Question

Question 4: Write a note on conventional financial engineering risk management products. What are the main objections of shariah scholars on the prevalent risk management products?

Answer 1

Please mentioned below the answer

Financial engineering is a multidisciplinary field involving financial theory, methods of engineering, tools of mathematics and the practice of programming. It has also been defined as the application of technical methods, especially from mathematical finance and computational finance, in the practice of finance.

Financial engineering draws on tools from applied mathematics, computer science, statistics and economic theory. In the broadest sense, anyone who uses technical tools in finance could be called a financial engineer, for example any computer programmer in a bank or any statistician in a government economic bureau. However, most practitioners restrict the term to someone educated in the full range of tools of modern finance and whose work is informed by financial theory. It is sometimes restricted even further, to cover only those originating new financial products and strategies.

Despite its name, financial engineering does not belong to any of the fields in traditional professional engineering even though many financial engineers have studied engineering beforehand and many universities offering a postgraduate degree in this field require applicants to have a background in engineering as well. In the United States, the Accreditation Board for Engineering and Technology (ABET) does not accredit financial engineering degrees. In the United States, financial engineering programs are accredited by the International Association of Quantitative Finance.

An older use of the term "financial engineering" that is less common today is aggressive restructuring of corporate balance sheets.

Financial engineering plays a key role in the customer-driven derivatives business which encompasses quantitative modelling and programming, trading and risk managing derivative products in compliance with the regulations and Basel capital/liquidity requirements.

Quantitative analyst ("Quant") is a broad term that covers any person who uses math for practical purposes, including financial engineers. Quant is often taken to mean "financial quant", in which case it is similar to financial engineer. The difference is that it is possible to be a theoretical quant, or a quant in only one specialized niche in finance, while "financial engineer" usually implies a practitioner with broad expertise.

"Rocket scientist" (aerospace engineer) is an older term, first coined in the development of rockets in WWII (Wernher von Braun), and later, the NASA space program; it was adapted by the first generation of financial quants who arrived on Wall Street in the late 1970s and early 1980s. While basically synonymous with financial engineer, it implies adventurousness and fondness for disruptive innovation. Financial "Rocket scientists" were usually trained in applied mathematics, statistics or finance; and spent their entire careers in risk-taking. They were not hired for their mathematical talents, they either worked for themselves or applied mathematical techniques to traditional financial jobs. The later generation of financial engineers were more likely to have PhDs in mathematics or physics and often started their careers in academics or non-financial fields.

Mathematical finance is the application of mathematics to finance. Computational finance and mathematical finance are both subfields of financial engineering. Computational finance is a field in computer science and deals with the data and algorithms that arise in financial modeling.

The first degree programs in financial engineering were set up in the early 1990s. The number and size of programs has grown rapidly, so now some people use the term "financial engineer" to mean someone who has a degree in the field. The financial engineering program at New York University Polytechnic School of Engineering was the first curriculum to be certified by the International Association of Financial Engineers.

Risk” is widely used to explain an event pertaining to the probability of an outcome to occur. ... This section covers the issues of how risk is defined by researchers in various disciplines and therefore, how it is specifically related to Islamic finance through a generic and unique name, that is, Shariah risk. This paper provides the review of risk from its origin, where the concept of risk has been a concern for humanity since days of old, without the usage of its proper terminology. The study relies solely on related literature and highlights the application of risk in Islamic finance. Reviews of previous studies normally have its own terminology in research methodology. This section covers the issues of how risk is defined by researchers in various disciplines and therefore, how it is specifically related to Islamic finance through a generic and unique name, that is, Shariah risk. The major issue highlighted is where the sources are, which led to a deviation from the path that creates harmful effects. There are other sources for the risk that still need to be clarified further, but this study revealed the sources that lead to the changes of circumstances which result in having risks, based on the Quranic evidences in Islamic perspective. Hence, this paper aims to fill the gap of the current literature by showing the need to conduct further research on the derivation of Shariah risk and its potential in determining capital requirements in Islamic financial institutions.

The establishment of Islamic financial institutions has brought about a new landscape in the financial system. They offer various financial products and services (hereafter, financial services) that comply with Shariah rules and principles. This means that in offering financial services, underlying contracts which include processes, utilization of financial services, and legal documentation should follow the rules and principles of Shariah. This is to relate the potential of Islamic financial contracts to serve Maqasid Al-Shariah, which is the main thrust of the Islamic financial system and guidelines for Islamic finance operations (Lone, 2016; Lone & Ahmad, 2017).

Failing to comply with the underlying contracts means that Islamic financial institutions deserve specific attention because it may erode customers’ confidence in Islamic financial institutions and the whole financial system (El Tiby, 2011; Lahsasna, 2014). Although the unique contractual features of the financial services have exposed Islamic financial institutions to the mix of risks, the risk resulting from failure in complying with Shariah principles is considered as a unique aspect and significant in Islamic financial institutions.

It is necessary to have a clear explanation on the origin and definition of risk itself before the appearance of its generic names as well as other possible sources of risks in Islamic finance. The subjects have not been touched by many researchers except for a few that have looked at the foundations and epistemology of risk in the context of language, logic, and social science such as Thompson (1986), Hayes (1992), and Althaus (2005). Despite its current popularity, the concept of risk was seen as neutral in earlier literature. The term “risk” itself has been referred to as the probability of an event that occurs together with the amount of losses or gains that might entail. Today, however, the notion of risk is more likely to be attributed only with negative outcomes (Hayes, 1992).

Therefore, the main concern of this paper is to clarify the origin of risk and its definitions as well as the sources which ultimately led to a unique name such as Shariah risk. It addresses the issues of the following questions: Where did the word “risk” originally derived from? What are the possible sources of risk that finally contributed to the generic and unique name such as Shariah risk? Subsequently, this study could potentially extend the existing literature in two ways. First, it makes significant contribution to the dearth of studies on risk origin and its various definitions. Second, this work illustrates the possible sources of risk that can contribute to the importance of Shariah risk derivation which has received little or no attention in previous literature.

This paper is divided into six sections as follows. Section “The Origin of Risks in Islamic Finance” starts with an insight into the origin of risk in Islamic finance followed by the definitions of risk in section “Definitions of Risk”. Section “Sources of Risk” provides the sources of risk involving its generic name. Section “Applications of Risk in Islamic Finance” describes the application of risk in Islamic finance. Section “Conclusion and the Way Forward” highlights concluding remarks and the way forward.