Question

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

Financial Engineering does help minimize risk in any investments. If you look at the history of the evolution of derivatives, you can see that it was initially used by farmers to fix the price they were going to sell after the harvest. CBOT which is the oldest Futures exchange was established in 1848 for this purpose. But people quickly realized that they can make quick profits if they buy and sell these futures contracts itself. Of course they were not farmers who sold the commodities nor were they merchants who actually wanted to buy these commodities.
One way of defining risk is the probability that I get my money back with some interest i.e the other person will not default on me. Consider the example of CDOs. CDOs are financial instruments in which a bank which has issued loans to its customers groups them together and sells it off to an investor. The investor makes money on them by the interest payments made my the loan takers. Now if the bank just acts as an intermediary and its main source of money is by selling the CDOs, it wants to give away as many loans as possible without much thought about the creditworthiness of the loan taker. Now the investor who buys the CDOs with these bad loans will loose money because the loan taker defaults on his payment. This is what happened during the credit crisis of 2007. Now, You can not blame the Financial Engineer/Quant who designed the CDOs. If they were used the way they were intended to, then there wouldn't be any problem with the derivatives or any other financial instruments.
Lets look at the efficiency of these derivatives products. There are various types of investors- risk takers, value investors, day traders. The reason we have so many financial instruments is to serve all these people. So, with the evolution of the financial market the market efficiency increases. Investors are free to choose from wide variety of available financial instruments.

There is one caveat though. As with most mathematical models, there are a few underlying assumptions. You can easily distort the truth by changing these assumptions or just ignoring some assumptions. So its very important that you know which assumptions can go wrong and let everybody know who use your mathematical model.

The nature of risks faced by Islamic banks is complex and difficult to mitigate, for different reasons. First, unlike the conventional banks, given the trading-based instruments and equity financing, there are significant market risks along with credit risks in the banking book of Islamic banks. Second, risks intermingle and change from one kind to another at different stages of a transaction. For example, trade-based contracts (murabaha, salam and istisnaa) and leasing are exposed to both credit and market risks.5 For example, during the transaction period of a salam contract, the bank is exposed to credit risk and at the conclusion of the contract it is exposed to commodity price risk. Third, because of rigidities and deficiencies in the infrastructure, institutions and instruments, the risks faced are magnified and/or difficult to mitigate. For example, there are objections to the use of foreign exchange futures to hedge against foreign exchange risk and there are no shari’a-compatible short-term securities for liquidity risk management in most jurisdictions.

The potential of futures contracts in risk management and control is tremendous. Conventional banks manage risks by utilizing commodity forwards and futures contracts. In these contracts, unlike salam, payment of the price of the commodity is postponed to a future date. In the traditional fiqh, postponing both the price and the object of sale is not allowed. Therefore the Islamic banks at the present do not utilize the commodity futures contracts on a large scale. Nevertheless, by virtue of a number of fiqh resolutions, conventions and new research, the scope for commodity futures is widening in Islamic financing. For example, Kamali (2005) argues that, if new technology can eliminate gharar in the contract, then it may be reconsidered. He asserts that the implementation of a contemporary futures contract removes ghararthat is the basis of forbidding these contracts and, consequently, may be allowed. In the future these contracts may prove to be instrumental in managing the risks of commodities. Another argument given to accept the postponement of both the price and the object of sale is the occurrence of many transactions in real life. One such transaction is a continuous supply–purchase relationship with known but deferred price and object of sale (bai’ al-tawrid). For example, public utilities are consumed and the bill is paid when it comes at a future date. The postponement of the price and delivery actually enhances efficiency and convenience and sometimes the postponement in fact becomes inevitable.