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THE GLOBAL UNVERSITY IN ISLAMIC FINANCE (INCEIF)

Kuala Lumpur, Malaysia

SUKUK PRICING STRATEGIES: RISK

ASSESSMENT vs. SHARIAH STANDARDS

A Dissertation Proposal submitted in partial fulfillment of therequirement of the Doctorate of Philosophy in Islamic Finance

BY

NIDAL A. ALSAYYED

(0900313)

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SUKUK PRICING STRATEGIES: RISK ASSESSMENT vs. SHARIAH

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January 2010

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Reviewed and approved by,

Dr. Ahcene LahsasnaGraduate Studies Academic Advisor

Shariah and Legal Studies Department

..

Prof. Datuk Syed O. AlHabshi

Chief Academic Officer & Dean

Professor of Islamic Economics, Banking, and Takaful

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In the name of Allah, The most Merciful,

TABLE OF CONTENTS

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ABSTRACT (English & Arabic)

Approval Page

Declaration Page

Acknowledgement

List of Tables

List of Figures

List of AbbreviationCHAPTER ONE: INTRODUCTION

1.0 Introduction

1.1 Sukuk overview in Malaysia and Middle East

1.3 Historical background

1.4 Objectives of the study

1.4.1 Motivation of the study

1.4.2 Contribution of the study1.4.3 Organization of Chapters

CHAPTER TWO: LITERATURE REVIEWS

2.0 Introduction

2.1 Basic Principles of Islamic Financial Systems

2.2 The concept of Debt & Equity in Islam

2.3 The development of sukuk in Malaysia and Middle East

2.3.1 Murabahah - based Sukuk

2.3.2 Ijarah- based sukuk

2.3.3 Mudarabah based sukuk

2.3.4 Salam & Istisna Sukuk

2.4 The structure of Islamic Bonds (Malaysia vs. Middle East)

2.4.1 Sale-based Financing Debt Instrument

2.4.2 Lease-based Financing equity-Equity Debt instruments

2.5 Sukuk and Islamic Bonds vs. Conventional Bonds

2.6 Unresolved Issues on Malaysian and Middle East Sukuk2.7 Conclusion

CHAPTER THREE: SUKUK PRICING ENGINEERING

MODELS

3.0 Introduction

3.1 Evolution and Profiles of Sukuk Structures and Markets

3.2 Innovative Mathematical Approach and

3.3 Conclusion

CHAPTER FOUR: THEORITICAL FRAMEWORK AND

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ABSTRACT

The purpose of this dissertation is to provide an empirical analysis of different corporate &

sovereignsukuk(Islamic Bonds) structures from a financial and economical perspective.

This examination includes murabahah, mudarabah, andIjarah -basedsukuk, while the

former offering a fixed return, and the latter, the most popular form ofsukuk, and a variable

return. The potential for other more novelsukukstructures based onMusharakah

partnership contracts is also investigated, andsukukpricing issues are explored using

alternative benchmarks to London Inter-bank Offer Rate (LIBOR).

I aim to conduct a hybrid contemporary research project utilizing Islamic Financial

Engineering tools to modernsukukstructures; outside the conventional law ofmuamalat

and under the guidance of the Quran and Sunnah. The project seeks to expand the

knowledge, clear misconceptions, provide guidance, help decision makers standardize

shariah parameters and practices in the issuance ofsukuk, and bridge the relevant gap in

Islamic capital market, instruments, pricing policies, strategies, and risk transfer- among

scholars, jurists, practitioners, and financial institutions in the Middle East and Malaysia.

The central feature of this research is to offer a different interpretation and design models

of the source material of the Shariah towards a vital, important, and viable economic

sukukpricing & structures in todays Islamic Finance.

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KEY WORDS: Islamic Financial Price Engineering, Musharakah- basedsukuk,Ijarah-

basedsukuk, Malaysia, Middle East, Conventional Law of Muamalat (The shariah

perspective on commercial transactions), AAOIFI1, IFSB2,Ijtihad, and Alternative

Benchmarks to LIBOR, and Benchmarking

INTRODUCTION AND LITERATURE REVIEW

The unprecedented advances in information technology & communications and the

diverted approach to Intensive Knowledge Economics had left its fingerprints on the

financing instruments and methodologies for governments, financial institutions and

corporations; which had depended on the imitative (traditional- taqlidi) banking and

finance approach for a very long time. In todays market which was accompanied with not

only the evolvement of multinational corporations3, mutual funds, treasury stocks, Credit

Cards, CDs; Financial markets, commodity markets, and precious metals markets; but also

with the newly developed tools, instruments, and formulas of multi-applied transactions

conducted in those markets.

The most important of those instruments penetrated the Islamic financial markets are

sukuk; which continue to remain the topic that researchers can never keep up with its

diversified and multi facet aspect. In spite of the fact; that many had referred tosukukin the

1Accounting and Auditing Organization for Islamic Financial Institutions2 The Islamic Financial Services Board (IFSB)3 I am not referring only to those corporations with Foreign Direct Investment; but also to those DAC

corporations (based in USA, Japan, UK, France, and German).

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context of conventional bonds, debt securities, non shariah compliantsukuk4, innovations

insukukstructure will continue to be the motive force in real expansion of the Islamic

Financial Industry.

To bring new and significantly different products to the market; will require the

introduction of a new production technique, the opening up of new market5 The industry

products have become commodities and increasingly both less profitable and more

expensive to sell. Islamic Financial services industry will have to reinvent itself if it is to

continue to prosper in the 21st century.

Innovativesukukstructures pricing strategies are new models; which needed to be

formulated In light of the operative procedure of Islamic Capital markets.6Sukukdesign

and pricing structures are conducted by trained professionals in a highly centralized and

controlled market. In addition the contract specifications and its related procedures are such

that the prospects of uncertainty and risk-taking (gharar) are virtually eliminated. Adequate

understanding of the mechanisms ofsukukpricing and profiles and the relevant market

procedures since only then will be able to determine the nature of the issues before us in

each case and specify the purpose of our inquiry and its hypotheses7.

The commercial reality of the market can be judged from an Islamic law view point

without negatively influencing the public interest and under the spirit of shariah The

4 Sheik Taqi Usmani declared early in the first quarter of 2008 that bulk of the sukuk issued in the market

defied Islamic norms (Usmani, M. Taqi: An Introduction to Islamic Finance,Idaratul Maarif, Karachi,

Pakistan).5 Peter Drucker(1999), Economist, Drucker on Financial Services, Innovate or die6 Ali Abd Al-Qadir (2006), Encyclopedia of Islamic Banks7 Mohammad H. Kamali (2002), Islamic Commercial Law: An analysis of futures andOptions

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shariah provides us with the necessary tools (maslahah being one of them) to reach an

acceptable formula for both practitioners and in line with the public interest.

STATEMENT OF THE RESEARCH PROBLEM

Islamic finance as an emerging form of financial intermediation would require

tremendous investment in research and development to promote innovation. Of

importance is to develop a broader range of Islamic financial market instruments

that include instruments with equity ownership features, Islamic asset-backed

securities, inclusion of permissible forms of credit enhancements as well as

Shariah-compliant risk mitigating instruments. The development of an Islamic

Bonds (Sukuk) market for hedging is required for market-making activities to

support the development of secondary markets. Malaysia has recently established a

Shariah Scholars fund to fund such research and development efforts. The fund

also aims to promote greater engagement among the international Shariah scholars

and thus provide a platform for deliberation on the Shariah compatibility of newly

developed Islamic financial instruments and markets.

The increasing complexity in the way that debt is created and distributed in the

financial system raises important implications for financial stability. The originate

and distribute strategy that has been adopted by some institutions warrants

addressing more comprehensively the full range of risks to which the banks are

exposed. This includes the liquidity, equity, foreign exchange, profit, and moral

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hazard risks in banking institutions. Credit risk exposures have also taken on more

complicated forms, including counterparty risks on derivatives and foreign

exchange transactions. The valuation of such financial transactions and instruments

are also often difficult to measure particularly under distressed market conditions.

In addition, the correlations between credit and market risk, both within and across

national borders, have become more complex. Of concern has also been lack of

adequate information on debt concentrations in the system partly due to the

increasingly elaborate ways in which debt is passed on from originating institutions

to different investors. The propensity to under price credit risk, especially under

conditions of excess liquidity, has also increased concerns over underwriting

standards. The consequent sharp pricing corrections would in turn have the

potential to result in broader economic disruptions.

We cannot simply accept the argument of some contemporary scholars referring to

high percentage ofsukukapplications as they closely resemble conventional debt

instruments without scrutinizing and investigating this matter in all relevant

aspects. Sukukcan be structured and applied to contribute a major role in the

expansion and development of the economic structure of any country.

Moreover; we cannot neglect the massive total notional value, the huge use of

leverage involved with multiplesukukstructures and that early indications of the

investment portfolio structural problem show up quicker in thesukukmarkets.

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RESEARCH QUESTIONS

1. What is the pricing strategy which best suit the most commonly issuedsukuk

structures (Middle East and Malaysia)? How risk can be assessed and valued?

2. What are the Shariah parameters (standards) that have to be adhered to each sukuk

structure and its applicability and challenges?

3. What are the associated sukuk hedging (risk mitigating) tools that are currently

employed and in the Islamic banking industry? How Shariah compliant?

Challenges.

JUSTIFICATION OF THE STUDY

I aim to illustrate the implication of key parameters in pricing todays most popular sukuk

structures and assessing different types of risk associated with todays volatile market.

Flow charts are used to illustrate different innovative structural models, pricing strategies,

financial transfers and the rights and obligations ofsukukinvestors as well as the

beneficiaries of the funding as indicated by Shariah standards of AAOFI & IFSB.

Historical data have been used to assess whether the payments flows are more stable in the

case of sovereign & corporatesukukwhere the returns are based on gross domestic product

(GDP) growth rather than interest.

HYPOTHSIS OF THE RESARCH

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The conventional debt instrument (Interest, usury, orRiba) and gharar insukukis evidently

a pervasive concept that permeates the whole spectrum of contracts and transactions in

Islamic law. It is also a broad concept in that it comprises uncertainty and risk-taking as

well as excessive speculation, gambling and ignorance of the material aspects of contracts.

The basic tools of evaluation and analysis that Islamic law has provided are comprehensive

enough to relate to all these concerns and especially to the overriding one, namely to

ensure, fairness and prevent excessive uncertainty and abuse in commercial transactions

and contracts.

To determine the correct procedure for the resolution ofikhtilafin Muslim societies today,

one should refer to the Constitutions and laws of the countries concerned. Resolutions of

difference s must be made in a maslahah oriented manner in the interests of the people and

by accommodating their views. Once a selection has been made by the ruling authorities,

everyone must comply with it and disagreements must be laid to rest. Of course, there is no

single formula for resolving ikhtilaf. Often the shariah, or the applied law of a country,

provide only genera l guidelines and leave specific decisions to be made by the experts or

those in charge of community affairs.

Islamic legal theory on financial transactions; that have similar aspects to the application of

financial derivatives , sources and principles, and how they were applied by different

schools and scholars to derive religious verdicts. I will InshaAllah- 'streamline' Islamic

law through a number of Sunni schools, various conceptions of shari'ah, and modern

attempts at law reform through dynamic scholarship andIjtihad(independent judgment).

Upon completion we should be able to explain the developments process in Islamic legal

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thought within our socio historical contexts, and identify key debates among Muslim

scholars using modern case studies.

RESEARCH METHODOLOGY AND SOURCE OF DATA

A hybrid research method is used (60% quantitative and 40% qualitative) that will employ

many tools among of which a specially designed questionnaire (English & Translated to

Arabic in some cases) to collect data from major players (hundreds of copies) in this

industry (Malaysia and Middle East). Such questionnaire will consist of multiple choice

questions based on the hypothesis as well as a blank spaces to get the practitioner open

responses.

Moreover; the other methodology that will be used is case-study where triangulation of the

data is required to confirm results (Yin 2003). The following methods will be used for

collecting primary and secondary data:

Primary DataFocus group discussions:

Practitioners

Practicing lawyers

Focus group discussions, with participants ranging from 7-10 per group. This is to ask questions

on the type of Islamic derivatives being used in their practice.

Practitioners from following banks/financial institutions:

- KFH

- Mabank Investments Bank

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- Bank Islam

- CIMB Investment Bank

- Deutsche Bank

- Canyon

Research Questions Answered:

4. What sukukstructures are currently being used in Islamic banking and finance?

5. What are these sukukused for?

6. How are these sukukused?

Online forums/discussion groups through internet:

IBF net,

linked-in.

Questions posed in these forums to find out on Islamic derivatives.




3. How are these sukukused?Interviews:

face to face;

through the phone, and

email.

Interviews will be with Shariah advisors and scholars on the Shariah parameters.

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Proposed Shariah Advisors/scholars:

Sheikh Nizam Yaqubi

Dr. Ali Daghi

Research Question Answered:

1. What are theShariah parameters that have to be adhered to and complied with to

enable them to be used in Islamic banking and finance?

Secondary Data

Documents from banks/financial institutions:

fact sheets;

brochures,

agreements, and

Others.

Documents with diagrams that explain the structure of these sukuk will also be used to

support the interviews and focus group discussions.

- KFH

- Mabank Investments Bank

- Bank Islam

- CIMB Investment Bank

- Deutsche Bank

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- Canyon




3. How are these sukukused?

Online Databases/Archives:

Journals articles; Newspaper articles;


1. What are the associated sukuk hedging (risk mitigating) tools that are currently

being used in Islamic banking and finance?

2. What are these instruments used for?

3. How are these instruments used?

INCEIF digital Library, IIUM Library , UM, National Library, Online

Databases/Archives:

Fiqh Sources Al-Quran

- Sunnah/Hadeeths

-Ijma IbnMundhir

-Qiyas Usul- al-fiqh

Sources from the bibliography/references of Dr. & Dr.

These sources offiqh will support the interviews with the scholars, on the Shariah

parameters.

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Research Question Answered:

1. What are theShariah parameters that have to be adhered to and complied with

to enable them to be used in Islamic banking and finance?

POPULATION AND SAMPLE

While Fiqh, especially worship (Ibadat) type, prescriptions are permanent in nature and for

all individuals, economic and financial descriptions may change from time to time and

from society to another. This research argues that the methods of reasoning for reaching an

Ijtihad ruling in Islamic financial are not necessarily identical. While Fiqh has a well

developed methodology in the form of Usul al-fiqh, Islamic financial engineering for

innovativesukukstructures are in its search for finding whether it is shariah permissible or

not should rely on a methodology that suits its social and descriptive nature.

RESEARCH INSTRUMENT (s)

Under Construction.

ADMINISTRATION OF THE INSTRUMENT (s)

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The instruments will be administered by the researcher, Shariah scholars, research

supervisors, as well as some research assistants. Methods of data interpretation includes but

not limited: -Regression, and multiple regression analysis of the data collected.

SCOPE OF THE STUDY

Little has been written previously on the use of Musharakah partnership contracts for

sukuk, and pricing issues have not hitherto been systematically investigated.

The study is expected to cover the period from 2000 to 2010 (for data analysis) and till date

for literacy review. Also the study will cover major Middle East countries (Saudi Arabia,

Bahrain, United Arab Emirates, Jordan, and Qatar) and Malaysia.

LIMITATION OF THE STUDY

The data analyses were restricted to four countries, but this could be extended. Alternative

pricing benchmarks were suggested for some famoussukukstructures.

In each of the foregoing it is clear that there are diverse opinions, enough dynamism and

latitude within the Shariah to reform and/or reinterpret the Fiqh rules to be better reflective

of modern transactions, circumstances, and cultural outlook. Where the methodology and

legal principles are not sufficient, the sanctity attached to contractual obligations, including

treaties in the Shariah; make it possible to reform conventional muamalat law. At the

same time there are some concepts such as usury, insurance, and speculative contracts,

which will be much more difficult, if not impossible, to overcome if the conventional

Shariah muamalat law are adhered to.

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THEORITICAL FRAME WORK

Under Construction

EXPECTED RESULTS, CONCLUSIONS AND OUTCOMES

Possible results will include the investigation to (but not limited to):

1. Investigate Special Purpose Vehicles as a prerequisite for the successful issuance

and management ofsukuk. The use of GDP-based pricing benchmarks would have

resulted in greater payments stability for sovereign debt in Middle East, but not for

Malaysia.

2. Recommend that Ministries of Finance and Central Banks of Muslim countries

should review their debt financing policies and explore the potential of manysukuk

structures.

3. Provide and highlight an overview of the key regulatory institutions and industry

associations in Islamic Finance today and focus on areas that merit increased

attention.

4. The growth of Islamic Finance sector is impacted by increased involvement of

western regulators; as well as credit rating agencies; existing of sound accounting

procedures, and increased protection of stakeholders of Islamic Financial

Institutions.

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5. Elaborate the experience of Malaysia in developingsukukmarket and the methods

that have been

BIBLIOGRAPHY8 (Sample out of 113 Articles & Books)

[1] Abbas, A. (2005), Helping to build an Islamic Capital Market, Banker Middle

East, 1 October, pp. 15-17

[2] Wilson, Rodney (2008), Innovation in the Structuring of IslamicsukukSecurities, Humanomics, Vol. 24, No. 3, pp. 170-181. Emerald Group Publishing

Limited.

[3] Aseambankers (2005), Capitalizing on Opportunities in the SukukIndustry,Aseambankers, Kuala Lumpur, pp. 1-5

[4] Aquil, B. (2005), Tracking the progress ofSukuk, Islamic Banking and FinanceMagazine, 14 October, pp. 6-7.

[5] Bahrain Monetary Agency (now Central Bank of Bahrain) (2002), IslamicBanking and Finance in the Kingdom of Bahrain, Bahrain Monetary Agency,Manama, pp. 72-75

[6] Dommisse, A. and Kazi, W. (2005), Securitization and Shariah Law, BankerMiddle East, 1 July, pp. 7-8

[7] Eastern Oracle (2005), Malaysias PT Orient to issue SukukMusharakah forIndonesian Port, IFIS Islamic Finance Weekly, 3 October, p.2.

[8] New Millennium Publishing (2005), First Airline SukukLead-Managed by DubaiIslamic Bank, IFIS Islamic Finance Weekly, 14 October, P.6

[9] McNamara, P. (2005), How to Sell Sukuk, Banker Middle East, 1 August, pp. 4-5.

[10] Alexakis, Christos (2009), Islamic Finance: regulatory framework - Challengeslying ahead, International Journal of Islamic and Middle Eastern Finance and

Management, Vol. 2 No. 2, pp. 90-104, Emerald Group Publishing Limited

8 I have gathered all available relevant articles, papers, lectures, and books titlesrelevant to the subject of my proposal.

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[11] Chapra, M.U., and Khan, T. (2000), Regulation and Supervision of IslamicBanks, Occasional Paper No. 3, Islamic Development Bank/Islamic Research and

Training Institute, Jeddah.

[12] Alvi, Ijlal (2008), Capacity Building Needs for Issuing Sovereign Sukuk,Quarterly Newsletter, August, p.3, Dow Jones Islamic Market Indexes.

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TABLE OF CONTENTS

ABSTRACT (English & Arabic)

Approval Page

Declaration Page

Acknowledgement

List of Tables

List of Figures

List of Abbreviation

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CHAPTER ONE: INTRODUCTION

1.0 Introduction

1.1 Sukukoverview in Malaysia and Middle East

1.3 Historical background

1.4 Objectives of the study

1.4.1 Motivation of the study

1.4.2 Contribution of the study

1.4.3 Organization of Chapters

CHAPTER TWO: LITERATURE REVIEWS

2.0 Introduction

2.1 Basic Principles of Islamic Financial Systems

2.2 The concept of Debt & Equity in Islam

2.3 The development ofsukukin Malaysia and

Middle East

2.3.1 Murabahah - based Sukuk

2.3.2 Ijarah- based sukuk

2.3.3 Mudarabah based sukuk

2.3.4 Salam & Istisna Sukuk

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2.4 The structure of Islamic Bonds (Malaysia vs. Middle

East)

2.4.1 Sale-based Financing Debt Instrument

2.4.2 Lease-based Financing equity-Equity Debt instruments

2.5 Sukukand Islamic Bonds vs. Conventional Bonds

2.6 Unresolved Issues on Malaysian and Middle East

Sukuk

2.7 Conclusion

CHAPTER THREE: SUKUKPRICING ENGINEERING

MODELS

3.0 Introduction

3.1 Evolution and Profiles ofSukukStructures and

Markets

3.2 Innovative Mathematical Approach and3.3 Conclusion

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CHAPTER FOUR: THEORITICAL FRAMEWORK AND

HYPOTHESIS DEVELOPMENT

4.0 Introduction

4.1 Theoretical Framework

4.1.1 Legitimacy Theory

4.1.2 Social Issue Life Cycle Theory

4.1.3 Hypothesis Development

4.1.4 Islamic Financial Reporting Associations (IFSB vs. AAOIFI)

4.1.4.1Quantity & Quality of Disclosure

4.1.4.1.1 Reputational Sensitivity of Industry

4.1.4.1.2 Ownership Status

4.1.4.1.3 Size of Enterprise

4.2 Conclusion

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CHAPTER FIVE: RESEARCH METHODOLOGY

5.1 Introduction

5.2 Data Collection

5.2.1 Contents Analysis

5.2.2 Disclosure Index

5.2.3 Questionnaire (Mail Survey)

5.3 Sample Selection

5.4 Conclusion

CHAPTER SIX: FINDING AND ANLYSIS

6.1 Introduction

CHAPTER SEVEN: CONCLUSION

7.1 Introduction

7.2 Conclusion for Research Results and Findings

7.3 Limitation of the Study

7.4 Research Outlook

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BIBLIOGRAPHY

APPENDIX: Sample Questionnaire