126 AN INTRODUCTION TO ISLAMIC FINANCE
which can qualify to be pooled together and the holders of these assets may
desire to sell these assets in the market for various valid reasons. For exam-
ple, Islamic banks may have accumulated a portfolio of leases (ijarah) which
it can sell through securitization to free up its investible funds. Similarly, a
specialized fi nance house or corporation can offer assets to be securitized.
The pool of assets is converted into marketable securities through the
process of securitization which can be carried by either specialists in secu-
ritization or by an Islamic fi nancial intermediary. The process of securiti-
zation ensures that the security is structured to match the risk and return
profi le demanded by diverse group of investors. For example, some inves-
tors may have a lower risk appetite than others or may be looking for lon-
ger maturities. The structuring of the security will ensure that the designed
security is attractive to the investor and offers portfolio management and
diversifi cation benefi ts.
These asset - linked securities are traded in the market through competi-
tive bidding to the pool of investors, which includes individuals, Islamic
bank portfolios, institutional investors such as pension funds or insurance
funds, and corporate treasuries. The investors trade these securities in pri-
mary and secondary markets. There is no reason to believe that the targeted
investors will be limited to Islamic investors the risk/return profi le of the
security may also be attractive to conventional investors. The great interest
in mortgage - backed securities in the conventional system shows the appetite
for securitized products.
Table 6.1 lists the main differences between the conventional and
Islamic securitized securities. In the former, the resultant security is a debt
security with a predetermined stream of coupon payments and where princi-
pal is guaranteed (often through formal credit guarantees). In the latter, the
security’s cash fl ow stream will depend on that of the underlying asset and
the principal will not necessarily be guaranteed. It is possible that in some
cases, depending on the underlying asset, the security owner may have a
high certainty of full repayment of principal but it may not be guaranteed.
The holder of a conventional asset - backed security does not own the
underlying asset but the ownership control in an asset - linked security will
be higher. The asset ownership is also determined by how much recourse
the security owner has to the underlying asset. One of the major differences
between the two types of securities is the variables used in the pricing. In a
conventional mortgage - backed security, the typical pricing model uses vari-
ables such as probability of prepayment or refi nancing, which depend on
the expected interest - rate levels in the future, loan - to - debt ratio, the credit
rating of the borrower, and so on. Since its principal is guaranteed through
credit-enhancing mechanisms, the security is priced like a coupon - bearing
debt security with an early prepayment option. In the case of an Islamic
security, however, the price will depend on typical variables determining
the expected periodic cash fl ows in the future but will also have to factor in the
expectation of the future market value or the residual value of the underly-
ing asset. In the absence of any guarantee of principal, the redemption value