Financial Engineering
in Islamic Finance
Zamir Iqhal
EXECUTIVE SUMMARY
The objective of this article is to examine the scope of financial
innovation and engineering within an Islamic financial system.
The article concludes that, contrary to common helief, Islamic
finance provides the hasic huilding blocks that can be used to
construct more complex instruments that will enhance liquidity
and offer risk management tools. With the introduction of asset
securitization and swap transactions conforming to Islamic
principles, the issues of secondary markets and risk management
can be addressed. The first section discusses the significance of
innovation in Islamic financial markets. The second section
discusses the process of introducing new products in the market
and their scope. The third section illustrates an Islamic form of
asset securitization as an example of financial engineering. The
fourth section evaluates the structure of a commodity swap
transaction to determine its validity. And finally, the fifth section
concludes the discussion. ' 1999 John Wiley & Sons, Inc.
Islamic financial markets have earned due recognition from inter-
national financial markets in the past decade. Continuing success
The views expressed in this article are of the author and do not reflect the views of The World
Bank group. The author is thankful to Clement Henry and Ahbas Mirakhor for their valu-
able comments.
Thunderbird Intemational Business Review, Vol. 41(4/5) 541-560 (July-October 1999)
' 1999 John Wiley & Sons, Inc. CCC 1096-4762/99/0400541-19
541

542 IQBAL
and rapid growth is the result of increased demand for Islamic fi-
nancial products hy hoth domestic and international financial inter-
mediaries. Islamic hanking is no longer confined to the houndaries
of Muslim countries hut is estahlishing roots in non-Muslim coun-
tries as well. Furthermore, its clientele base is no longer restricted
to Muslims.
Islamic financial markets are currently facing the challenge of
maintaining their momentum and achieving sustainable growth.
The size of the Islamic market, both in terms of its asset base and
annual turnover, is still considered far below its true potential. The
market suffers from a lack of depth and breadth, due to its limited
set of instruments. There is an evident need for new instruments that
can enhance market liquidity, develop secondary markets, and per-
form risk management.^ But the process of creating new instru-
ments is complex and sensitive, as it requires multidisciplinary con-
siderations including a deep understanding of Islamic jurisprudence.
SIGNIFICANCE OF INNOVATION IN ISLAMIC
FINANCIAL MARKETS
The 1980s witnessed the rapid introduction of financial innovations
in international financial markets. Financial innovations carried
traditional finance and banking into sophisticated markets featuring
a high degree of liquidity and a wide array of instruments that could
share and transfer various sources of risk. The trend occurred in
both domestic and international financial markets. Demand for liq-
uidity enhancing and risk management instruments was prompted
by increased volatility in the prices of financial assets due to the
breakdown of the fixed exchange rate system, the oil shocks and ex-
cessive government spending. The innovation and growth in finan-
cial markets was further induced by advances in financial theory,
breakthroughs in information processing and communication tech-
nology, and the deregulation of financial markets.^
The Bank for International Settlement (BIS) identifies three types
of financial innovations which have had the most significant impact
on the markets innovations to enhance liquidity, to transfer risk
(price and credit), and to generate revenues (from credit and equi-
ty).^ The marketability, negotiability, and transferability of financial
^Askari and Iqbal, 1995.
2Jorion and Da Silva, 1995.
for Intemational Settlement, 1986: pp. 130-139.