An Introduction to Islamic Finance: Theory and Practice

245

CHAPTER

12

Financial Engineering

F

inancial engineering and innovations are the forces driving the global fi nan-
cial system toward the goal of greater economic effi ciency. The 1980s wit-
nessed the rapid introduction of fi nancial innovations in the international
markets. Financial innovations transformed the traditional fi nancial and
banking markets into highly sophisticated markets featuring a high degree of
liquidity and a wide array of instruments to share and transfer various sources
of risk. The trend occurred in both domestic and international fi nancial mar-
kets. The demand for liquidity - enhancing and risk management instruments
was prompted by the increased volatility in fi nancial asset prices arising from
the breakdown of the fi xed exchange - rate system, the oil shocks, excessive
government spending and infl ationary policies. The innovation and growth in
fi nancial markets was further induced by advances in theory, breakthroughs in
the information - processing and communication technology and deregulation
of markets.
Financial engineering involves the design and development of innova-
tive instruments and processes, as well as the search for creative solutions
to problems in fi nance. Financial engineering may lead to a new consumer -
customized fi nancial instrument, or a new security, or a new process which
ultimately results in the lowering of funding costs or in increasing return
on investments or expanding opportunities for risk sharing. The types of
fi nancial - innovation activities that have the most signifi cant impact on the
markets are those that:

■ Enhance liquidity. Marketability, negotiability, and transferability of

fi nancial claims create liquidity by expanding the menu of options avail-

able to market participants.

■ Transfer and share price and credit risk through the development of

derivatives markets. Derivatives, apart from risk sharing, make markets

more complete and create important additional social benefi ts such as

the dissemination of uniform prices upon which investment decisions

can be made, and the lowering of transaction cost in the capital markets.

■ Generate revenues from credit and equity.

An Introduction to Islamic Finance: Theory and Practice, Second Edition

by Zamir Iqbal and Abbas Mirakhor

Copyright © 2011 John Wiley & Sons (Asia) Pte. Ltd.