In recent years, the Islamic finance system has witnessed remarkable growth as well as transformation. This is a demonstration of its potential as one of the competing forms of financial intermediation. In order to ensure adequate and proper development of the Islamic finance system, focusing on the appropriate pre-requisites are important in order to ensure efficient evolution. Critical to this is performing an analysis and forecast of the movements of the Islamic financial instruments.
During the 1980s and 1990s, Islamic banks struggled to expand their investment horizons as well as increase their yields and as such investment products were forced to improve. Over time, the Islamic financial system increased in sophistication and has become a global system that has led to the establishment of infrastructure institutions for the Islamic finance industry. The main aim of this industry is to set uniform standards and regulations as well as facilitate the integration of Islamic financial institutions into international markets (United Nations). As the sector continues to grow, it is faced with various challenges (United Nations) including:
· To strengthen and harmonize legal and regulatory frameworks. Reducing the legal uncertainties will reduce the operational risk as well as enhance the risk management capabilities of Islamic banks.
· To develop adequate instruments, markets and market infrastructure in order to support operations.
For the purpose of this research paper, I am going to concentrate on the financial instruments present in Islamic banks and try to forecast the movement of the Shariah based financial instruments.
Effective and viable money markets in an Islamic system require active support and participation by the Central Bank. The challenge for money markets in an Islamic financial system is the development of instruments that satisfy the liquidity, security and profitability needs of the markets while at the same time ensuring compliance with the rules of Shariah (Askari, Iqbal and Mirakhor, 2015).The Islamic system is based on risk sharing and not risk shifting because of the prohibition against interest and debt in Islam. This paper will therefore look at some of the Islamic financial instruments that have been put to use in Islamic banks. Forecasting will assist in knowing the amount of revenues to expect, control the staff required at work and manage other costs that might be associated with the financial instruments.
Objective of the paper
The objective is to understand the various movements of the separate financial instruments. The findings of the research study will also help to understand why such movements occur and their consequences. In that regard, the sector players can prepare adequately for the same. The objective of this paper includes:
1) To forecast the movement of Shariah based financial instruments.
2) To investigate the volatility of Shariah based financial instruments.
The Shariah is the Islamic legal system (Hassan and Lewis, 2007) although Islam prohibits interest-bearing debt instruments, it has a variety of instruments and arrangements that entail risk sharing and asset based financial asset (Askari, Iqbal and Mirakhor, 2015)
Mudaraba (profit-loss sharing)
Under this, an economic agent with capital develops a partnership with another economic agent who has expertise in deploying capital into real economic activities with an agreement to share the profits. This involves an arrangement in which the capital owner entrusts capital to an agent (mudarib) to trade with and then return to the investor the principal plus a previously agreed on share of the profits. As a reward for the agent’s labor and entrepreneurship, the agent receives the remaining share of the profit. Any loss resulting from an unsuccessful business venture are borne by the investor (Askari, Iqbal and Mirakhor, 2015).This contract usually is limited to a certain period of time at the end of which the profits are shared according to pre-agreed profit-sharing ratios.
In the case of a project, this form of partnership is where one partner (rabb al-mal) finances the project while the other person (mudarib) manages the project. This mode of financing does not require that a company be created because the financial institution provides all of the capital and the customer manages the project. The rabb al-mal has possession of the assets but the mudarib has the option to buy out the rabb al-mal’s investment (Hassan and Lewis,2007)After the mudarib buys out the rabb al-mal, a certificate of permanent ownership in a project is issued where the holder is not entitled to exercise management control (Sandikci and Rice,2011). Mudaraba receives funding from special investment accounts (Hassan and Lewis, 2007)
The profit sharing rates between the two parties is usually a percentage of the profit, rather than a lump sum payment. In the event of a loss incurred, during the normal business process (and not because of misconduct or neglect of the entrepreneur) the financier usually loses all his or her money. In such instances, the entrepreneur only loses his time and effort (Krom, 2013).
Wadia arises when a person keeps his or her property with another person for safekeeping and also allows the other person to use it without the intention of receiving any return from it. (Askari, Iqbal and Mirakhor, 2015). Wadia is the equivalent of Islamic bank reserves at the central bank (Sandikci and Rice, 2011)
Sukuk (Participation securities)
The Islamic Sukuk is structured in such a way that the issue is based on the exchange of an approved asset like buildings for a specified financial consideration. A bond certificate is supported by an asset and is transformed into an object of value; it qualifies to become an object of trade (Hassan and Lewis, 2007). The investor can sell the bond to the issuer or even to a third party if a secondary market for Islamic bonds exists.
It is used a means of raising government income through sovereign issues as well as a way for companies to obtain funds through offering corporate Sukuk. Judging from the Sukuk report that was issued by IIFM (2013) International Islamic Financial Market, the global total of Sukuk achieved a highly respectable issuance between 2001 and 2013 worth US$472. 68 billion.
Sukuk certificates are unique in the manner that, unlike other financial instruments, the investor usually becomes the holder of the asset. Thus, he has a responsibility of bearing the risk of the underlying assets. The holders of Sukuk Certificates must carry the burden presented by the unique risks.
The table below shows the Islamic money instruments and their non-Islamic equivalents:
Table 1.1: Islamic money instruments and their non-Islamic equivalents
Islamic Money Market Instruments
Asset backed securities
Negotiable Certificates of Deposits (CDs)
Islamic bank reserves at the Central Bank
Source: (Hassan and Lewis, 2007)
Looking carefully at these 3 instruments we can be able to forecast what is expected to happen in Islamic banking.
Table 1.2: End of Period in Billions of Dirhams.
Certificates of Deposits
Capital and Reserves
Source: (Central Bank of UAE)
Table 1.3: Total Global Sukuk Issuance
Source: ( International Islamic Financial Market (IIFM))
This paper will use SPSS to analyze and forecast the Islamic financial instruments that are in question in order to be able to know what to expect in the future. This is useful in deciding the number of staff to be hired, the costs that will be incurred during operation as well as the profits that can be gained.
The model that will be used in the paper includes:
P= B0 +B1 +B3
Where P= Profits
B0= Mudaraba (certificates of deposit)
B1= Wadia (Capital and Reserves)
B3= Sukuk (Asset-based securities)
Given the time series data for Certificates of Deposits, the data shows that the issuance of certificates of deposits skyrocketed in 2007 and then fell again in 2008. It then rose steadily between 2008 and 2010, fell again in 2011 and has been rising steadily from 2012 to 2014.
Given the time series data for capital and reserves, it rose steadily from 2006 to 2009 where it remained constant until 2010 where it rose sharply in 2011 then dropped again in 2012. It then rose steadily from 2012 to 2014.
Given the time series data for Sukuk (asset based securities), it can be seen that it reduced between 2004 and 2005 before rising sharply in 2007. After 2007 however, there has been a sharp decline in asset based securities.
From this analysis, we can expect that there will continue to be a decline in Sukuk in the following years. However, forecasting this information will give us the right situation. Further analysis on SPSS using forecasting brings us closer to what is really happening on the ground and what is to be expected. The data has been transformed to be able to handle the forecast function effectively and bring out the most accurate results. The variables have been transformed in order to create models that can be used for analysis in forecasting. The variables that are then used for forecasting include Wadia transformed, Mudaraba transformed and Sukuk transformed. The year was also transformed to accommodate the other variables. The sequence charts are then used to create the graphs that show the forecasted values.
The forecasted values for Mudaraba have now become totally different from what we had forecasted before using scatter plots. Forecasting still shows that Mudaraba will continue to increase however the graphs are slightly different as shown below:
The forecasted values for Wadia from the scatter plot graph showed that Wadia are expected to increase. The forecasted values for the Wadia transformed using forecasting as an analysis brings us to the following result:
The actual values for Sukuk as shown by the scatter graph showed that there is a high possibility of the Sukuk issuance declining in the coming years. However, further analysis through forecasting gives us a different graph. The graph shows that the issuance of Sukuk will reach at a point where it will be constant for some years.
Methodology for volatility
Volatility indicates how the Islamic financial instrument will fluctuate from the intended target or the expiration date compared to its current situation. This is usually measured using variance or standard deviation.
Valid N (listwise)
For volatility, the higher the variance the more insecure the financial instrument is. in the case of the three Islamic financial instruments (Wadia, Mudaraba and Sukuk), their variances are 1. This means that they are highly insecure and could increase and fall at any given time. The three Islamic financial instruments can then be viewed as unstable and a high risk to investment.
Limitations of Research
This research has had some limitations especially related to the data that may have affected how the analysis was handled or results that were achieved from the analysis. This whole research has been based on second hand information because it was not possible to collect the data at the time. Since it involves time series, it becomes hard to collect the primary data as and when it is required hence the need to use secondary data that was collected and stored for years in order to get the information.
The other limitation was the missing values for the years that were not recorded. An example from the tables given above would easily illustrate this. The Mudaraba and Wadia had missing values for the year 2004 and 2005. The Sukuk on the other hand had missing values from the year 2010 to 2014. The presence of missing values may have distorted the information and thus may have influenced the results of the forecast.
The Islamic financial instruments have also been very well or widely researched hence getting information on the instruments is quite a tiring exercise. Even then when information has been obtained from the Central Bank of UAE in my case, the instruments have not been recorded by the Islamic names but by the non-Muslim equivalents. This brings about distortion of information as it becomes hard to know which information is 100% equivalent to the Islamic financial instrument. The non-Muslim equivalents mostly have information that have been merged together and thus becomes hard to differentiate on one specific variable required. For example, the Islamic financial instrument Sukuk has a non-Muslim equivalent of asset based securities and in some cases it is recorded as bonds hence becomes confusing. The case of Wadia also applies. Wadia’s non-Islamic equivalent is Islamic bank reserves at the Central Bank. However, it is not possible to get information on the Islamic bank reserves at the central Bank only. The information has been put together with capital.
The last limitation would be the fact that there are several Islamic financial instruments but there are very few cases where information has been recorded on the instruments. The information or data on these instruments is limited to the main three that I have discussed above.
Some of the fundamental components of the financial architecture as well as infrastructure (like rating, management of the liquidity of financial instruments, credit assessment, information gathering and statistics and Shariah screening technologies) is yet to be fully integrated and embedded both nationwide and in cross-border systems.
From the forecast done, it can be clearly seen that Mudaraba as a financial instrument will be constant at some point, then it will fall sharply before increasing again sharply to its peak value. It will then decline sharply to its lowest before it increases steadily then falls again though not as sharply as the previous times. It will then increase steadily.
The Wadia on the other hand can be seen to have a series of highs and lows though not as distinct as Mudaraba. Wadia will also start off as being constant before it falls sharply then increases steadily until it becomes constant for a year. It then goes through a sharp increase and falls again before it starts to increase again steadily.
The Sukuk however has a totally different trend from the rest. It is expected that it will fall before rising sharply for a period of 2 years after which it will fall again for a period of 2 years. After the two years’ decrease, it will increase for a year before it becomes constant for a long period of time.
These conclusions show that there is no confidence in either of the Islamic financial instruments as they will increase at times, decrease sharply for long periods of time and in some instances even remain constant. However, it is better to remain constant than worried about falling. Hence it would be advisable to first issue Sukuk before considering Wadia and Mudaraba.
I would advise that research be done to look into the reasons why these financial instruments are not stable. What could be the underlying factor that would lead to a possible sharp increase and decline in an Islamic financial instrument? I would also advise that the Sukuk be looked into to find out the reasons for it remaining constant and what could be done to improve its performance.
International Islamic Financial Market (IIFM). n.d. 06 05 2015
Askari, Hossein, Zamir Iqbal and Abbas Mirakhor. Introduction to Islamic Economics. Singapore: John Wiley & Sons Singapore Pte. Ltd, 2015.
Central Bank of UAE. n.d. 06 05 2015
Hassan, M Kabir and Mervyn K Lewis. Handbook of Islamic Banking. UK: Edward Elgar Publishing Limited, 2007.
Krom, CL 2013, ‘Islamic Banking and Finance’, CPA Journal, 83, 1, pp. 56-59, Business Source Complete, EBSCOhost, viewed 28 April 2015.
Sandikci, Ozlem and Gillian Rice. Handbook of Islamic Marketing. UK: Edward Elgar Publishing Limited, 2011.
United Nations. Economic Trends and Impacts in the ESCWA Region (Economic ans Social Commission for Western Asia). n.d.