Financial Engineering 247
■ (^) A fi rm in the Islamic fi nancial markets will lose its business competitive-
ness because of its inability to handle variability in its cost, revenues and
profi tability through managing fi nancial risk
■ (^) A fi rm without active risk management will be perceived as a high - risk
fi rm and thus will be subject to higher funding costs
■ (^) A fi rm will be subject to high risk of fi nancial distress
■ (^) A fi rm will be exposed to a higher risk during a system - wide fi nancial crisis
■ (^) It will be diffi cult for IFIs to integrate with the international fi nancial
markets.
The key to the rapid development of secondary markets and of liquidity -
enhancing products for implementing effective risk management is the
application of fi nancial engineering.
The pace of fi nancial engineering in Islamic fi nance has been very slow
by comparison with the conventional system. There are several reasons for
this slow growth.
As an emerging market, the focus has been on establishing interme-
diation services and attempting to get recognition in international fi nancial
markets. Therefore, there has been more emphasis on ironing out the basic
functionality of the banking and fi nancial systems and the corresponding
regulatory and standard - setting framework.
Second, introducing a new, Shari’ah - compliant, product requires con-
siderable effort as it has to receive approval from Shari’ah scholars, not all
of whom are necessarily well - versed in economics and quantitative fi nance.
As we will see in the next section, the Shari’ah has not established a clear
stand on the permissibility of derivatives, which have played a key role in
advancing fi nancial innovation.
In addition, all attempts at fi nancial engineering have revolved around
replicating a conventional security that is easily recognizable by investors
and borrowers. However, it is sometimes easier to develop new products
than trying to replicate a conventional security, which may lead to more
confusion and questions about the product.
Finally, although academic research on Islamic economics and fi nance
has made healthy progress, it has not developed fully to the point where it is
able to tackle certain critical issues such as asset pricing, risk premium, risk
mitigation, hedging, and so on.
All these factors have combined to slow down the introduction of new
products in the Islamic fi nancial market.
Scope of Financial Engineering
The process of fi nancial engineering can be viewed as a process of build-
ing complex instruments utilizing basic building blocks or unbundling and
repackaging different components of existing fi nancial instruments such as
return, price risk, credit risk, country risk, and so on. Today’s highly liquid
instruments and derivatives are based on a simple and basic set of instruments.