means, “the stability of the banking system will reinforce and be reinforced by the stability of the real sector”.[66] By this, a better integrity of the system can be achieved. The legitimating of risk in Islamic economics

If risk is equal to the possibility of loss, its prohibition in Islam is understood, as Islam clearly states that wealth shall be developed and protected. Still, risk can be found in almost all economic activities, though it is intrinsic. However, decisions are not made regarding the risk it involves nor can the value of a decision be measured according to its risk. The decision is made on the basis of the “wealth it creates and value it adds”.[67] Thus, risk is part of the value and does not determine the value in its own. When risk is seen positive, it refers to added value and created wealth. For this, it can be said:

“Risk is legitimate when it is necessary for value creating. But when no value is added, it is a form of gambling.”[68] Tolerable risk

Risk can be acceptable, when it complies with the following conditions:[69]

- It is inevitable: This means that the aimed value cannot be acquired in any additional way without taking the specific risk of loss or failure.
- It is insignificant: This condition implies that the possibility of failure must be considerably small, compared to the possibility of success.
- It is unintentional: The final condition is derived from the others. As mentioned before, an economic activity is engaged to create value. Risk cannot lead the intention for participating in a transaction. Inevitability of risk

For this, risk must be an inseparable part of real, value-adding transactions. By separating it from real transactions even more different risks are developed and economy becomes highly unstable. the

According to Shariah, the “exchange of pure liability for a given price is unanimously prohibited”.[70] Furthermore, already by nature risk and economic activities are inseparable. So Islamic economics only complies with economic reality. Likelihood of failure

As said, this condition implies that a smaller possibility of failure than that of success. The expected utility rule does not align with this thought. It is based on the expected value, which equals the probability of the outcome times its magnitude.[71]

In a lottery for example, the possibility of losing is much higher than that of winning. According to Islam, lotteries for this reason are prohibited. But the expected utility rule only looks at the expected value, no matter what situation seems to be more likely. Thus, a “wishful behavior” according to the decision maker’s preferences is triggered, what must not necessarily reflect objective reality. This behavior is seen as gharar, as the decision maker does not look objectively at the situation, but only at the size of the prize and believes he can get it, though the opposite is more probable.

From an Islamic point of view the decision maker is obligated to take the right steps to reach his goal and to believe in Allah guiding him to avoid possible but less likely failures. It is his duty and not a recommendation to act this way. So “entrusting Allah thus compliments rational decision-making and never substitutes for it.”[72]

2.3.3 Gharar Definition

Gharar means risk or trading in risk.[73] It is derived from the word “gharra” meaning “to deceive” and is also translated as “that which has a pleasant appearance and hated essence”.[74] It stands for low probability but high prizes, as it is common in all forms of gambling. This is the reason, why a decision maker even engages in such situations.

Gharar is defined in many different ways, but Kotby (1990) points out two definitions. The first is by Al-Kasani: “Gharar is risk in which existence and non-existence are equally likely”.[75] The second is by Al-Ramly: “Gharar is what involves two possibilities; the more likely of them is the less desirable”.[76] The essence of these definitions is that “any transaction with probability of success less than or equal 0.5 involves gharar”.[77] Islam does not forbid risk for its being, but certain levels of it, which make a transaction illegal according to Islamic rules. The difficulty is given in determining the “significance level” from where risk gets prohibited. It is not 0.5 for all kinds of transactions.

In the Shariah gharar is defined as a situation, in which at least two parties are engaged and it is “equivalent to a zero-sum game with uncertain payoffs”.[78] To better understand the types of games, this section briefly describes them. Investment vs. gambling

Al-Suwailem (2006) determines one main difference to distinguish between investment and gambling and that is the confidence of success. A fund manager starts a new fund, because he believes in its success. However, a gambler already knows from the beginning that his probability to lose is much higher. As stated before, the high price encourages him to participate in the losing project.

This differentiation also complies with the concept of causality of Islamic principles. Al-Suwailem (2006) holds that if an action fails more often than it is successful, it can neither be seen as efficient nor as successful. It must be accepted as a failure. Types of games

As defined before, a game is a situation, where at least two parties engage and their payoffs are uncertain at the beginning. Looking at the sum of players payoffs, three categories can be defined:[79]

- Positive-sum games o Zero-sum games
- Mixed-sum games Positive-sum games

These are games where players have the same interests, making them gain and lose together. The objective will be to reach a positive outcome.

Figure 1 shows such a situation. (A, B) are the players and the branches showing the possible outcomes. As stated above, in a positive-sum game, the players have the same goal, which means they will either win or lose together. The left branch will bring up the negative payoff, the right branch the positive. As the game starts, the players do not know which branch they will take. But as they both have the same aim, their objective will become mutual gain. This situation makes it a Pareto-optimal game, as “both players are likely to be better off playing the game compared to not playing”.[80] It is also important to hold, that it is not necessary that both parties gain equal payoffs, but they may gain and lose together.

illustration not visible in this excerpt

Figure 1. Positive-sum games (source: Al-Suwailem (2006), p.71)

An example for such a game is musharakah, where both partners invest capital and labor, gaining and losing together as the project succeeds or fails. Zero-sum game

In difference to positive-sum games, here one party will win for sure while the other will lose.[81] This is a classic case of gambling. For example, two parties betting on a football match with each being for the other team. If A wins, he will get the whole amount and vice versa. This situation is shown in Figure 2.

illustration not visible in this excerpt

Figure 2. Zero-sum game (source: Al-Suwailem (2006), p.71)

The “zero-sum” indicates that the players’ interests are in opposite direction, but their gain and loss need not to be equally proportioned. In comparison to the positive-sum game, the zero-sum game is pare to inferior, as mutual gain is not possible and the players are better off, not playing the game. Mixed games

As the name suggests, this situation is a mixture of the first two. It is possible that both win, but just like in a zero-sum game, because of different interests, also only one could win, leaving the other to lose.[82] This situation is shown in Figure 3.

illustration not visible in this excerpt

Figure 3. Mixed games (source: Al-Suwailem (2006), p.72)

Most economic activities account to such a mixed or non-zero-sum game. A situation can either end up as a conflict or in cooperation.[83]

2.4 Financial engineering in Islamic finance

As defined in the beginning, the Shariah determines the way by which the goals set by Islam can be achieved.[84] For this the Shariah offers a substantial set of rules and guidelines. One might say, that because of these “constraints” it is not possible to move freely enough to develop new products and options to ease the financial life. However, literature proves that people are most creative under constraints.[85] Creativity is set free when facing a constraint and trying to find a way to overcome it. Al-Suwailem (2006) notes that history shows that it were constraints which drove financial innovation ahead and enhanced economic performance and welfare.

This shows that constraints do not prevent creativity. This can especially be seen with respect to Divine rulings, which comprise the wisdom of Allah and following them will only enhance life. Islam offers the necessary environment to best practice creativity and innovation. The Quran underlines that “reflecting and pondering upon signs of truth, and condemns those who blindly follow inherited culture even if it contradicts the facts”.[86] This is especially important when trying to invent necessary instruments, which enable the participation in economics and finance. Creativity is a crucial factor for financial engineering.

2.4.1 Principles of financial engineering

Financial engineering describes how to “use risk management strategies to manipulate the shape of risk profiles one firm is facing”.[87] There are four principles of financial engineering:

- Principle of balance
- Principle of integration
- Principle of acceptability o Principle of consistency

The first two determine the objectives, the next the methodology. Principle of balance

This principle is concerned with finding the right balance between Islamic teachings and human incentives. For example, capitalism tries to solve all problems using for- profit and market-oriented approaches. On the other hand, communism concentrates on solving the same problems by solely emphasizing non-profit approaches. Islamic economics teaches to use a “balanced approach”, as both for-profit and non-profit are necessary to reach economic satisfaction.[88]

Cooperative approaches are better in realizing financial and economic objectives. The best example for this is insurance. Taking the Shariah into account, commercial insurance is unacceptable, but cooperative and mutual insurance is accepted without any doubt. Thus, cooperative arrangements offer more efficiency than commercial instruments and can better serve economic needs. Principle of acceptability

Though this principle belongs to methodology, it must be stated here because of logical sequencing. This principle holds that “all economic dealings are generally acceptable unless otherwise stated by Shariah”.[89]

The belief here is that all economic activities have the goal to satisfy human needs and preferences. Islam believes that human beings are naturally drawn to the good, so their activities should add to the good of the society. To avoid the evil in the world, Islam offers a set of rules to enable economic activities.

For-profit activities face a more preventive set of rules while non-profit activities are taken on with affirmative rules. Al-Suwailem (2006) notes, that this is derived from human nature of incentives. When the incentive is strong enough to aim for profits, Quran tries to prevent extreme response by confirming it with caution. For example, if the incentive for donating is not strong enough, Quran emphasizes it to enhance it. However, commerce and trade are important in Islam and by the Quran confirmed activities.[90]

This principle is mainly important for innovation, as it states that there are no bounds to innovation and creativity as long as the positive effects prevail. It is just important to make sure that none of the prohibited activities is part of the business. If that is the case, everything is possible. Al-Suwailem (2006) explains it the following way: “Accordingly, if two views are presented regarding a certain product, one considers it acceptable while the other doesn’t, then the burden of proof is on the latter. Those who accept don’t have to prove it, since this is the default position of Shariah.” From this point of view, Shariah calls the one who rejects to prove his position. Principle of integration

As stated earlier, interest separates finance from real activities. This separation does not align with economic activities, as it creates extra costs to keep up the separation and so is inefficient. The higher the costs of separation, the higher the transaction costs and inefficiencies rise. Al-Suwailem (2006) notes that the separation itself may cost much more than keeping the sectors integrated. Thus, the Shariah “insists on the integration between two sectors to achieve balanced and sustained economic growth”.[91] Principle of consistency

The final principle holds, that “form and substance of Islamic products must be consistent with each other, i.e. form should serve substance and, means should conform to ends”[92]. Figure 4 shows the steps, a product evaluation should go through.

According to Al-Suwailem (2006), the steps are:

1. Evaluate the substance or the end result of the product. If acceptable, go to step 2. Otherwise, go to step 3
2. Evaluate the form of the product. If acceptable, the product is acceptable. Otherwise, go to step 3.
3. Revise the product, and then go to step 1

The starting point is the substance, followed by form. The final approval cannot be made with only one of them, both is important.

illustration not visible in this excerpt

Figure 4. Steps of product evaluation (source: Al-Suwailem (2006), p.102)


[1] Koh/Koh/Lee/Phoon (2004), p.4

[2] Shadab (2007), p.36

[3] Shadab (2007), p.38

[4] Usmani (2007), p.2

[5] Ayub (2005), p. 3

[6] Iqbal/Tsubota (2006), p.8

[7] Ayub (2005), p. 3

[8] Iqbal/Tsubota (2006), p.7

[9] Abdel-Khaleq/Richardson (2007), p.413

[10] Wilson (1999) p.41 f.

[11] Iqbal/Tsubota (2006), p.11

[12] Usmani (2007), p.2

[13] Jahn (2006), p.1

[14] Jahn (2006), p.1

[15] Gait/Worthington (2007), p.4

[16] Jahn (2006), p.1

[17] Gait/Worthington (2007), p.4

[18] Jackson (2004), p.2

[19] Jahn (2006), p.1

[20] Jackson (2004), p. 2

[21] Jahn (2006), p.2

[22] Jahn (2006), p.2

[23] Rowey/July/Fèvre (2006), p.1

[24] Khaf/Khan (1992), p.9

[25] Rowey/July/Fèvre (2006), p.1

[26] Al-Suwailem (2006), p.96

[27] Tannenbaum (1999), p.2

[28] Al-Suwailem (2006), p.69

[29] Khaf/Khan (1992), p.10

[30] Rogers (2004), p.4

[31] Usmani (2007). p.2

[32] Rogers (2004), p.11

[33] Khaf/Khan (1992), p.11

[34] Gait/Worthington (2007), p.5

[35] Mehmood (2002), p.675

[36] Aslam (2003), p.7

[37] Mehmood (2002), p.682ff.

[38] Husain (2004), p.2

[39] Mehmood (2002), p.685

[40] Husain (2004), p.4f.

[41] Mehmood (2002), p.689ff.

[42] Ayub (2005), p. 3

[43] Iqbal/Tsubota (2006), p.7

[44] Ayub (2005), p. 3

[45] Iqbal/Tsubota (2006), p.8

[46] Abdel-Khaleq/Richardson (2007), p.413

[47] Iqbal/Tsubota (2006), p.11

[48] Iqbal/Tsubota (2006), p.12

[49] Al-Jarhi (2003), p.3

[50] Khaf/Khan (1992), p.27

[51] Gait/Worthington (2007), p.8

[52] Khaf/Khan (1992), p.21

[53] Khaf/Khan (1992), p.20

[54] Khaf/Khan (1992), p.21

[55] Al-Suwailem (2006), p.96

[56] Khaf/Khan (1992), p.21

[57] Al-Jarhi (2003), p.4

[58] El-Gamal (1998), p.2

[59]Al-Jarhi (2004), p.15

[60] Al-Jarhi (2004), p.15

[61] Al-Jarhi (2003), p.9

[62] Al-Suwailem (2006), p.14

[63] Al-Suwailem (2006), p.55

[64] Al-Jarhi (2004), p.17

[65] Matthews/Tlemsani/Siddiqui (2004), p.3

[66] Al-Jarhi (2004), p.17

[67] Al-Suwailem (2006), p.56

[68] Al-Suwailem (2006), p.57

[69] Al-Suwailem (2006), p.58

[70] Al-Suwailem (2006), p.59

[71] Al-Suwailem (2006), p.60

[72] Al-Suwailem (2006), p.61

[73] El-Gamal (2001), p.2

[74] El-Gamal (2001), p.5

[75] Cited by Kotby (1990), p. 65

[76] Cited by Kotby (1990), p. 65

[77] Kotby (1990), p. 65

[78] Al-Suwailem (2006), p.69

[79] Al-Suwailem (2006), p.70

[80] Al-Suwailem (2006), p.70

[81] Al-Suwailem (2006), p.71

[82] Al-Suwailem (2006), p.72

[83] Al-Suwailem (2006), p.72

[84] Jahn (2006), p.1

[85] Al-Suwailem (2006), p.89

[86] Al-Suwailem (2006), p.90

[87] Kotby (1990), p.63

[88] Al-Suwailem (2006), p.92

[89] Al-Suwailem (2006), p.95

[90] Al-Suwailem (2006), p.95

[91] Al-Suwailem (2006), p.99

[92] Al-Suwailem (2006), p.102

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Islamic investments funds versus hedge Funds
University of Vienna  (Universität Wien)
Macro Economics and Finance
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Islamic, Funds, Macro, Economics, Finance
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Mag.rer.soc.oec Adnan Siddiqi (Author)Peter Hrubi (Author), 2008, Islamic investments funds versus hedge Funds, Munich, GRIN Verlag,


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