Managing Financial Risk of Sukuk by Ali Arsalan Tariq

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sukuk 236 islamic 171 financial 138 rate 130 risk 128 certificates 121 assets 116 markets 103 shari 79 asset 70 risks 69 fixed 66 contract 59 contracts 59 certificate 55 finance 54 instruments 54 management 53 price 53 options 51

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international banking copyright aa tariq september a dissertation submitted in partial fulfilment of the requirements for the degree of masters of science at loughborough university uk
managing financial risks of sukuk structures ali arsalan tariq m

i would also like to take this opportunity to thank my supervisor doctor humayon dar for his insightful guidance and for always being welcoming and patient with my unannounced visits throughout the year
last but not least i would like to thank my friends at loughborough university that have made my summer of all the more memorable

evolution and profile of sukuk structures and markets
islamic financial assets overview of theoretical aspects

sukuk and the challenge of institutional reform
pricing of sukuks with embedded options vi conclusion bibliography

the objective of this research is to review the evolution of sukuk markets describe the sukuk structures and analyze the various risks underlying the islamic sovereign and corporate sukuk structures
in islamic capital markets interest rate swaps and other conventional forms of derivative instruments such as credit derivatives and detachable options are not available as islamic law also prohibits these

the paper therefore aims to analyze the securitized structures of sukuk and suggest shari ah compatible frameworks which can replicate the functions of interest rate swaps and derivatives in managing the risks of sukuk
investment banks governments corporate clients researchers and students interested in islamic finance and banking are hoped to benefit from such studies

the second group of literature comprises of the actual sukuk issuance prospectuses of various corporations tabreed uae gutheri malaysia and sovereigns malaysia and qatar as well as the islamic development bank

the success and popularity of the sukuk framework as an alternative asset management platform will invariably require inbuilt mechanisms which can be instrumental in mitigating risks that exist in the structures due to the benchmarking of sukuk with market references such as libor
following this will be an exploration of extending the models proposed by neftci and santos to the sukuk structures

these have important implications for the nature of financial assets trading in these assets for the risks of the assets and their mitigation and for management of islamic financial assets
the presumption that finance and economics are independent of religious considerations is challenged to the extent that an islamic financial industry is thriving

it is maintained that when money is loaned the funds are used to create either a debt in which case there is no warrantable rationale why the lender should accept a return or an asset in which case there is no justifiable reason why an unconditional assurance of interest should be imposed by the market
recently scholars have also placed increased scrutiny on not only the rationale for the prohibition of interest but also on the lack of theory in support of interest

however if the situation is such that the players are providing a prize and that there is one a neutral player who does not contribute to funding that prize then the arrangement would become shari ah compliant
whereas in a lottery the participant gains at the ultimate expense of everyone else in a stock market or any other legitimate trade everybody can be a a winner if systemic economic conditions allow it to be so

there are a number of traditional islamic financial contracts and through financial engineering new contracts can be designed in compliance with the prohibition of riba and gharar
avoidance of unethical investments and services shari ah scholars have been unanimous in disapproving of investments in business sectors that may be deemed as a unethical such as casinos tobacco companies wineries sex business etc

one party supplies the capital to a second entrepreneurial party mudarib for the procession of some trade on the condition that the resulting profits are distributed in mutually agreed proportions while all capital loss is borne on the provider of the capital
it offers the opportunity of pure finance in the sense that the owner of the capital can invest without having to personally manage the capital investment and without having to be exposed to infinite liabilities

if the company is incorporated this ownership is the common stock if the company is not incorporated and is privately held this ownership is the share

consequently the fact that the bank or investor bears all the loss of the investment in the event of failure may encourage the entrepreneur to behave against the interests of the investor
a study of islamic finance usually necessitates an analysis of what implications the religious rulings have on the operations of functioning financial institutions

price deferred sale if the buyer is in need of finance s he can buy from a seller on credit and defer the payment of price for a future date agreed with the seller
three predominant forms of dtp contracts arise and these can be classified as price deferred sale object deferred sale and object and price deferred sale

pricing a salam contract is also more intricate than a murabaha contract and involves accounting for the credit risk of the buyer and expected change in value of asset over the time of the contract
object deferred sale if the buyer has funds available at hand or if the seller needs to finance his production and supply the buyer can pay in advance and receiving the goods will be deferred for a future date

if the rents are received later perhaps after the years lease period it means that both the rent price and the apartment object are deferred

for example construction of a road project is carried out on the basis of a cost plus arrangement where the cost is million and the mark up rate is
e floating rate ijara certificates ownership of durable assets given on rent and or ownership of usufructs of durable assets

the primary condition of issuance of sukuk is the existence of assets on the balance sheet of the government the monetary authority the corporate body the banking and financial institution or any entity which wants to mobilize the financial resources
evolution and profile of sukuk structures and markets generally sukuk are asset backed stable income tradable and shari ah compatible trust certificates

due to the fact the murabahah and istisna receivables are part of the pool the return on these certificates can only be a pre determined fixed rate of return
this can be considered as an alternative to sukuk because of its seniority to the issuer s equity its redeeming nature and its relatively stable rate as compared to dividend payouts

expanded list of sukuk in response to the emergence of interest in issuances of islamic asset backed financial instruments the accounting and auditing organization for islamic financial institutions aaoifi released an exposure draft of its shari ah standards concerning sukuk in november

certificates of these are documents of issuer sells usufruct of an ownership of usufructs to equal value issued for the asset to be made available in be made available in the sake of leasing assets that the the future as per specification future as per description lessor is liable to provide in the future whereby the rental subscribers are buyers of is recovered from the the usufructs

certificates of ownership these are documents of of services to be made equal value issued for the available in the future as sake of providing or selling per description services through non existing supplier with the description of the subject matter such as educational programs of a specific quality schedule duration etc
without mentioning the educational institution and obtaining the value in the form of subscription income in which case the holders of the certificates become owners of the services

murabahah certificates these are documents of issuer sells murabahah equal value issued for the commodity purpose of financing the murabahah commodity and subscribers are the buyers the certificate holders of that commodity become the owners of the murabahah commodity

participation certificates these are documents representing issuer is the inviter to a managed on the basis of projects or activities that are partnership in a specific project or musharakah contract managed on the basis of activity musharakah by appointing either one of the parties or any other party subscribers are the partners in the to manage the operation
musharakah contract mobilized funds are the share contribution of the subscribers in the musharakah capital certificate holders own the assets of partnership and are entitled to profit if any

musaqa irrigation these are documents of issuer is the owner of the land that certificates equal value issued on the consist of trees basis of a musaqa contract for the sake of using the subscribers are those who assume the mobilized funds for irrigating irrigation process on the basis of musaqah trees that produce fruits and contract
holders become entitled to a share in the crop as per certificate holders are entitled to a agreement

indeed the largest issuance as of this writing is the million mandate awarded to dubai islamic bank in june by the department of civil aviation dca uae to raise funding for the expansion of the dubai international airport

table most prominent sukuk issues name of ijara sukuk type amount maturity pricing malaysian global first guthrie co

under the arrangement the spv buys the parcels from the government of qatar and re sells them to the buyers of the issues
qatar qatar global sukuk qsc was incorporated as a joint stock company in doha during october established as a joint venture special purpose vehicle spv by the government of qatar qatar international islamic bank qiib and hsbc

under the terms of the agreement between the issuer lessor and government lessee the rental payments will be calculated semi annually in april and october with reference to libor plus the margin and will equal the periodic distribution amounts payable on the respective dates
x m x number of days in return accumulation period the spv on behalf of the investor leases the land parcel back to the government of qatar in conformity with the master ijarah agreement

m f the spv leases out the land parcels back to the government of qatar f the government of qatar pays semi annual lease rentals f the spv disburses semi annual distribution payments equal to the government s rental payments
malaysia malaysia global sukuk was incorporated in labuan malaysia as a specialpurpose vehicle solely for the purpose of participating in the sukuk issuance transactions

after the expiry of the agreement in the government will buy back the properties at face value effectively protecting the bond issue from any variations in the value of the underlying assets
the lead manager of the issuance was hsbc and the comanagers included abc islamic bank abu dhabi islamic bank bank islam dubai islamic bank islamic development bank maybank international and standard chartered bank

there are several covenants that the company has agreed to under the terms of the arrangement and these include f to maintain a gearing ratio the proportion of the company s total capital that is borrowed of not more than
the advisors to the issuance include bank islam ltd shari ah structuring and lead arranger abn amro financial and global coordinator aseambankers malaysia berhad co arranger and shamil bank of bahrain middle east coordinator

hybrid corporate sukuks islamic development bank idb the idb is a multilateral development financing institution founded in december by the first conference of the finance ministers of the organization of the islamic conference oic
each certificate holder is granted the right to receive payments arising from the trust assets that include ijarah leasing contracts murabaha conditional sale contracts and istisna conditional sale of item to be manufactured contracts

if at any time the proportion of ijarah contracts falls below then the arrangement will be dissolved and the idb will be obliged to purchase all the assets owned by the trustee at the time of the dissolution event
however if murabaha and istisna are proportions of a portfolio consisting of at least tangible assets then the securitized certificates of this portfolio may be traded on secondary markets

however it should be observed that in the case of the ijarah sukuk arrangements libor serves as a market reference for the returns and the intrinsic distributions arise from the rentals pertaining to the leasing arrangements with the originator and spv
the prospectus contained clear and precise shari ah considerations outlined by numerous leading scholars and it involved an innovative portfolio combination of ijarah murabaha and istisna projects

most significantly the idb sukuk prospectuses raised funds for projects in developing nations in a wide range of schemes that included power transmissions hospitals steel manufacturing mineral water networks livestock breeding sea port development pharmacology research agricultural irrigation telecommunications projects rural development and colleges
the qatar issuance funded a large medical complex hamad medical city in doha and the malaysia sukuk certificates raised funds for several government owned hospitals as well as offices

it may be mentioned again that sukuk based on fixed rates are exposed to this risk in the same manner as fixed rate bonds are exposed to the interest rate risk
market risk is composed of interest rate risks foreign exchange risks equity price risks and commodity risks

every contract benchmarked with libor inherits the possibility that in the future the libor rates will rise and that the issuer on the asset side will not have made as much profit as future market conditions might dictate
the sukuk issuers will have to respond to fluctuations in libor because any increase in earnings will have to be mutual with the investors

in the event of a divergence between the unit of currency in which the assets in the sukuk pool are denominated and the currency of denomination in which the sukuk funds are accumulated the sukuk investors are rendered to an exchange risk
the unit of account of the idb is an islamic dinar id and is equivalent to one special drawing right sdr of the imf that is weight composed of in us in euro in japanese yen and in great britain pounds

although recently this mismatch has resulted in a profit for the idb because of the weakness of the us relative to the islamic dinar any appreciation of the us against the id will invariably result in a currency loss
indeed the sukuk issues can be based on this simple principle and can be based on multi currencies instead of creating a contingency claim on the issuer s balance sheet in terms of the guarantees

table a summary of risk characteristics of sukuk structures types of sukuk description of sukuk structure credit risk rate of return interest fx risk p rate risk zero coupon sukuk istisna murabahah debt certificates unique basis of credit very high due to fixed if all other p a non tradable risks exist see khan rate remains for the conditions are th and ahmed entire maturity of the similar fx risk u issue will be the same c fixed rate ijara sukuk securitized ijara certificate holder default on rent very high due to fixed for all cases of a owns part of asset or usufructs and payment fixed rate rate remains for the sukuk
this is hence this can be a diminishing musharakah a tradable and ahmed however unique in the very useful tool to th as well as redeemable however mtfs could sense that the rate is not overcome the fx e be based on the strength indexed with a risk by p of the entire balance benchmark like libor diversifying the th sheet hence least exposed to pool in different c this risk currencies

the client of the bank may default on the conditions of the contract and the sub contractor may fail to render the necessary services
unlike conventional financial institutions islamic banks do not have access to derivative instruments and other credit risk management mechanisms due to shari ah considerations

often it is the case that a fine balance is struck between shari ah conformity and project feasibility considerations to the extent that jurists and shari ah consultants play a continuously integral role in the formulation of the sukuk prospectuses
shari ah compliance risks shari ah compliance risk refers to the loss of asset value as a result of the issuers breach of its fiduciary responsibilities with respect to compliance with shari ah

to match the market requirements of sukuk to be floating rate and the shari ah requirements of rents to be fixed rate the ijara sukuk are based on a master ijara agreement with several subordinate ijara agreements

in this case the first spv would have to manage the financial obligations of buying and reselling the underlying sukuk assets to the second spv that would be a trust with the purpose of issuing the certificates
the importance of such a liquidity facility can most effectively be garnered where the arrangement has floating rate payments because fixed rate returns would imply the non existence of interest rate differentials

in case the obligor fails to pay the rentals on the ijarah agreements that form the coupon payments the certificate holder can exercise the right to nullify the contract and force the obligor to buy back the assets
the principal amount paid may not be equal to the sukuk issue amount and as a result there is the risk that the assets may not be fully redeemed

the sukuk certificates are medium to long term in maturity and their continued success will largely depend on their ability to evolve into highly liquid means of fund investment with adequate risk management mechanis miss as is the currently the case most of the certificates tend to be held until maturity
the sukuk structures as welcome as they are in dealing with liquidity management issues in islamic finance are exposed to a liquidity risk because there currently does not exist a well structured and sufficiently liquid secondary market

the features of this state are f lack of hedging and financial engineering processes f non existence of inter bank money markets f lack of best practice uniform regulatory standards and regimes f weaknesses in litigation and legal framework support particularly in the treatment of default f non uniform accounting auditing and income and loss recognition systems f non robust investment appraisal promotion and monitoring infrastructure f ineffective external credit assessment systems f rudimentary state of financial markets and f weak inter segmental support and linkages
this creates a state which can be termed as one of institutional rigidity and which cannot be removed in the short run invariably increasing the risks of sukuks

managing the financial risks of sukuk structures sukuk certificates serve to replicate the functions of conventional bonds and tradable securities in resources mobilization from markets and injecting liquidity into the enterprise or government and in providing stable resource of income for investors
sukuk investors have an inherent right to information on the use of their investments nature of the underlying assets and other particulars that would otherwise be considered redundant in conventional investments

sukuk and the challenge of institutional reform we can highlight a number of pointers for institutional reform that will have a bearing on the competitiveness of sukuk structures
de broeck et al document these changes and the implications of the refor miss with an increase in government debt gdp ratios there has been an increased significance for more cost effective financing strategies that minimize debt management costs

it is discussed that the change to market based funding is expected to increase the volatility of debt service and also has ramnifications for the price discovery process in secondary markets
in response to these pressures it has been observed that governments have shifted from an institution of relationship financing to that of open market funding

financial innovation is a never ending phenomenon and the deterioration of international borders have speeded up in recent years witnessed by the formation of the single euro currency and evolution of the basel ii concordat
the emergence of the market for asset backed securities over the past two decades has permitted banks around the world to free their capital by re packaging and re selling portfolios of loans assets and other receivables

it allows them to make their investment decisions independently of the credit standing of the originator and instead to concentrate on the degree of protection provided by the structure of the spv and the capacity of securitized assets to meet the promised principal and interest payments
as an example banks can offer longterm fixed rate financing without significant risk by passing the interest rate and other market risk to investors seeking long term fixed rate assets

it is considered that the central bank or the security commissioner will have a pivotal role in mediating the interactions between the brokers and traders to lend adequate support and supervision to facilitate the functioning of markets
the optimal structure of an islamic secondary market would be a dealer market where several groups of individuals will liquidate substantial proportions of assets into tradable securities

the government of malaysia launched the capital market master plan in to develop a framework for the malaysian capital market directed at increasing the competitiveness of the capital market and facilitating an efficient provision of financial instruments and securities
with the emergence of dubai and bahrain as powerful financial hubs in the middle east the incentive now is to formulate an efficient regulated and liquid international see the previous footnote

have active stock markets but these will have to be reinforced to accommodate the growing islamic financial sector market that has so far played a bit part role in comparison to conventional stocks and shares on these markets

the statistics provided by the bank for international settlement shows that of all the financial risk management tools in the global markets interest rate derivatives such as fixed to floating rate swaps constitute of the total is comprised of fx derivatives and the remaining of commodity and equity derivatives
sukuk and the challenge of derivatives derivatives trading in conventional markets provide two fundamental challenges to sukuks a fixed and floating rate swaps have been very effective in reducing the funding costs and hence raising overall competitiveness and b these have been very effectively been used to manage credit and market risks

the permissibility of the contract within islamic doctrines is debated and much of debate is with regards to historical records of the use of the contract during the time of the prophet muhammad
the contract affords the buyer of a good to make a deposit whereby if he decides to buy the specified product in the future he will pay the difference between the full price and the deposit

the put option is exercised when the discount prices fall and this alleviates the interest rate risk faced by the investor in the bond
according to shari ah the urboon cannot be used for generic commodities which hinders its possibility to fully replicate the functions of conventional option contracts that are on unspecified underlying assets

it is argued that this circumstance in islamic finance is not economically irrational because involving in a zero sum game cannot make both parties better off so in fact it would be pareto optimal for both parties not to play zero sum games

any eagerness by shari ah jurists to accept embedded options may be undermined on the underlying uncertainty associated with the exercising of the option
the risk is considered inevitable because it has to be realized for any outcome to be experience whether it is beneficial or not

the buyer of the bond would not have received the coupon payments and the issuer may not have benefited from the liquidity profits of the bond issuance

instead of tying into interest rate movements that are typical of conventional bonds sukuk options can be related to the value of the underlying assets and their continued viability and profitability with respect to existing economic conditions
finally embedded option bonds have been traditionally popular among private sector issuers in developed markets and less so among governments of both developed and emerging markets

thus another advantage of puttable structures is that after the issuance of such certificates the government will ensure that their economic position is sound so as to be able to honour future commitments in the event that such a put option is exercised
a depreciation of spot value with an increase in interest rates will necessitate a short position in interest rate futures contracts

if the market price of the stock goes down owners of the convertibles lose nothing as the down sides of these assets are protected by the debts
in conventional financial markets the embedded call and put option features of bonds as well as fixed floating rate swaps play an important role in mitigating market risks of debt instruments in two important ways

thus the opportunity of an exchange of debts against real assets and usufructs can be added to the debt certificates as an embedded option for the settlement of debts
hence this financial asset is bundled with a number of risks such as f liquidity risk the holder cannot cash his asset before the years so it is a very illiquid asset

suppose the constructor writes an option on the certificate that if the holders of the certificate wish starting from the second year the completion of the construction the holders can purchase apartments or acquire apartments on leases utilizing their zero coupons
it is relatively easier to forecast what will happen to the borrowers credit worthiness over say a years period as opposed to his credit worthiness in years

for example f the zero coupon holders may be given the option to exchange their certificate for a suitable amount of output of the company depending on the nature of the company and output or for the common stocks of the company if the company or its subsidiaries are listed f the certificate holders can put back the certificate and rescind from the contract during a specified time period prior to maturity and the company can call back the certificate during a specified time period prior to maturity
once the call option is utilized the interest rate risk reinvestment risk credit risk and exchange rate risks are all isolated

this agreement will cover the nature of the cash flows to be exchanged and the timing of the cash flows which are contingent on the valuation of future market variables
the value of a swap with an institution that has a high credit rating should be greater than the value of a swap with an institution that has a lower credit rating

hence the zcess are exchangeable with the frss in compliance with shari ah given the condition that they are of identical face values
we have already described a a floating rate sukuk frs and b a fixed rate zero coupon embedded sukuk zces based on leasing and istisna transactions respectively

the market for sukuk certificates continues to grow and an important facet of this growth is the increased number of sovereign issuances typified by those issued by malaysia bahrain and qatar and interestingly saxony anhalt in germany
it is expected that sukuk will encourage many muslims world wide to participate in financial markets and hence will be instrumental in expanding and deepening these markets particularly in the emerging countries

with the globalization of financial markets and increased convergence of islamic finance and conventional markets indirect interest rate effects as well as other financial risks will necessitate the development of islamic financial risk management techniques

a greater pool of investors is attracted to this component of islamic finance because of the relative simplicity of the issuances and similarity between conventional fixed income securities and sukuk certificates
the main functioning notion for the development of sukuk markets is the belief that islamic financial instruments can familiarize with conventional capital market syste miss reflecting this is the conception that sukuks can

there is more work to be done and these topics can be expanded upon in further studies
mimic features of bonds and profit from modern advancements in conventional asset backed securities markets

al suwailem sami decision under uncertainty an islamic perspective in islamic finance challenges and opportunities in the twenty first century conference papers loughborough fourth international conference on islamic economics and banking archer simon and rifaat ahmed abdel karim islamic finance innovation and growth london euromoney books and aaoifi ariff mohammad and mannan m
ahmed ausaf contemporary practices of islamic financing techniques jeddah idb irti ahmad ausaf and khan tariqullah islamic financial instruments for public sector resource mobilization jeddah idb irti al jarhi mabid ali and iqbal munawar islamic banking faqs occasional paper jeddah islamic research and training institute

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AlHuda Material\sukuk islamic

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sukuk islam asset finance issu certifi financi contract bankable bond ijarah leas structur profit holder rate developed purchase risk investor

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86

Published Date

2004-09-21 13:58:57

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Managing Financial Risk of Sukuk by Ali Arsalan Tariq

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