Risk-Conscious Valuation and Design of Contracts for Islamic Principles and Sustainable Development: A Mathematical Framework for Islamic Financial Engineering

Starting from the fundamental principles, whether a designed contract implies a clean bay´ rather than ribā is central to our discussion. We argue that ribā 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 ribā 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 (ribā) 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-māl) and the entrepreneur (muḍārib) within a muḍāraba contract. Therefore, an unbiased quantitative estimation of the risks and returns is de