You are on page 1of 43

Islamic Economic &

Finance
BFB2123

Topic 7
Risks and Returns
2

LEARNING OBJECTIVES
1. General understanding of risk management in
Islam.
2. Describe the concept of risk and return in Islam.
3. Describe the measurement on risk and return in
Islam.
4. Explain the concept of profit maximization.
5. Identify the theory of profit maximization from
Islamic perspective
1. Introduction

3
4

RISK AND RISK MANAGEMENT


PROCESS

• Risk can be defined


• “uncertainty about financial loss from an
exposure”; or
• “the relative variation of actual from expected
outcomes”

• Risk management can be defined as:


• process that identifies loss exposures faced by an
organization and selects the most appropriate
techniques for treating such exposures; Risk
management is a formal process that enables the
identification, assessment, planning and
management of risks.
2. Concepts of Risks and Returns

5
6

• The risk/return trade off is the balance


between the desire for the lowest possible
risk and the highest possible returns.
• A common misconception is that the
higher the risk the greater the returns.
• The risk/return trade off tells us that the
higher risk gives us the possibility of higher
returns.
7

R Low Risk
Low Potential Returns
e
t
u
r High Risk
n High Potential Returns

RISK
8

• However, there are no guarantees. Just as risk means


higher potential returns, it also means higher potential
losses.
9

ISLAMIC PERSPECTIVE

• Risk has no religion


• Muslims believe in the hereafter; life on this world is
transitory
• You will be rewarded according to your intentions
• Risks cannot and should not be avoided
• Man are required to act diligently but Allah
determines the final outcome.
10

ISLAMIC PERSPECTIVE

• Epic on the Hijrah


• Planning for Battles
• ‘Tie your camel, then say Isha’ Allah’-
Hadith At Tarmidzi
• ‘O my sons! Do not enter by one gate, but
enter ye by different gates. I cannot avail
you against Allah at all. Verily! The
decisions rest with Allah. In Him I put my
trust, and let all those who trust put their
trust on Him’(12:67)
11

RISK IN ISLAMIC MODES


OF FINANCING
• Murabahah Financing
• Murabahah is the most predominantly used Islamic
financial contract.
• If the contract is standardized its risk characteristics can
be made parable to interest-based financing.
• The different viewpoints can be a source of counterparty
risks as a result of the atmosphere of an ineffective litigation
12

RISK IN ISLAMIC MODES


OF FINANCING
• counterparty risk specific to murabahah arises due to
this unsettled nature of the contract, which can pose
litigation problems.
• late payments by the counterparty as Islamic banks
cannot, in principle, charge anything in excess of the
agreed upon price.
• Non-payment of dues in the stipulated time by the
counterparty implies loss to banks
13

• Musharakah – Mudarabah Financing


• Very high credit risk involved. The credit risk is expected
to be high because:
• there is no collateral requirement,
• there is a high level of moral hazard and adverse selection,
and
• banks' existing competencies in project evaluation and
related techniques are limited.
14

• Salam Financing
• Salam is an agricultural-based contract
• the counterparty risks may be due to factors
beyond the normal credit quality of the client
• the client may be very good but the supply may not
come as contractually agreed due to natural
calamities
• salam contracts end up in physical deliveries
and ownership of commodities
• banks exposed to storage costs and other related
price risk
• Such costs and risks are unique to Islamic banks
15

• Istisna Financing
• counterparty risks under Istisna' faced by
the bank from the supplier's side are similar
to the risks mentioned under salam.
• contract failure regarding the quality and time
of delivery
• less exposed to natural calamities as compared to
the object of salam.
• it can be expected
• the subcontractor of istisna although substantially
high, is less severe than that of the salam
16

• default risk on the buyer's


• If the istisna contract is considered optional and not
binding - under certain fiqh jurisdictions, a counterparty
risk as the supplier maintains the option to rescind from
the contract
• if the client is given the option to rescind from the
contract, and he/she declines acceptance at the time
of delivery, the bank will be exposed to additional risks
3. Risk and Return Measurements

17
18

TYPES OF RISKS
• Credit Risk
 Loss of
• Country Risk
confidence Risk
• Investment Risk
• Liquidity Risk  Spillover Risk
• Operating Risk  Other Risk
 Forgery
 Buglary
 Natural
Catastrophe
19

RISK MEASUREMENT
• The difference between actual returns and
expected returns is the existence of what
we term as risk.
20

METHODS
• Relative Risk
• Evaluates specific portfolio returns to a benchmark
return.
• Different relative risk measures use different
benchmarks.
• Methods used are:

• Semi Volatility

• Downside Volatility

• Shortfall Probability
• Value at Risk (VaR)
21

METHODS
• Absolute Risk
• This risk measure is taken into account for portfolio
returns.
• Methods used are:
• Maximum Drawdown
• Autocorrelation
• Risk Perceptions
22

OVERALL RISKS FACED BY


ISLAMIC FINANCIAL
INSTITUTIONS
Number of Average
Relevant Response Rank*
Credit Risk 14 2.71

Mark-up Risk 15 3.07

Liquidity Risk 16 2.81

Market Risk 10 2.50

Operational 13 2.92
Risk
The rank: has a scale of I to 5, with 1 indicating 'Not Serious' and 5 denoting ‘Critically Serious'.
ADDITIONAL ISSUES REGARDING 23

RISKS FACED BY ISLAMIC


FINANCIAL INSTITUTIONS
Number of Average
Relevant Rank*
Response

Lack of understanding of risks involved in Islamic 17 3.82


models of financing.
The rate of return on deposits has to be similar to 14 3.64
that offered by other banks.
Withdrawal Risk: A low rate of return on deposits will 14 3.64
lead to withdrawal of funds.
Fiduciary Risk: Depositors would hold the bank 14 3.21
responsible for lower rate of return on deposits

The rank: has a scale of I to 5, with 1 indicating 'Not Serious' and 5 denoting ‘Critically Serious'.
24

RETURN MEASUREMENT
• Can be viewed as a growth rate of the amount of the
principal invested, which is then translated into
percentage.
• It is important to note that historic/past returns may be
used as a yardstick but they may or may not be repeat
the future.
25

• Accounting calculations that need to take into


account:
• Cash
• Fees
• Zakat
• Taxes
• Exchange Rates
• Market Valuation
26

METHODS
• Simple Returns
• Refers to a percentage
change of the market value of
an investment over a period of
time.
• Types of a simple returns are:
• Discrete returns
• Continuous returns
27

METHODS
• Returns with Contribution
• Simple returns are only
applicable where the amount
invest is the same over the
measured tenure.
• The methods used are:
• Money Weighted Returns
• Also known as Internal Rate of
Return (IRR)
28

MITIGATION OF RISKS
• Risk Avoidance
• Risk Assumption or Retention
• Loss Prevention and Reduction
• Risk Transfer
• Hedging or Neutralization
• Combination
4. The Profit Maximization Concept in
Islam

29
30

INTRODUCTION
• Conditions of equilibrium in many areas of economic
theory are defined in terms of maximization
(minimization) of some magnitude, e.g firms maximize
profit and consumers utility
31

INTRODUCTION
• Islamic economists argue maximizing behavior may
promote greed and conflict with notions of fair play
and justice
• Maximizing behavior of economic agents will tempt
them to violate Islamic norms. Islam pleads for fair profit
and moderation in consumption. Such views require
examination
32

METHODOLOGICAL
ISSUES
• Pursuit of self-interest and
maximizing behavior are linked
together inseparably
• Individuals desire well-being
through need fulfilment and must
seek wealth, Muslims or non-
Muslims.
33

METHODOLOGICAL
ISSUES
• Pursuit of self-interest does not prevent the pursuit of
spiritual goals as religion demands.
• Mainstream economics too does not exclude other
motives one can attempt to achieve
• Islamic economics cannot disallow the pursuit of self-
interest as it is a natural instinct of human-beings. Its
norms do not allow self-interest go berserk.
34

PROFIT MAXIMIZATION
• Maximization hypothesis has been the logical
outcome of the marginal analysis in economics
• The difference of output and input price sets –
profit - regarded is accepted exclusively as
belonging to their owners
• The difference of output and input price sets –
profit - regarded is accepted exclusively as
belonging to their owners
35

PROFIT MAXIMIZATION &


COMPETITION
• Profit maximization is a legacy of classical
model of industry composed of tiny owner
operated firms powerless to influence
price by individual action either of inputs
or the product
• Competition allowed only normal profit–
fair and legitimate to which Islam too
would have no objection. Competition
could promote efficiency and equity
36

PRICING POWER &


PROFIT MAXIMIZATION
• Under imperfect competition where firms have pricing
power, there is nothing to normalize profit
• The activity may tend as it does to become exploitative
of both the consumers and the factors of production
37

PROFIT MAXIMIZATION :
REALITY
• Profit maximization is a mathematical concept which
requires measurement
• Future profits cannot be measured
• That makes profit maximization a heuristic analytical tool
without content. Its value is directional only.
• Price theory needs the assumption; it has predictive
value.
38

ISLAMIC ECONOMICS &


PROFIT MAXIMIZATION
• Objective of the Shariah is to ensure general human
well-being and socio economic justice
• It teaches that all wealth belongs to God and that
human beings are merely trustees of this wealth
• Is not profit maximisation but profit-sharing or
distribution
39

METHOD – MULTIPLICITY
OF OBJECTIVES
• F = F(X1, X2..., Xn.)
• F may stand for `Falah'.
• `Falah' - the ultimate goal of a Muslim
(`success' in this world and the
Hereafter)
• where profits, prices and output i.e.,
the quantifiable variables, are
represented by the Xn.
40

IMPLICATIONS ON THE
ECONOMY
• Multiplicity of objectives might imply as follows:
• The achievement of ‘falah' necessitates a balance
between material and spiritual attainments.
• In particular, firms should be able to accumulate an
adequate amount of wealth, which can be used for the
general good.
41

IMPLICATIONS ON THE
ECONOMY
• Consumers in an Islamic society tend to be better off
because of higher output and lower prices.
• Excessive profits in the sense of super normal profits will not
be earned by the firms but will be passed on to the
consumers in the form of more output at lower prices.
42

IMPLICATIONS ON THE
ECONOMY
• The types of goods produced would be those required in
order to fulfill the basic needs.
• Only when basic needs have been fulfilled would firms then
go into the production of goods for conveniences.
• The general welfare of the society is not a sole
responsibility of the state, but one which can be shared
by the entrepreneurs.
43

THANK YOU.
WALLAHUA’LAM