282 AN INTRODUCTION TO ISLAMIC FINANCE
Market Risk
Market risk for a fi nancial institution arises in the form of unfavorable price
movements such as yields (rate - of - return risk), benchmark rates (interest
rate risk), foreign exchange rates (FX risk), equity and commodity prices
(price risk) which have a potential impact on the fi nancial value of an asset
over the life of the contract. Islamic banks are further exposed to market
risk arising from the volatility in the values of tradable, marketable or leas-
able assets. The risks relate to the current and future volatility of market val-
ues of specifi c assets from different risk factors that include the following:
Mark - up Risk Islamic banks are exposed to mark - up risk as their mark - up
rate used in murabahah and other trade - fi nancing instruments is fi xed for
the duration of the contract while the benchmark rate may change. This
means that the prevailing mark - up rate in the market may increase beyond
the rate the bank had fi xed in a contract and therefore the bank is unable
to benefi t from any increase. This is especially applicable to the murabahah
contract, where the mark - up rate is fi xed at the time of the contract. In
the absence of any Islamic index of rate of return, Islamic banks often use
LIBOR as the benchmark, which aligns their market risk closely with the
movements in LIBOR rates.
Price Risk In the case of bay’ al - salam, Islamic banks are exposed to com-
modity price volatility during the period between the delivery of the commod-
ity and the sale of the commodity at the prevailing market price. This risk is
IFSB PRINCIPLES OF CREDIT RISK
Principle 2.1: [Islamic Financial Institutions] shall have in place a strat-
egy for fi nancing, using the various Islamic instruments in compliance
with Shari’ah, whereby it recognizes the potential credit exposures
that may arise at different stages of the various fi nancing agreements.Principle 2.2: [Islamic Financial Institutions] shall carry out a due
diligence review in respect of counterparties prior to deciding on the
choice of an appropriate Islamic fi nancing instrument.Principle 2.3: [Islamic Financial Institutions] shall have in place appro-
priate methodologies for measuring and reporting the credit risk expo-
sures arising under each Islamic fi nancing instrument.Principle 2.4: [Islamic Financial Institutions] shall have in place Shari’ah -
compliant credit risk mitigating techniques appropriate for each Islamic
fi nancing instrument.