Financial Engineering 271
In this example, both parties agree to exchange cash fl ows to match
their obligations to the sukuk holders. However, in reality, the party with
the better credit quality tends to charge the other party an additional cost
to reduce its own overall cost. Since the charging of an additional cost to
assume the other party’s liability may raise Shari’ah objections, no addi-
tional cost in the swap is incorporated. We leave this issue to be discussed
by Shari’ah scholars.
DEVELOPMENT OF AN ISLAMIC BENCHMARK
The availability of an effi cient, frequently quoted and globally accessible
reference rate for pricing assets and a benchmark for evaluating portfo-
lio performance is vital to the success of today’s fi nancial markets. Islamic
fi nancial markets are no exception to this and their growth and develop-
ment are similarly dependent on an effi cient and stable benchmark. While
Islamic fi nancial markets have made considerable progress in the last few
decades, the issue of benchmarks has received little attention to date. In the
absence of a suitable equity - based benchmark compatible with the princi-
ples of the Islamic fi nancial system, markets have often resorted to the use
of interest - based benchmarks such as LIBOR to determine mark - up rates in
trade fi nance, to price assets and to evaluate portfolio performance.
A model developed by Haque and Mirakhor (1997) addressed the design
of an equity - based index, which fully conforms to Islamic principles and
can ultimately serve as a benchmark for issuing government paper.^5 Their
approach is based on a simple argument; namely, that government paper
collateralized against its development and infrastructure projects which do
qualify for equity - participation should not carry a return which is anyway
less than the private - sector projects of similar risk. Therefore, given an effi -
cient index to measure the return on private - sector security, governments can
issue paper such as the National Participation Paper (NPP) to fi nance their
development projects. The return on such an index needs to be adjusted for
a risk premium, which would be negative for the government paper because
governments are assumed to be insulated from credit and default risks.
The model argues that the principles of Islam dictate that the return
on the fi nancial sector in the economy should be determined by the return on
the real sector of the economy. The return on the real sector could be derived
from the expected growth of the dominant private - sector productivity as it
is the main contributor to a country’s nominal GDP. A desirable index needs
to be effi cient in terms of its ability to eliminate any arbitrage opportunity, to
discourage speculative behavior and to be allocationally and operationally
effi cient. However, the fact that fi nancial markets in the developing Islamic
countries are not yet fully developed means that an index based on a single
indicator may not prove to be effi cient. However, a weighted index of dif-
ferent indicators representing activity in domestic, international, private and
public sectors can be more robust, effi cient and stable.