250 AN INTRODUCTION TO ISLAMIC FINANCE
instrument, these are allowed and recognized by the Shari’ah and carry
different risk/return characteristics. As discussed earlier, the introduction
of securitized assets will exploit these instruments to design and customize
risk/return profi les that are critical for the effi cient construction and man-
agement of portfolios.
Promotion of Risk Sharing and Reduction of Leverage The prohibition of inter-
est in Islam curtails the creation of leverage through debt. Instead, the sys-
tem promotes a balanced sharing of risks and rewards through equity - and
partnership - based fi nancial contracts. Following these principles, the fi nan-
cial engineer will focus on developing products which promote risk sharing
through making full use of equity (musharakah) and partnership (muda-
rabah) contracts. Not having access to debt, the fi nancial engineer will fi nd
it diffi cult, if not impossible, to create leverage.
Materiality and Linkages The founding principle of Islamic economics is to
promote the real sector — that is, goods and services — and to link the fi nancial
sector to it as closely as possible. Shari’ah, therefore, insists on the integra-
tion of the two sectors to achieve balanced and sustained economic growth.
If they are not coupled well, transaction costs increase and effi ciency suffers.
Financial engineering in Islam will focus on innovations which promote real -
sector activities and offer innovative ways to fi nance these activities. By using
risk - sharing contracts, the fi nancial engineer will rely on asset - linked securi-
ties through the securitization of real - sector assets. Shari’ah rules concerning
ownership also ensure that there is clarity in asset ownership by the investor
and thus the issue of “remoteness” of assets and ownership witnessed in the
conventional system will be minimized.
Transparency and Simplicity Financial engineering in the Islamic fi nancial sys-
tem seeks to eliminate gharar through advocating the reduction of asym-
metrical information between the parties. Products would be designed to
avoid having excessive uncertainty regarding the future payoffs and risks for
either party. Where there are unknowns, these would be fully disclosed at the
time of the contract. A judicious application of this principle will make
the products transparent and will reduce their complexity.
Different Approaches to Financial Engineering
The principle of fi nancial engineering to introduce advanced fi nancial instru-
ments can be applied in the following ways:
Reverse Engineering or “Wrapping” The fi rst approach entails taking an exist-
ing instrument in the conventional system and evaluating each of its compo-
nents to fi nd the closest substitute from the basic set of Shari’ah - approved
instruments. This means breaking down the instrument and then rebuilding