Concept and Mathematics of Islamic Valuation and Financial Engineering

Starting from the fundamental principles, whether a designed contract implies a clean bay’ rather than riba is central to our discussion. We argue that riba and gharar may easily arise through neglect of risk or inappropriate valuation methods for value and risk of assets and financial instruments. This possibility, in turn, strongly necessitates an estimation of expected forward values, market risk, and default risk, which is consistent with Islamic principles of avoiding riba and gharar. Based on consistent estimatation of risk and return, the expected costs of risks should be quantified for all parties to the contract in order to judge, whether a contract is free from usury (riba) and evitable risk (gharar) and whether it the remaining inevitable risks are distributed fairly between the counter-parties, for example between the investor (rabbu l-mal) and the entrepreneur (mudarib) within a mudaraba contract. Therefore, an unbiased quantitative estimation of the risks and returns is desirable so as to put Islamic principles to work. We argue that Islamic principles, in particular the avoidance of riba and gharar, should be applied to real economic value in the first place, and not a priori to a 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. © Authors