The Islamic Financial System 129
The success of an asset - linked securities market will largely depend
on the supply and variety of assets, and on the ability to innovate security
structures with distinct features such as return, risk, maturity, creditwor-
thiness, geographical exposure, sector (technology, manufacturing, etc.)
exposure, and currency exposure. It can be argued that, as the underlying
pool of Islamic assets expands, a vibrant market for securitized securities
will develop and in its fully developed form such a market will offer great
opportunities for portfolio and risk management to all classes of investors.
From this, the following conclusions about the capital markets can be
drawn:
■ (^) The elimination of debt markets will not deprive investors of diverse
investment opportunities.
■ (^) Asset - linked securities offer a better value proposition than the plain
debt security.
■ (^) With the application of fi nancial engineering or spanning, the capital
market can develop securities and fi nancial products with the full spec-
trum of risk profi les.
Derivative Markets
No discussion of fi nancial systems can be complete without a mention of
derivative markets, which perform the following three main functions:
- Risk reduction and redistribution: It is widely accepted that the primary
function of the derivatives market is to facilitate the transfer of risk
among economic agents. Financial derivatives unbundle the risks asso-
ciated with traditional domestic and cross-border investment vehicles,
such as foreign exchange, interest rate, market, credit, and liquidity
risks. Derivatives facilitate the redistribution of these risks from those
who do not want or are not capable of hedging them to those who are
in a better position to manage them. - Price discovery and stabilization: The existence of derivatives markets
for futures and options is expected to increase information fl ows into
the market and is known to lead to a price-discovery function in the
fi nancial sector. - Completeness of markets: Another critical function of the derivatives
market is that it can enable individuals and fi rms to customize and mon-
etize payoffs that might not otherwise be possible without considerable
transaction costs.
Research on the scope of derivative securities and trading of risk in an
Islamic fi nancial system is in its early stages. Shari’ah scholars are work-
ing on assessing the permissibility of derivatives such as forwards, futures,
options and swaps. Unlike fi nancing and investment instruments, which have
been in existence for several centuries and, therefore, have been taken up