New Model for Shariah-Compliant Portfolio

Optimization under Fuzzy Environment

Younes Elahi* and Mohd Ismail Abd Aziz

Department of Mathematics, University Technology Malaysia

81310 Johor Bahru, Malaysia
elahi.math@gmail.com

Abstract. In this paper, a new fuzzy model is presented to improve methods for
Shariah-compliant portfolio optimization, and provides an overview of faith-
compliant portfolio optimization. The spread of fuzzy variable is adopted as
criteria in practical risk management in Islamic finance. First, the effect of
shariah-compliant strategy to portfolio optimization is covered in the literature
review. After analyzing the literature, it was identified that the previous models
lack the fuzzy environment so that they were unable to deal with uncertainty.
Consequently, a new model is proposed to apply the fuzzy environment to
Shariah-compliance portfolio optimization. In this research activity, an E-S
model by the linear combination of the risk and reward for fuzzy shariah-
compliant is proposed. Finally, some future works are presented along with a
conclusion.

Keywords: Shariah guidelines, Portfolio model, Fuzzy Expectation-Spread

(E-S) model.

1 Introduction and Outline

The growing capital value of the Muslim countries and they require of these investors
to invest their capital in financial products that do not divergence with the Shariah
triggered the development of Shariah-compliant investment products such as Islamic
equity funds. Since Shariah prohibits the participation in interest-based assets [1],
specific guidelines need to be introduced as more constraints into models for
constructing Shariah-compliant portfolios [2].
The main problem of the classical problem (in theoretical and computational
finance) is optimizing a portfolio of finitely numerous assets. As the determining
work of Markowitz (1952, 1959, 1987) it is commonly agreed that portfolio
performance must be measured in two distinct dimensions: the expected return rate
with mean, and the risk for measured the uncertainty of the return rate. Another
theoretic approach is stochastic dominance [3], [4].
The sense of stochastic dominance is referring to models of risk-averse
predominance. It came from the theory of Majorization for the discrete case, was

*
Corresponding author.

A. Abd Manaf et al. (Eds.): ICIEIS 2011, Part III, CCIS 253, pp. 210–217, 2011.
© Springer-Verlag Berlin Heidelberg 2011
 New Model for Shariah-Compliant Portfolio Optimization under Fuzzy Environment 211

afterward extensive to common distributions, and was now generally used in

economics and investment [5-10].
Current portfolio study is in progress from original research work by Markowitz
[11]. Markowitz was presented mean–variance model, which is the first portfolio
selection model. Founded on this model, absolute deviation portfolio optimization
[12] and semi-absolute deviation models were propounded [13].
It is discussed that in actuality, many proceedings with fuzziness are characterized
by probabilistic approaches, though they are not random events See [14]. Lately,
some authors began to work on fuzzy portfolio selection problems[15]. Shariah-
compliant Portfolio selection using fuzzy mathematical programming has been the
focus of this paper.
The outline of this paper is as follows. In Sect. 2, we remember some fundamental
concepts related to Islam and portfolio optimization. In Sect. 3, first we study on
shariah-compliant portfolio optimization, and the second moment is referred to as
some useful formulas for cases of strategies in Islamic finance; then we derive a
model of portfolio compliance strategies. In Sect. 4, we formulate Fuzzy Portfolio
Optimization. Then, according to the Fuzzy Expectation-Spread (E-S) model, we
introduce the Shariah-compliant Fuzzy Portfolio Optimization model. Section 5
concludes the paper.

2 Fundamental Concepts
In this section, we present some basic primary senses for entrance the discussion:

2.1 Shariah-Compliant

Islamic finance is controlled by the Shariah, which prohibits speculation, but covenant
that income must be derivative as profits from shared business risk rather than interest
or guaranteed return[16]. Quran, Hadith and Ijtihad are the main Shariah sources for
these rules. The Quran is the principal source of Islam, including the terminology of
God as delivered to the prophet Mohammed while the Hadith consists of story
minutes of the events and sayings of the prophet himself. Ijtihad is the third Shariah
source, that the origin and formulation of Shariah laws by practiced scholars.
While there is no higher institution liable for religious faiths to be followed by all
Muslims, Shariah scholars [17] take these sources and specify so called Shariah-
compliance strategies to be followed within asset selection[18-20]. Despite these
religious limitations and legal uncertainty encompassing the ability of investor
interest under Islamic fiqh, Islamic finance can make balanced to equity, mortgages,
and derivatives known in conservative finance[16].

2.2 Portfolio Optimization

The portfolio selection problem refers to form a good portfolio. It is complicated to

choose which assets should be selected because of the doubt on their returns. The
central purpose in a portfolio selection Problem is to find optimal proportions of the
stock for creating a portfolio which complements the investor’s preferences
212 Y. Elahi and M.I. Abd Aziz

presumptuous that the investors’ wish to strike a balance between maximizing the
return and minimizing the risk of their investment [21].
Portfolio problem: Let , ,..., be stochastic return rates of assets 1,2, . . . , .
We suppose that | | ∞ for all 1, . . . , . Our plan is to invest our capital in
these assets in order to get some attractive characteristics of the total return rate on the
investment. Denoting by , , . . . , the fractions of the original capital invested in
assets 1,2, . . . , we can quickly gain the formula for the whole return rate:
(1)
Obviously, the set of feasible asset allocations can be determined as follows:

: ... 1, 0, 1, . . . , (2)

Usually, stochastic calculus instruments starting by the standard Black-Schole’s

theory for option pricing and portfolio optimization [22, 23].

3 Shariah-Compliant Portfolio Optimization

Common rules for Islamically allowable forms of financial activity can funded in The
Quran, Islam’s Holy Book, and the hadıth [24]. The main characteristic of Islamic
economic behavior is Increase risk sharing between the procurer of funds (investor)
and both the financial agent and the user of fund [25].
In this part, we review how Shariah-compliance can be modeled within the
framework of portfolio optimization. We let the standard condition, i.e. an asset
space, 1, . . . , from which a portfolio can be produced, and we imagine that
the total wealth has to be invested and short-sellings is not permissible, which is
practical since short-sellings is usually not allowed under Shariah. Then every
portfolio can be exposed by a share vector
,...., where 0,1 represents the weight or fractional capital
invested in each asset, and
∑ 1 it hold [2].
For the following we as well suppose an objective function by which the
efficiency of a portfolio is measured and a set of constraints stemming from
investment guidelines other than Shariah guidelines. The objective function is
cogitative the investment strategy. Moreover, the return/risk transaction and could
stem, for example, from the mean-variance model [11], [26] or index tracking senses
[27]. Furthermore, we supposed to have the following conventional portfolio
optimization model that before or lacking about Shariah-compliance:
Min Subject to comply with constraints in

∑
(3)

Sector rules have to be satisfied on the single assets or the total portfolio, whereas
compliance is measured as an element of them.
 New Model for Shariah-Compliant Portfolio Optimization under Fuzzy Environment 213

We suppose an economic guideline we have to compute a financial ratio

for each asset, which measures the level of participation in a non-
compliant financial activity, and to evaluate the value with a maximum permissible
value , the so called threshold value. Thus, we have to organize a set of
limitation of the following type:
(4)
Clearly, these guideline’s consequences in an additional decrease of the asset universe
and thus their achievement can be safe in a preprocessing phase analogously to the
sector rules. Therefore, Shariah-fulfillment of a portfolio can be operationally
generated by a preprocessing stage in which the asset universe for a conventional
portfolio optimization model is specified. However, the useless way to model
compliance with relate to a guideline is to formalize conditions (4) as set of
mathematical inequalities, which are introduced as constraints into the portfolio
model. Conceptually, a financial principle can be modeled by a set of logical
limitations of the following type:

0 If (5)

Unequal of (5) can be turned into a set of mathematical inequality like follows: We
describe a binary variable for each asset, has been following form:

1 if is complaint
(6)
0 otherwise

and we use the constraints:

(7)

. (8)

Constraints (7) ensure that for every asset

0 only if 1 (9)

According to constraints (8) guarantee, that is 0 if the guideline (6) is not fulfilled.

3.1 Modeling Portfolio Compliance Strategies

A portfolio complies with a specific rule if the sum of the ratio values over all
assets, weighted by their share values is less than the threshold, i.e.

∑ . (10)
A portfolio is acquiescent with related to a strategy if fulfils all
guidelines . So, for a central strategy and the set of rules we find the
following portfolio optimization model:
214 Y. Elahi and M.I. Abd Aziz

Min
Subject to (2)-(4) and
∑ . (11)
The portfolio-based fulfillment strategies can now be modeled as follows:
Strategy 1: Best of Shariah strategy. In this strategy, we must solve the model for
each alone. In addition, the optimal portfolio related to this strategy is the one
produced by the model yielding the best portfolio presentation.
Strategy 2: Consensus/Ijmaa Shariah strategy. To introduce Shariah-compliance
under the Ijmaa strategy, we have got to substitute (11) by:

∑ . , (12)

Strategy 3: Liberal strategy. We define the binary variables for model of the liberal
compliance strategy as the following:

1 if the portfolio is complaint for

0 otherwise

There are nonlinear compulsions, and with attention to solvability of the optimization
model must be present as follows:
∑ . 1 . , , (13)

That is a being as much as needed great number. Now caused by (12) at least for
one ; , we attain
1 and we have at least one .

Strategy 4: Majority/Kasra strategy. We change in the model for the liberal strategy
for the majority strategy via
| |
∑ , (14)

Which certifies that at least the majority of main strategies regards as the
portfolio as being compliant [2].

4 Shariah-Compliant Fuzzy Portfolio Optimization

In this section, first, we present formula of the Fuzzy Portfolio Optimization. Then we
showed the effect of shariah-compliant on this formula.

4.1 Fuzzy Portfolio Optimization

Definition: If is a fuzzy variable with a possibility distribution function :

0, 1 , and its spread is defined by the following L-S integral
 New Model for Shariah-Compliant Portfolio Optimization under Fuzzy Environment 215

∞, ∞
dΦ , (15)

Where is the expected value of fuzzy variable [28] and Φ is the credibility
distribution of the fuzzy variable [29]. Every financier has to decide on an appropriate
combine of assets to comprise in his investment portfolio. Specified a set of potential
investments indexed from 1 to , allow indicate the fuzzy return in the next time
period on investment , 1, . . . , . A portfolio is shown by specify what fraction of
one’s assets to situate into each investment. That is, a portfolio is a set of nonnegative
numbers , 1, . . . , that summation to one. The return the investor would
related achieve by using a given portfolio is introduced as∑ , which is also a
fuzzy variable, then the reward with such a portfolio is shown as the expected return
∑ .
Now, we will describe the risk coupled with an investment to be the spread of the
fuzzy return ∑ , that is the quadratic deviation from the expected value. In our
portfolio selection problem, we would like to minimize the risk and not incur too
small reward. So, we formally build the following E-S model by a linear arrangement
of the risk and the reward:
min ∑ ∑
. . ∑ 1 , (16)
0, 1,2, … ,

The positive parameter denotes the important relation between risk and reward [30].

4.2 Shariah-Compliant Fuzzy Portfolio Optimization Model

We recall the criterion of shariah-compliant in portfolio optimization by [2] Ulrich

Derigs, Shehab Marzban(2011). They used as the same formula presented in
equation (6):

1 if is complaint
0 otherwise

In a new model, with the above condition, we present the following E-S model by a
linear combination of the risk and the reward for fuzzy shariah-compliant:

min ∑ ∑
. . ∑ 1 , (17)
0, 1,2, … ,
where is a positive parameter. In the fuzzy environment, the positive parameter
denotes the relation between risk and reward.

5 Conclusion
Within this paper, we have attention to the problem of Shariah-compliant portfolio
construction. The analysis revealed that, fuzzy methodology allows us to add
216 Y. Elahi and M.I. Abd Aziz

uncertainty into data bases and also to combine personal characteristics into the
models. A financial asset comprises multi norm decision-making with the fuzzy
deterministic formulation [21]. Monetary novelty will help to more growth and
improve of Shariah-compliant derivative contracts. For example, extend of faith
derivatives fine for the Islamic insurance (taka ful) industry, limitation the possible of
risk diversification from a larger group of available assets [16].
In addition, the essential condition of such faith rules by the Shariah scholars the
accessibility of modeling tools for setting up the Shariah-compliant portfolio
optimization model is a main requirement, Although, not obligatory for trend the new
paradigm in practice[2].
As a consequence, This model decreases complexity of computation and could be a
fine replacement for Shariah-compliant portfolio optimization model, that present by
Ulrich, D., Marzban, S . With sustaining this system, this model will develop in the
future. Such as, Shariah-compliant Fuzzy risk and return optimization model and
Shariah-compliant Fuzzy pricing optimization model.

Acknowledgment. This publication is supported by Ministry of Higher Education

and Research University Grant (RUG), Universiti Teknologi Malaysia (No:
Q.J130000.7108.01H56).

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