Concept and Mathematics of Islamic Financial Engineering

Abstract:     
We argue that Islamic principles, in particular the avoidance of ribā and gharar should be applied with respect to real economic value rather than to monetary value in terms of conventional currency.

In order to reconcile monetary value with economic value, we propose a reference currency linked to an appropriate commodity basket, reflecting the common economic realities and needs of the respective monetary union. Based on this currency, real economic value can be computed in analogy with conventional financial engineering methods, but on a different reference assets, which are commodity-linked rather than interest-based.

In order to reflect global economic needs and realities, a global reference currency should be linked to a basket of commodities including in particular the natural resources necessary to ensure both sustainable survival of mankind and a sustainable living standard above poverty.

Referring to the recent financial crisis of the European Union (EU), we argue that apart from the common economic realities and needs within a given socio-political union, such as the Organization of Islamic Cooperation (OIC), also the different realities and needs should be honoured appropriately. We propose a three-level construction of reference currencies, reflecting the economic realities and needs globally, for each region, and for each country.

The previously defined multi-level currency on the basis of a basket of economic key commodities is proposed as a suitable numéraire for asset-based valuation, particularly suitable in the context of Islamic financial engineering.

We compare conventional financial engineering, based on bank account and zero-bond numéraires as computed from fixed income forward contracts, with Islamic financial engineering based on numéraires computed from commodity-based bay´u s-salam or/and forward contracts.

Number of Pages in PDF File: 21

Keywords: mathematical finance, financial engineering, Islamic finance, trade contract, fair value, market risk, derivatives valuation, interest, currencies, inflation, real value

JEL Classification: E17, E31, E37, E40, F02, F31, F36, P44, Q20, Q43, C13, C15, C19, C30, C40, C51, C53, C60, G12, G13

working papers series