246 AN INTRODUCTION TO ISLAMIC FINANCE
Financial development and innovations have had a positive impact
on the economic growth of various countries. One of the advantages of
fi nancial engineering is that it is for the common good and that there is no
copyright on fi nancial products. Once an instrument is launched, it can be
copied by anyone, improved upon, combined with other instruments and
re - launched.
In addition to broadening choice, fi nancial engineering facilitates the
transformation and reshaping of risk. It thus supports the development of new
products that break down, transfer and pool risks to match the needs of users.
The development of new fi nancial instruments has created opportunities for
households and companies to improve their management of fi nancial, liquidity,
market, and credit risks, which has facilitated the smoothing of inter - temporal
consumption and investment across space.
Financial engineering has also been used often to exploit and to over-
come investment regulations applied to US institutional investors. The
invest ment regulations may restrict exposure to certain asset classes, or
to an investment-grade credit rating, or preclude exposure to foreign
exchange risks or foreign credit risk. For example, a fi xed-income man-
ager’s investment guidelines may prevent investment in equities but a desir-
able exposure to equities may be achieved through a structured note where
a fi xed-income security has embedded exposure to returns in equity mar-
kets; thus achieving a play in equities markets and still complying with
regulatory requirements.
FINANCIAL ENGINEERING IN THE ISLAMIC
FINANCIAL SYSTEM
Financial engineering is one of the most critical current needs of Islamic
fi nancial markets in general and of Islamic risk management practices in
particular. IFIs are still operating on traditional instruments, which do not
fully satisfy market needs for liquidity or for risk and portfolio manage-
ment. The asset portfolios of IFIs predominantly consist of trade - related
short - term assets. There is a shortage of products for medium/long - term
maturities, as secondary markets lack depth and breadth.
The lack of effi cient secondary markets and liquidity in the Islamic fi nan-
cial markets has indirectly limited the range of maturity structures available
to the investor. Given the absence of liquidity, IFIs cannot easily expand port-
folios across capital markets and are restricted in opportunities for portfolio
diversifi cation. This presents a challenging opportunity of developing highly
liquid instruments to satisfy the demands of the investors and the users of
funds seeking longer maturity structures with the fl exibility of adjusting
portfolios at the lowest cost.
The absence of risk management tools will continue to have a signifi -
cant impact on the current and future growth of the market because: