An Introduction to Islamic Finance: Theory and Practice

261

APPENDIX

C

Potential Applications of

Financial Engineering

F

ollowing are a few examples demonstrating the application of fi nancial -
engineering techniques in the area of risk management and benchmark-
ing. These examples use the basic instruments to develop new instruments
that are currently not available in the market. It should be noted that the
instruments discussed here are only examples and they should be taken
with the qualifi cation that the fi nal approval and application rests with the
Shari’ah experts.

SYNTHETIC CURRENCY FORWARD CONTRACT

The concept of arbitrage pricing and the ability to replicate a security syn-
thetically has played a critical role in the development of derivatives and risk -
management tools in conventional fi nance. Arbitrage is used extensively to
demonstrate that in an effi cient market two instruments with identical risk/
return characteristics cannot have different prices. The ability to construct
and to replicate a security or portfolio synthetically helped in the develop-
ment of derivative products, as it was demonstrated that two portfolios — one
with a derivative security and the other with plain vanilla securities — would
have identical risk/return profi les in a world free of arbitrage. Such arbitrage
principles and the techniques of fi nancial engineering can be applied, using
the basic building blocks of the Islamic fi nancial system, for devising deriva-
tive instruments that are not currently practiced.
A currency forward contract is an agreement to buy or sell a foreign
currency at a predetermined price at a predetermined future date. Islamic
instruments permit similar forward contracts (future delivery at a pre - agreed
price) but only in the case of commodities, provided certain conditions
stated by the Shari’ah are followed. The Islamic forward contract, bay’ al -
salam, permits one party to purchase a commodity at a predetermined price
for a future delivery and the purchaser is required to make full payment at

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

by Zamir Iqbal and Abbas Mirakhor

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