The Effect of Innovative Islamic Profit Rate Benchmark on Pricing Islamic Derivatives Securities

The growth of the Islamic capital market depends on the success in developing and structuring risk management products, in particular financial derivative securities that are Shari’ah compliant. The financial engineering industry succeeded in developing Islamic derivatives that provide the same economic benefits provided by conventional counterparts and that are Shari’ah compliant. The developed securities include: Islamic Profit Rate Swap(IPRS), Islamic Cross Currency Swap (ICCS) and others. The pricing and valuation of Islamic derivatives follows the same mechanisms that are used to price the conventional derivatives. A major input to the pricing is the discount rate or equivalently, the profit rate in Islamic finance. This paper examinesthe effect of mis-specification of the profit rate on the pricing and valuation of Islamic derivatives in the context of Islamic Profit Rate Swap. The paper employs a case of an Islamic profit rate swap contract where two widely accepted benchmark rates are used to price the con-tract namely LIBOR and Government bond yields. The results which indicate that the variations in benchmark rates lead to very large variations in the cash flow profiles of the contract’s counterparties lead to a conclusion that the development of an innovative Islamic benchmark rate that is universally acceptable and applicable is necessary for the continuous development of Islamic capital market