The concept of value : towards a consistent valuation method for Islamic financial engineering

Abstract EN

Islamic finance is continuously growing in order to challenge the conventional interest-based financial system, with increasingly advanced regulatory implementations and corresponding contract engineering.

However, to a large extent, the valuation methods applied in order to determine the value of assets and contracts are commonly taken from conventional finance, and this has been practically unquestioned until recently.

Therefore, the purpose of this paper is to develop and propose a concept of real economic value (rather than a nominal one) and corresponding valuation methods which are more suitable for Islamic financial engineering and risk management.

In this paper, valuation methods are derived rather directly from an asset-based concept of value with certain key commodities as the preferred benchmarks.

First, arguments are provided to support that certain Islamic principles such as the avoidance of ribÉ (interest) and gharar (ambiguity in contracts) should be applied with respect to real economic value rather than to monetary value in terms of conventional currency.

Second, motivated in particular by the desired sustainability of the monetary system, a multilevel currency is proposed on the basis of a basket of economic key assets, in particular, commodities.

A suitable real economy value-reference and a corresponding asset-linked currency are proposed as a suitable numéraire for an asset-based valuation, the latter being recommended in the context of Islamic financial engineering.

Third, conventional and Islamic financial engineering are compared methodically, highlighting their differences.

The former is based on bank accounts and zero-bond numéraires computed from fixed-income forward contracts.

The latter is proposed on the basis of certain asset-based numéraires.

The latter should be chosen such that they reflect real economic value.

It is argued that this approach helps to identify and disable synthetic riba.

Fourth, the valuations of bay al-salam (forward sale) and forward contracts are compared, in particular from the mathematical point of view.

Fifth, the mutual dependency of valuation measure and riskprofile is briefly discussed, and a possible construction of reference rates from asset-return related to Sukuk is described.

As an underlying result, most of the existing mathematical methods, such as martingale-measures and relative prices with suitable numeracies can still be employed for the alternative valuation concept presented in this paper for the purpose of Islamic finance.

However, they are employed here in a different manner, as the selection of an admissible numéraire within the context of Islamic financial engineering becomes more restricted.

The latter excludes, for instance, any reference to conventionally used zero-bonds.