Performance at Risk: Another Approach to Value at Risk for Islamic Finance

Basel Accords promote Value at Risk (VaR) – which is the most used method – as the preferred one to measure and report market risks of financial institutions. Using VaR usually requires having asset valuation models and identifying their risk factors as model input parameters, allowing thus to stress them and calculate valuations (mark–to–market or mark–to–model). The previous requirements will make VaR calculation – roughly adapted from conventional finance – complicated for Islamic finance as there are not well–known valuation models, and the risk factors may not be easily identified. Moreover, Islamic finance induces specific risk considerations, like pricing market risks in ijârah2 contracts, in which they pertain to leased assets’ residual values. Such data might be either inexistent or uneasy to exploit in usual financial activities. Although difficult to achieve, the regulators will expect an Islamic financial institution (IFI) to be able to measure and report such risks. We propose in this paper to consider the performance that can be missed versus the same capital invested in the sukuk3 market that serves as a reference. We assume that an IFI has economic models, possibly validated by either auditors or regulators, which produce asset revenue as a time series of cash flows that can be valuated with comparison to sukuk revenue. From these cash flow time series we can model and compute the expected performance and hence the Performance at Risk (PaR) using methods and techniques from the VaR framework. Doing so, we aim at capturing the volatility of returns through the volatility of revenues. Then we show how the PaR can be used for management needs (e.g. displaced commercial risk measurement) as well as regulatory needs (e.g. regulatory capital measurement). Therefore, the paper proposes a VaR’s paradigm shift towards its effective application to Islamic finance in order to compute market risk. © Author