SHARIAH REVIEW OF ISLAMIC PROFIT RATE SWAP STRATEGIES IN ISLAMIC FINANCIAL
INSTITUTIONS: THE CASE OF MALAYSIA
BY
SYED EHSANULLAH AGHA
A research paper submitted in fulfillment of the requirement for the degree of Master of Science in
Islamic Banking and Finance
IIUM Institute of Islamic Banking and Finance International Islamic University Malaysia
AUGUST 2015
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ABSTRACT
“Nothing ventured, nothing gained” is the first principle of investment. The possibility of an adverse outcome is an essential part of business activities. This uncertainty about future outcomes is defined as risk. The broad perspective on risk and its management is embodied in the essential objectives of Shari’ah, which is wealth protection.
However, in the light of the Shari’ah legal maxim that states ‘al-ghurm Bi al-ghunm’
(liability accompanies gain) and ‘al-kharaj Bi al-Daman’ (benefit goes with liability) risk cannot be isolated from economic affairs. The legitimacy of revenue generation requires that it has to be created based on real economic activities that involve real business risk and liability. On the other hand, exposing to excessive risk not only hurdles investment, but also deters economic growth, which might be against the maqasid al-Shari’ah (objectives ofShari’ah). As Islamic finance industry grows 15 to 20 percent annually, the need of hedging tools to mitigate certain risks in a volatile market increases. For instance, with a rapidly emerging market of Sukuk, both investors and issuers are exposed to currency fluctuation risk. Similarly, in the case of Islamic REITS, if the fund is invested in overseas properties. Islamic Profit Rate Swap (IPRS) is a contract designed as a hedging mechanism to minimize market participants' exposure to the risk of inflation and rate of return. By nature Swap products are derivatives which violate Shari`ah principles. According to Sami Al- Suwailem 97.30% of derivatives products are being used for speculation. This research aims to review from Shariah perspective the legality of the structure and mechanism of Islamic profit rate swap as currently offered by many Islamic financial institutions in Malaysia. Specifically the paper highlights the Shariah parameters and guidelines in structuring IPRS. It is observed that IPRS products may involve the following Shariah Issues: Combination of Several Contracts, Use of the same commodity for various Murabaha transitions, Organized Twarruq, Premature Termination and Mark to Market. Finally, an improved new structure of IPRS is proposed to reduce operational cost and Shari`ah non-complaint risk for Islamic financial institutions.
iii
ﺚﺤﺒﻟا ﺺﺨﻠﻣ
رﺎﻤﺜﺘﺳﻼﻟ لوﻷا أﺪﺒﳌا ﻮﻫ ةﺮﻃﺎﺨﳌا ﻞﻤﺤﺘﻟ داﺪﻌﺘﺳﻻا
، ىأ ﺎﻬﻨﻋ ﻚﻔﻨﻳ نأ ﻦﻜﳝﻻ ﺔﲰ ﻲﻫو
ﺳﻻا رﺎﻤﺜﺘﺳﻻاو ﻞﻳﻮﻤﺘﻠﻟ ﺎﻇﻮﺤﻠﻣ اﻮﳕ ﺔﻴﻟﺎﳌا ﺔﺣﺎﺴﻟا ﺪﻬﺸﺗ .ىدﺎﺼﺘﻗا طﺎﺸﻧ ﻮﻤﻨﻟا ﻊﻣو .ﻲﻣﻼ
ت ﻮﻌﺼﻟا ﻦﻣ ﻪﻬﺟاﻮﻳﺎﻣ ﰿﺎﻌﺗ تاودﻻ ﺔﺟﺎﳊا زﱪﺗ دﺮﻄﳌا ،
ﺖﺤﳒ ﺪﻗو .ةﺮﻃﺎﺨﳌا ﺎﻫزﺮﺑا ﻦﻣو
ﻲﻋﺮﺷ رﻮﻈﻨﻣ ﻦﻣ سرﺪﺗ ﺔﻗرﻮﻟا ﻩﺬﻫ.ضﺮﻐﻟااﺬﻫ ﺮﻳﻮﻄﺗ ﰲ ﺔﻴﻣﻼﺳﻻا ﺔﻴﻟﺎﳌا تﺎﺴﺳﺆﳌا تﺎﺴﺳﺆﳌا ﰲ ﺔﻣﺪﺨﺘﺴﳌا ﻲﻫ ﺎﻤﻛ ح رﻻاو ﻢﺨﻀﺘﻟا ةﺮﻃﺎﳐ ﰿﺎﻌﺗ ﱵﻟا تاودﻻاو ﺐﻴﻟﺎﺳﻻا .ﺔﻳﺰﻴﻟﺎﳌا ﺔﻴﻣﻼﺳﻻا ﺔﻴﻟﺎﳌا لدﺎﺒﺘﻟ ﺔﻴﻗﺎﻔﺗا ﻲﻫو ."ح رﻻا تﻻﺪﻌﻣ ﺔﻟدﺎﺒﲟ" فﺮﻌﻳ ﺞﺘﻨﳌا اﺬﻫ
ﲑﻐﺘﻣ ﺢﺑر لﺪﻌﻣ فﺮﻃو ﺖﺑ ﺢﺑر لﺪﻌﻣ فﺮﻃ ﲔﺑ ح رﻷا تﻻﺪﻌﻣ ﻢﺘﻳو .ﺲﻜﻌﻟا وأ
ﺔﻌﻳﺮﺸﻟا مﺎﻜﺣاو ئدﺎﺒﻣ ﻊﻣ ﺔﻘﻔﺘﳌا ﺔﻴﺳﺎﺳﻷا دﻮﻘﻌﻟا ﻦﻣ ﺔﺴﻠﺳ ﺬﻴﻔﻨﺗ لﻼﺧ ﻦﻣ ﺎﻫﺬﻴﻔﻨﺗ .ﺔﻴﻣﻼﺳﻹا ﺣﻮﻟو
ﻰﻠﻋ يﻮﻄﻨﻳ ﺪﻗ اﺬﻫ نأ ﻆ اﻻ
ﺷ ﻜﺎ ﻟﻴﺎ ت ماﺪﺨﺘﺳا ،دﻮﻘﻌﻟا ﲔﺑ ﻊﻤﳉا :ﺔﻴﻟﺎﺘﻟا
ﻞﻜﻴﻫ حﱰﻘﻳ ،اﲑﺧأو .ﺮﻜﺒﳌا ءﺎ ﻹاو ﻢﻈﻨﳌا قرﻮﺘﻟا ،ﺔﲝاﺮﳌا دﻮﻘﻋ ﻒﻠﺘﺨﳌ ﺔﻌﻠﺴﻟا ﺲﻔﻧ
. ﺞﺘﻨﳌا اﺬﳍ رﻮﻄﺘﻣ
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APPROVAL PAGE
I certify that I have supervised and read this study and that in my opinion, it conforms to acceptable standards of scholarly presentation and is fully adequate, in scope and quality, as a research paper for the degree of Master of Science in Islamic Banking and Finance.
………….……….
Younes Soualhi Supervisor
This research paper was submitted to the Institute of Islamic Banking and Finance and is accepted as a partial fulfillment of the requirements for the degree of Master of Science in Islamic Banking and Finance.
……….……….
Khaliq Ahmad
Dean, IIUM Institute of Islamic Banking and Finance
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DECLARATION
I hereby declare that this research paper is the result of my own investigations, except where otherwise stated. I also declare that it has not been previously or concurrently submitted as a whole for any other degrees at IIUM or other institutions.
Syed Ehsanullah Agha
Signature ……… Date ………..
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COPYRIGHT PAGE
INTERNATIONAL ISLAMIC UNIVERSITY MALAYSIA DECLARATION OF COPYRIGHT AND AFFIRMATION OF
FAIR USE OF UNPUBLISHED RESEARCH
Copyright © 2015 by International Islamic University Malaysia. All rights reserved.
THE EFFECTS OF DEBT ON VALUE OF THE FINANCIAL FIRMS AND THEIR BANKRUPTCY COSTS: A CASE OF
MALAYSIA
I hereby affirm that the International Islamic University Malaysia (IIUM) holds all rights in the copyright of this work and henceforth any reproduction or use in any form or by means whatsoever is prohibited without the written consent of IIUM. No part of this unpublished research may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise without the prior written permission of the copyright holder.
Affirmed by Syed Ehsanullah Agha
……… ………
Signature Date
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DEDICATION
This work is dedicated to the most pious and loving woman I have ever known, my mother. For all her sacrifices, love and the way she takes care of me in my student
life, I will always be grateful. May Allah Almighty give her healthy long life.
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ACKNOWLEDGEMENTS
All praises be to Allah Almighty, Lord of the Universe, and Peace and blessing of Allah be upon His final Messenger Prophet Muhammad (P.B.U.H), his Family and Companions.
I take this opportunity to express my deep regards and profound gratitude to those who have contributed and helped me both directly and indirectly in the completion of this research. Firstly, I would like to give special appreciation to my favorite lecturer and my respected supervisor, Associate Professor Dr.Younes Soualhi for his exemplary guidance, diligence and continuous monitoring throughout the course of this research and I am also grateful for the time he gave me, without which completion of this research in due time would not have been possible.
Finally, I would also like to acknowledge my special gratitude and appreciation to my parents for their continuous support and prayers, my brothers and sisters for their kind words of encouragement. May Allah Almighty reward all of them for their continuous support.
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TABLE OF CONTENTS
ABSTRACT...ii
Abstract in Arabic ...iii
Approval Page...iv
Declaration ...v
Copyright Page...vi
Dedication ...vii
Acknowledgements...viii
List of Tables ...xi
List of Figures ...xii
CHAPTER ONE: INTRODUCTION ...1
1.1 Background of the Study ...1
1.2 Statement of the Problem...3
1.3 Research Objectives...3
1.4 Research Questions...4
1.5 Research Methodology ...4
1.6 Structure of the Study ...5
1.7 Limitations...6
1.8 Significance of the Research ...6
CHAPTER TWO: LITERATURE REVIEW...7
2.1 Introduction...7
2.2 General discussion on derivatives ...7
2.2.1 Institutional level...7
2.2.2 Individual level ...8
2.3 Swap products...9
CHAPTER THREE: RISK MANAGEMENT IN ISLMAIC FINANCIAL TRANSACTIONS...11
3.1 Introduction...11
3.2 Risk management...12
3.2.1 An Overview of Risk Management from Conventional Perspective...12
3.2.2 Risk Management from Maqasid al-Shari’ah Perspective...14
3.2.2.1 Risk Management inQur’an...15
3.2.2.2 Risk Management in Prophetic Tradition ...17
3.3 Risk taking and risk sharing: Reconciliation ...19
3.3.1 The Essential risk ...21
3.3.2 The Forbidden risk ...23
3.3.3 The tolerable risk to be avoided ...24
3.4 Conclusion ...25
CHAPTER FOUR: ISLAMIC PROFIT RATE SWAP ...27
4.1 Introduction...27
4.2 Swap as a Risk Management Tool ...28
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4.3 Mechanism of Swap Product...29
4.4 Main Objectives of Swap Instruments...29
4.5 Islamic profit rate swap ...30
4.6 Murabaha structure of IPRS...32
4.7 Conclusion ...36
CHAPTER FIVE: Discussion ...37
5.1 Introduction ...37
5.2 Wa`ad...37
5.3 Validity of Tawarruq in Swap...41
5.4 ISSUES of speculation ...43
5.5 Combination of Several Contracts...44
5.6 Premature Termination and Mark to Market ...46
5.7 Proposed Model for IPRS (Single Commodity Murabaha) ...47
5.8 Conclusion ...49
REFERENCES...52
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LIST OF TABLES
Table No. Page No.
4.1 Profit Rate Swap Cash flows 36
xii
LIST OF FIGURES
Figure No. Page No.
1.1 OTC Interest Rate Derivatives Turnover 29
1.2 Profit Rate Swap 35
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CHAPTER ONE INTRODUCTION
1.1 BACKGROUND OF THE STUDY
“Nothing ventured,nothing gained” is the first principle of investment (Al-Suwailem, 2006). The possibility of an adverse outcome is an essential part of business activities.
The broad perspective on risk and its management is embodied in the essential objectives of Shari’ah, which is wealth protection. However, in the light of the Shari’ah legal maxim that states ‘al-ghurm bi al-ghunm’ (liability accompanies gain) and ‘al-kharaj bi al-daman’ (benefit goes with liability) risk cannot be isolated from economic affairs. The legitimacy of revenue generation requires that it has to be created based on real economic activities, which involve real business risk and liability. Thus the element of risk and liability is essential for the legitimacy of profit entitlement. On the other hand, exposing to excessive risk not only hurdles investment, but also deters economic growth, which might be against the maqasid al- Shari’ah.
There are two types of risks: business risk and financial risk. Business risk deals with the uncertainty of future sales or the cost of inputs, while financial risk deals with the uncertainty of interest rates, exchange rates, stock prices, and commodity prices (Vishwanath, 2007). Hedging through derivatives is one of the means by which financial risks can be reduced. Derivatives are financial instruments that drive its returns and prices from other financial instruments. By employing derivatives, companies and individuals can hedge their risks (Bingham and Kiesel, 2013).
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Swaps and other derivatives were initially viewed to be among the prohibited areas of Islamic finance (Ayub, 2011). However, as a business entity Islamic financial institutions are exposed to all kinds of financial risks as their counter parties. As Islamic investments grow, the need of hedging tools to mitigate certain risks in a volatile market increases (Khan and Ahmed, 2001). With about $2 trillions of assets (Islamic Finance Outlook, 2014), the international divergence of Islamic finance business will definitely necessitate advance and flexible tools to manage financial and business risks (Jobst and Sole, 2012). With increasing use of derivatives in the conventional finance during late 1990s as hedging and speculation tools, Islamic economists came into the grey area of Islamic hedging tools. On the basis of maslahah (public interest), Kamali (1996) discussed for the first time the possibility of options and futures in Islamic Commercial Law (Ayub, 2011).
Islamic finance practitioners tried to develop ‘Islamic’ derivatives during 2000-2007. Theoretically, initial Islamic derivatives products were supposed to be based on the contract of Salam, Murabaha, Wakalah, ‘Urbun, ba`u al-khiyar.
However, financial engineers could not develop any financial derivative structures acceptable to the overwhelming majority of the contemporary jurists. Most of the products introduced, were using W`aad and Commodity Murabah as underlying contracts which are controversial (Ayub, 2011).
It is argued that the development of risk management tools in Islamic financial institutions was a relatively difficult task. Numerous reasons were discussed by scholars. According to Rosly and Bakar (2003) classical Islamic risk management strategies were rigid compared to conventional. Because Islamic commercial law puts some constraints for innovators in order to be in line with Sharia`h (Mohamad and Tabatabaei, 2008). There was a lack of robust demand for risk management tools
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(Ismal, 2010 and Bacha 1999).The absence of a central supervisory board also impacted the development of risk management in Islamic finance (El-Hawary, 2004).
1.2 STATEMENT OF THE PROBLEM
The global Islamic finance industry is growing at 15 to 20 per cent annually. As Islamic investments grow, the need of hedging tools to mitigate certain risks in a volatile market increases. For instance, with a rapidly emerging market of Sukuk, both investors and issuers are exposed to currency fluctuation risk. Similarly, in the case of Islamic REITS, if the fund invests in overseas properties.
To hedge rate of return and inflation risk, Islamic financial institutions are using Islamic profit rate swap (IPRS). This tool is structured based on Tawarruq and Wa`ad as underlining contracts which are controversial, according to some scholars.
In addition, a fundamental question is how Sharia`h boards will ensure that these products can be only used for the pure hedging purpose. There is a need to critically review the operation and mechanism of IPRS from Shraih perspective.
1.3 RESEARCH OBJECTIVES
This study aims to analyse“how”Islamic financial institutions hedge profit rate risk.
The objectives of the paper are as follow:
1- To discuss briefly the concept of Risk management in Islamic financial transactions.
2- To analyse currently available Islamic profit rate Swap arrangements.
3- To highlight the challenges and constraints in innovating Islamic Risk management tools.
4- To propose an effective structure for profit rate swap.
4 1.4 RESEARCH QUESTIONS
1. Dose Hedging business risk, contravene with the legal maxim “مﺮﻐﻟﺎﺑ ﻢﻨﻐﻟا Loss entails gain”?
2. Is Islamic profit rate swap as introduced by IF in Malaysia in line with Sharaih principles?
3. How to ensure the usage of Islamic hedging tools for hedging purposes?
1.5 RESEARCH METHODOLOGY
This study employs qualitative method of research. Inductive approach will be adopted to abstract what has been written about swaps practically and theoretically. It also adopted a deductive approach to derive legal provisions applied in derivative contracts from Quran and Sunnah. In order to produce an innovative and genuine piece of research work primary and secondary data available on the subject will be used as below:
1. Primary data: Bank documents, offer letters, contractual agreements and other Legal documentations used in executing IPRS in Malaysian Islamic banks. In addition, banking manuals and operating procedures will also be the source of primary information for the study. In the same way, the fatwas/guidelines issued by Sharia`h Advisory Council (SAC) (AAOIFI), and OIC Fiqah academy will remain crucial foundation for the study.
2. Secondary data: Textual references from the Quraan and Sunnah, Literature of Islamic jurisprudence, academic texts on the application of the IPRS, academic journals, thesis, internet resources and conference proceedings will be used as secondary data.
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For the purpose of Sharia`h critical review, the functional procedures in executing IPRS and its legality will be analyzed. The results would be reviewed with the Sharia`h standards of AAOIFI, SAC’s Fatwas and finally will be evaluated in the light of Maqasid al-Sharia`h.
1.6 STRUCTURE OF THE STUDY This paper is structured over five chapters.
The first chapter presents a sketch of the research as a whole, it contains following main titles:
1. Introduction 2. Problem Statement
3. Research Objectives and Questions 4. Research Methodology
5. Limitations
The second chapter will discuss Literature Review. In the third chapter, the following topics will be discussed briefly:
1. Concept of Risk
2. Risk Management in Islamic financial transaction 3. Risk Management from Maqasid Sharia`h perspective 4. The mechanism of Hedging
The fourth chapter will review Islamic profit rate swap, mainly focusing on the following areas:
1. An introduction to Swap
2. Islamic Profit Rate Swap strategies 3. The operation of IPRS
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In chapter five; findings, challenges and conclusion will be presented.
1.7 LIMITATIONS
Academic research always has its limitation; this research is not an exemption. This study is focusing on critical Sharia`h review of Islamic profit rate swap Strategies of Islamic financial institutions. The scope of the study will be on the current practice of Islamic profit rate Swap in Islamic financial institutions of Malaysia.
1.8 SIGNIFICANCE OF THE RESEARCH
The area of financial derivatives is comparatively a new field in Islamic finance and banking. Extensive research in this area has yet to be done. Particularly, there is a lack of literature on Islamic swap products that critically review the compliance of Malaysian practice. The relevant past studies have focused primarily on the Shari’ah permissibility of Swap products and structuring of them in line with Islamic Law, without identifying Shari’ah issues and challenges in structuring Swap products.
Therefore, the researcher believes that this research will contribute meaningful insights in relevant field and will highlight challenges and constraints in innovating Islamic profit rate swap products. It will also provide guidelines for Islamic financial institutions in structuring Islamic profit rate swap products.
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CHAPTER TWO LITERATURE REVIEW
2.1 INTRODUCTION
Numerous studies and researches have discussed conventional “derivatives” from Islamic point of view. This paper will organize the review of earlier research work into two parts. In the first part, forward, futures and options contracts will be discussed, while the second part will explain swap contracts only.
2.2 GENERAL DISCUSSION ON DERIVATIVES 2.2.1 Institutional level
The first institutional research work regarding derivatives was initiated by a group of Shari’ahscholars for a jurisdictional discussion in the Islamic Fiqh Academy (branch of the Jeddah based Organization of Islamic Conference OIC). The Academy in its 7th conference in 1992 discussed the legality of derivatives contracts specifically forward, future and options contracts. In its resolution academy unanimously acknowledges the financial and commercial advantages of future and forward trading. However, according to Academy’s resolution derivatives contracts violate the tripartite requirements of Islamic commercial law, i.e. existence, ownership and possession of the asset. In addition, they are involved in speculation and gharar (uncertainty) which lead to monopoly and price distortion. After highlighting the advantages and disadvantages of future markets, the Academy declared that in the light of provided relevant information future and forward transactions are not Sharia`h compliant (Qarārāt Majlis al-Majmāʿ al-Fiqhī al-Islāmī, 1984).
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The other study was undertaken by the Accounting and Auditing Organization of Islamic Financial Institutions (AAOIFI) Sharia`h board in 2004. The board eventually passed a resolution supporting the earlier decision of OIC International Fiqh Academy (AAOIFI Shari’ah standards, 2008).
2.2.2 Individual level
Kamali`s (1996) work is considered to be the earliest individual attempt to resolve the issue of derivatives contracts in Islamic finance industry. The paper discuses only the issue of futures and options. He came up with a new perspective based on the principle of Muslaha with legal evidence proving the legality of conventional futures and options. He supports his opinion by arguing that most of the arguments presented by scholars against futures and options contracts are not that much stronger to prove the impermissibility of derivatives transactions.
Bacha (2004) discussed derivatives instruments and its pricing mechanism generally from a conventional perspective. In the end of the book he specified a chapter naming “Derivatives Instruments and Islamic Finance”. The author attempted to come up with alternatives of conventional derivatives, based on different classical Shari’ah contracts, i.e. Bay’ al-Salam, Istisna’, Istijrar and Ju’alah. However, having expertise in the conventional field of finance only, his opinion regarding Islamic financial transaction is not considered a big authority. Due to not being a Shari’ah specialist, his proposal is insufficient from Islamic point of view.
Al-Bashir (2010) supported overall Kamali’s arguments regarding derivatives discussion. Indeed, his work is an extension of his teacher Kamali’s discussion in a greater detail explaining everything very comprehensively.
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Kunhibaya (2010) summarized the overall scholarly discussion regarding derivative instruments, i.e. futures and options. She explained five major Shari’ah objections pertaining conventional derivatives. They are as follow:
a) Deferment of both counter values in future sell, involves (Bay' al-Kali bil Kali, i.e. sales of one debt for another).
b) Nonexistence of counter values in futures and options at agreement date.
c) Trading of option is trading of mere right and charging of fee is not permissible for it.
d) Future transactions do not follow the requirements of “possession of the item” prior toresale.
e) Mostly derivatives are being used for speculative activities involving gambling and Gharar.
The author merely quoted the arguments and counterarguments of different scholars without her own contribution.
2.3 SWAP PRODUCTS
Badlisha (2004) elaborated currently available derivatives products from a practitioner’s point of view without discussing anyShariah issues (Zaharuddin, 2010).
Bakar (2004) focused on issues and product structuring of Profit rate Swaps and Forward Forex.
Al-Suwailem(2006) discussed Sharia`h-compliant hedging techniques and associated financial engineering tools. We will explain some of his ideas in coming chapters. Dusuki and Mokthar (2010) discussed Hedging, speculation and Swap products in conventional context providing Islamic perspective for each of them. The main objective of the paper was to present the current practice of Islamic FX, Profit
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Rate Swap and cross currency Swap. The authors raised a very fundamental question regarding Swaps. In international markets most of the derivatives products are used for speculative purposes. So how will the Shari’ah board ensure that these products are not being used for speculative activities? The paper didn’t provide a proper solution and the issue of speculative activities remains unsolved. Zahruddin (2010) analyzed conventional derivatives products from Islamic point of view, focusing on Options and Swaps. In chapter four, he discussed in detail Swap products from an Islamic perspective. Since my focus in this paper is only on Swaps, I will discuss his work on Swaps products only. He did not shed light on a very significant issue of Maqasad al- Shari’ah to justify the profit rate swap and cross currency swap products offered by Islamic financial institutions. My research paper will be an extension of his work and will try to incorporate some of the existing gaps.
The latest academic work in the area of Islamic Swap products is written by Alwi and Aznan Hasan in 2013. It is a book named “A mini guide to Islamic Derivatives: A primer to Islamic FX Forwards, Profit Rate Swaps and Options”. After discussing financial derivatives from Islamic perspective the authors explained in detail how Islamic Swap products can be structured in Islamic finance. This mini guide is a new addition to Islamic swaps as it describes Islamic swap products in a simple approach providing practical examples for each product. However the discussion is mostly from Malaysian Shari’ah scholar’s points of view and they did not discuss about guidelines of international Islamic financial market Swaps products.
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CHAPTER THREE
RISK MANAGEMENT IN ISLMAIC FINANCIAL TRANSACTIONS
3.1 INTRODUCTION
The possibility of an adverse outcome is the essential part of business activities.
Uncertainty is a natural component of activities that involve the future as it traverses across different levels. The existence of uncertainty about future outcomes is defined as risk (Damodaran, 2007). Risk is often linked with undesirable event that produces negative outcome. Holton (2004) argues that uncertainty is related to the potential outcomes of an experiment and that the outcomes have to be measured in terms of providing utility.
Be that as it may, in finance risk is defined in terms of variability of actual returns on investment around an expected return, even if the returns represent positive outcomes (Damodaran, 2007). Risks in economics and finance are classified in various ways. One way is to distinguish between business risk and financial risk.
Business risk is due to the uncertainty arising from the nature of a company’s or an individual’s business. It is related to factors affecting the product market, i.e. the uncertainty of the cost of inputs or the future sales. Financial risk is the uncertainty arising from possible losses in financial markets due to movements of financial variables, i.e. uncertainty of commodity prices, stock prices, exchange and interest rates (Jorion & Khoury, 1996).
On the other side, Muslim jurists used the word khatar and mukhatarah for business risk. Mukhatarah is defined as “possibility of unexpected outcomes” (Al- Sharbasi, 1981). Khatar and mukhatarah are interchangeably used with gharar
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(Uwaidah, 2010). According to Al-Mawsu’ah al-Fiqhiyyah Al-Kuwaytiyyah (1983- 2006) mukhatarah is the doubtful status of a business transaction in which gain and loss are unknown. By analysing various definitions of khatar and mukhatarah from juristic perspective, Muhammad (2008) concludes that the concept of risk according to Muslim jurists is almost similar to what is defined by conventional economists.
3.2 RISK MANAGEMENT
Operating in a dynamic environment, every business entity requires an active risk management strategy to protect itself from unexpected results. Sound risk management is the key responsibility of the management and should be part and parcel of the overall corporate governance structure. An effective risk management system comprises of identifying, measuring, monitoring and limiting risks. These processes depend on appropriate control and auditing procedures. In the following section, the concept of risk management will be deliberated briefly.
3.2.1 An Overview of Risk Management from Conventional Perspective
Risk management according to Cumming and Hirtle (2001), is attributed to “the overall process that a financial institution follows to define a business strategy, to identify the risks to which it is exposed, to quantify those risks, and to understand and control the nature of risks it faces”. Damodaran (2007) distinguishes between risk management and risk reduction. Risk management refers to a strategy for an organization’s advantage by seeking it out to exploit uncertainty and risks through various proactive policies to create value. Risk reduction on the other hand, is a defensive process to protect organizations from risk by using insurance, hedging and derivatives. Examining the likelihood and impact of the risk can assess the implication
