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Risk Analysis of Sukuk Market
by
Omar Zakaria Gad
Bachelor Thesis
submitted to the Finance Department
at the Faculty of Management & Technology
German University in Cairo
Student registration number: 16-1597
Date: 29 May 2012
Supervisor: Dr. Rania Salem
- ii -
Table of Contents
Table of Contents ............................................................................................................. ii
Table of Figures ............................................................................................................... iii
Table of Tables ................................................................................................................ iv
1 Introduction .............................................................................................................. 1
2 Sukuk Overview ....................................................................................................... 2
2.1 Definition and Types of Sukuk ..................................................................... 2
2.2 Sharia Standards and Types of Risks ........................................................... 5
3 Sukuk Market Risk ................................................................................................... 8
3.1 Analysis of Sukuk Market ............................................................................ 8
3.2 Indexes Overview ......................................................................................... 9
4 Market Risk Analysis ............................................................................................. 16
4.1 Value at Risk and Regression Analysis ...................................................... 16
4.2 Empirical Results ........................................................................................ 18
5 Conclusion .............................................................................................................. 22
References ...................................................................................................................... 23
Declaration...................................................................................................................... 26
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Table of Figures
Figure 1: Sukuk Market .................................................................................................... 3
- iv -
Table of Tables
Table 1: Risk Analysis Results ....................................................................................... 19
Table 2: Return/Risk Results .......................................................................................... 20
Table 3: Correlarion........................................................................................................ 20
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1 Introduction
Recently, financial institutions have experienced a dynamic, fast-paced ,and
competitive environment at a cross-border scale. Islamic banking is one of the fastest
growing industries that have experienced severe enhancement over the past few years.
Although most of Islamic Banks are within the Middle-East countries, Islamic financial
products as Sukuk have been demanded by many international banks in developed
countries (Yudistira 2004).
Islamic financial products are considered to be an extremely important issue to be
discussed for two main reasons; first, after the negative consequences which were
caused by the financial crisis in the last years, many investors began to be more
concerned about Islamic financial products as they proved to be stable within the crisis.
Second, the current revolutions "Arab Spring" in many of the Middle Eastern countries
lead to the evolution of the Islamists, who started to play critical role in political
decisions.
This paper is conducted for two main purposes. The first purpose is to explore the risk
analysis of Sukuk market compared to other different markets (Corporate bond,
Treasury bond, stock and gold) through using standard deviation and Value at risk, as
well as comparing the rate of return for each market. The second purpose is to
investigate the relationship between these markets with Sukuk market through
measuring the correlation and regression equation.
The paper is divided into three main sections. The first section discusses the definition
of Sukuk, its different types, standards applied as well as the different types of risks
facing the Sukuk. The second section explores the comparison between Sukuk market
risk and market risk of other markets, along with an overview on their indexes, criteria
and methodologies. The third section includes the market risk and correlation analysis
of Sukuk market compared to other different markets, in addition to an overview on the
methods used in the analysis.
- 2 -
2 Sukuk Overview
2.1 Definition and Types of Sukuk
Sukuk is an Arabic name derived from the word "Suk", it is considered to be the
Islamic equivalent of a bond. Sukuk are certificates of equal value representing
undivided shares" that prove the ownership of the asset to their holder. This asset could
be tangible as machine and land or intangible as copy right ) Dusuki 2010)
It was declared by Al Elsheikh & Tanega (2011) that Sukuk is a financial instrument
which can be traded in the financial markets like bonds. However; there are three main
differences between Sukuk and bonds. First, Sukuk requires asset ownership for the
sukukholders, unlike bonds which do not require any asset ownership. Moreover, the
bond issuers guarantee to pay the principle and the return to the bondholder, which is
not the case with the sukuk issuers. This increases the risk associated with the
sukukholder. Finally, the issuance of Sukuk is only permitted for companies that
provide Halal products (permissible with Sharia). For example, the issuer of sukuk
cannot be an alcoholic drinks producer or producing any other product that is non-
compliant with Sharia.
Tariq & Dar (2007) claimed that Sukuk is divided into three core categories, the first
category is based on sale contracts as Murabaha, Salam and Istisn'a Sukuk, the second
category is based on leasing contracts as Ijara Sukuk, and the last category is based on
partnership as Musharaka and Mudarabah Sukuk, each of these six types of Sukuk has
its own unique characteristics. Figure 1 shows the global contribution of each type of
Sukuk in terms of volume of issuance in 2007.
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Figure 1: Sukuk Market (Global Investment House 2008)
Ijara Sukuk is the first type of Sukuk which represents shares in a rented asset or the
usufruct of the asset which give their owners the right to own the asset, receive the rent
and dispose their Sukuk in a manner that does not affect the right of the lessee. Ijara
Sukuk is permitted to be traded as it is considered to be a usage of usufruct not a debt,
as debt is prohibited to be traded in Islamic Sharia. Moreover, it was claimed that Ijara
sukukholders bear all costs of maintenance related to the asset (Rohmatunnisa 2008).
Regarding the issuance of the Ijara Sukuk, there are some procedures that Sukuk issuers
should follow. The issuer should first sell the asset to Special Purpose Vehicle (SPV) in
a real contract, then SPV issues sukuk to individuals and banks and receive the
principle. After that, Sukuk issuer will pay the lease of the asset on agreed intervals to
the Sukukholder. Finally, on the maturity date, the Sukuk issuer will pay the principle
and get the asset back (Vishwanath & Azmi 2009).
The second type of Sukuk is Istisn'a Sukuk. Al Elsheikh & Tanega (2011) declared that
Istisn'a is a sale contract between seller and buyer for an asset before it comes to
existence. The seller should either produce it himself or could ask other suppliers to
produce it according to the agreed upon specifications, with fixed prices and fixed
delivery date written in the contract. Regarding Istisn'a Sukuk, they are certificates that
carry equal value and are issued with the aim of getting funds for producing products
that are owned by the certificate holders; afterward, they could be sold to a third party.
However, Sharia prohibits the sale of these debt certificates to a third party at a price
other than the face value as well as not trading them in the secondary market to avoid
trading debt and Riba.
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The third type of Sukuk is Salam Sukuk. Vishwanath & Azmi (2009) indicated that
when a business is willing to provide a specific product to a specific customer at the
future but does not have sufficient funds, they pre-sell this product through Salam
Sukuk then deliver the product later. Basically, Salam is an agreement to buy a
particular product with agreed price to be delivered in the future. Tariq (2004) added
that the profit of the investors comes from the difference between sale price and
purchase price, it was concluded that Salam sukuk is somehow similar to Murabaha
where goods are purchased and sold in international markets using short-term placement
system. However, this could be complicated and non-sharia complaint, as sharia
prohibits sale of debt.
The fourth type of Sukuk is Mudarabah Sukuk. Mudarabah is a contract in which one
party is responsible for providing the capital while the other is liable for managing the
project according to the agreement decided upon which is based on profit and loss
sharing. Mainly, there are two characteristics for Mudarabah; capital cannot be
guaranteed and returns depend on profit generated during the period (Dusuki 2010).
Al Elsheikh & Tanega (2011) defined Mudarabah sukuk as certificates for ownership of
the project according to Mudarabah structure; the holders of Mudarabah Sukuk are the
suppliers of capital and own shares in the equity that will allow them either to share
profit or loss according to the profitability of the project. Moreover, Mudarabah Sukuk
are allowed to be traded, which will add benefits to the Sukukholder who are willing to
liquidate their capital anytime
The last type of Sukuk is Musharakah Sukuk; Musharakah is an agreement where two
or more investors share capital and management of the project while sharing the
distribution of profits and losses with predetermined ratios (Vishwanath & Azmi 2009).
In other words, Dusuki (2010) defined Musharakah Sukuk as "A partnership
arrangement between two parties or more to finance a business venture whereby all
parties contribute capital either in the form of cash or in kind for the purpose of
financing the business venture. Any profits derived from the venture will be distributed
based on a pre-agreed profit-sharing ratio, but a loss will be shared on the basis of
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equity participation". Additionally, Tariq (2004) added that investing in Musharakah
Sukuk is more preferred than investing in Mudarabah sukuk as investors are sharing the
risk with other parties in Musharakah Sukuk unlike in Mudarabaha Sukuk where
investors bear most of the risk of the financial losses.
2.2 Sharia Standards and Types of Risks
This section covers the standards of sharia related to the characteristics, trading,
ownership, issuance and redemption of Sukuk. These standards would affect the supply
and demand of sukuk which would definitely affect their returns and risks. Starting with
the trading of Sukuk, it is permissible for tangible asset, usufruct and services to be
divided into equal tradable shares; on the other hand, it is prohibited to trade debts as
Istisna'a or Salam Sukuk (AAOIFI 2008).
Concerning the sharia standards related to the issuance of sukuk, the issuer should invite
the investors to subscribe through prospectus, which includes contractual conditions,
legal position, rights, originator, issue manager, name of certificates to be issued,
obligations mentioned in Sharia principles and the approval of the Sharia board for this
issuance. On the other hand, it is not permitted for the prospectus to mention that the
issuer accepted the liability to compensate the subscriber up to nominal value of the
certificate (AAOIFI 2008).
AAOIFI (2007) highlighted that the issuers of Sukuk should not keep the ownership of
the asset in their books, as the asset is transferred once the issuer issued the Sukuk. On
the other hand, Sukukholders should record the asset in their books once the transaction
takes place. Regarding the purchase price of the asset at maturity date, Kamalpour
(2009) declared that the price of the asset can be based on net value of the asset, market
value of the asset or price that is agreed by both parties at the time of purchase, this
makes Sukukholder bears more risk than bondholder, as bondholder can predetermine
the principle received in the future while Sukukholder's principle is ambiguous.
There are some other Sharia Standards related to Sukuk characteristics. Firstly, it is
allowed for Sukuk to be issued for short-term, medium-term or long-term periods.
- 6 -
Moreover, it is acceptable for the issuer of Ijara Sukuk to redeem the leased asset before
maturity date at the market price or agreed price between the issuer and the subscriber,
which is similar to callable bonds and results in higher risk for sukukholders than non-
callable bondholders. Finally, it is allowed for a third party to rent the asset through
parallel Ijara contract using same description for the usufruct as provided in the Sukuk
contract, this gives more flexibility and might lead to higher return. All these standards
discussed above will affect different types of risks facing Sukuk (AAOIFI 2008).
Sukuk risks are divided into five main types of risks; Credit risk, Market risk, Liquidity
risk, Operational risk and Sharia compliance risk. Islamic banks or any financial
institutions could face credit risk as a result of defaults and delay in payments.
Moreover, Sharia prohibits any increase in payment rates in case of delayed payments,
as it is considered Riba according to Sharia Standards. Considering Ijara Sukuk as an
example, Sukuk issuer might delay the rental fees or default them, which leads to credit
risk for the Sukukholder. On the other hand, Sukukholder can reduce this risk by
nullifying the contract and selling the asset, as Sukukholder is the one who has the
ownership of the asset (Tariq & Dar 2007).
Al Elsheikh & Tanega (2011) added that defaulting in goods delivery, delaying in the
delivery of the asset or delivering the asset with different specification compared to the
terms written in the contract are all examples of credit risk for Salam Sukuk. On the
contrary, credit risk for Mudarabah and Musharakah Sukuk occurs when the business is
generating losses that would result in the loss of the investors capital.
The second type of risk is Market risk; it is related to securities traded in the market.
Market risk could be either systematic risk as risk caused by the government policies on
the economy or idiosyncratic risk which resulted from the variation between prices of
different companies (AL-Maghlouth 2009). Global Investment House (2008) added that
interest rates and currency risk are among the factors that could affect the market risk of
Sukuk. Merely, any changes in the interest rate would have a direct effect on Sukuk
market, since Sukuk is a fixed income security as bonds. For example, if the interest
rate increases, the value of the Sukuk decreases, as investors would have other better
opportunities in the market with higher interest rate.
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Liquidity risk is the third type of Sukuk related risk. Al Elsheikh & Tanega (2011)
stated that the main reason for establishing Sukuk is to solve liquidity problems caused
by Islamic common products. However, prevention of trading Salam and Istina Sukuk
in the secondary market by Sharia causes sukuk liquidity problems. Moreover, Sukuk
does not exist in a well structure and sufficient liquid secondary market as conventional
bonds. Furthermore, Sukuk is not a short term investment; it is more a medium or long
term, which makes Islamic banks suffer more from liquidity problems (Tariq & Dar
2007).
The fourth type of Sukuk related risk is Operational risk, it could occur as a result of
losing or damaging the asset. Operational risk is very minimal in case of Ijara contract
of land, but could occur in case of equipment. However, Islamic form of insurance
(Takaful) gives the ability to manage this type of risk through giving the guarantee on
the asset and compensate sukukholder for any losses (Tariq 2004).
The last type of risk is Sharia compliance risk. It is defined as the reduction in the value
of the asset when issuer breaches his fiduciary responsibilities with respect to Sharia
compliance. Any non-sharia-compliant action made by the issuer would be considered a
breach of fiduciary responsibility, except if the issuer commits it in an innocent way.
Moreover, some of the scholars opinions contradict with each other, as some scholars
believe that Murabaha contract is binding only for the seller while others believe that it
is binding for both (AL-Maghlouth 2009). Al Elsheikh & Tanega (2011) assured that
the main solution to solve Sharia compliance risk is the formation of a system whose
main aim is to make sure that financial products are according to sharia.
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3 Sukuk Market Risk
3.1 Analysis of Sukuk Market
The main gap that was observed through viewing most of the papers on Sukuk
was that none of the papers deliberated the comparison between market risk of Sukuk
market and other markets or the correlation between them, therefore, this paper aims to
focus on this research gap and emphasis market risk and the correlation of Sukuk
market compared to other markets. This comparison will investigate Sukuk performance
and explore whether Sukuk has higher or lower market risk than other markets
(Corporate bonds, Treasury bonds, US stocks, global stock and Gold). The main reason
for choosing these markets is that they are the most popular markets globally with
trillions being traded. In addition, these markets are the main alternatives if the investor
decided not to invest in Sukuk.
In order to measure the market risk for these markets, their Indexes are used as
indicators for their performance and fluctuations. The indexes used are Dow Jones
Sukuk Index, Dow Jones Corporate Index, Dow Jones CBOT Treasury Index, S&P 500
and Dow Jones Global index while Gold bullion prices are used for Gold Market. This
section presents an overview on these different indexes used along with their criteria
and methodologies.
Dow Jones Sukuk index became one of the most well-known Indexes that was primarily
created to measure the performance of Global Islamic bonds, called Sukuk. In addition,
this index is beneficial for investors who seek sharia compliance as it is considered to be
a benchmark for Sukuk market. There are some basic features that a Sukuk must
possess in order to be included. These features oblige the Sukuk to be sharia compliant,
follow the standards issued by the Accounting and Auditing Organization for Islamic
Financial Institutions (AAOIFI) and meet the minimum requirements for maturity, issue
size and rating (CME Group Index Services 2012).
The minimum requirements are those criteria that differentiate Dow Jones Sukuk index
from other Indexes which will be discussed later in the paper. The requirements of Dow
- 9 -
Jones Sukuk index include; the currency used in the index is the US dollar and the
maturity date of the Sukuk should not be less than one year. Moreover, it is indifferent
whether the coupon rate of the Sukuk is floating or fixed but its minimum size should
not be less than USD 200 million. Finally, the minimum rating of the Sukuk should not
be less than BBB based on S&P Moody's ratings or any leading rating agency (CME
Group Index Services 2012).
Since its inception in October 2005, the method of calculating the Dow Jones Sukuk
index is the market capitalization which is updated once a month. The market
capitalization is defined as the value of the total Sukuk issued through multiplying
the Sukuk price by the number of Sukuk issued. Furthermore, the frequency of
calculating the fluctuation of the index prices is done on daily basis. When calculating
the total return of the index, it should include price change, coupon payment, accrued
interest and reinvestment cash flow in the same month (CME Group Index Services
2012).
The Dow Jones Sukuk index includes thirty different types of Sukuk, which are
categorized into two categories based on their ratings and their maturity dates. On the
30 of March 2012, most of the Sukuk are of low rating within A and BBB in which
fifteen of the Sukuk were rated as A while ten were rated as BBB. This low rating
indicates that most of the Sukuk in the index have high risk with high return.
Concerning the maturity date, most of the Sukuk had low maturity date within 1-3 years
and 3-5 years, in which eight of the Sukuk have 1-3 years while seventeen had 3-5 years
maturity date (CME Group Index Services 2012).
3.2 Indexes Overview
This part includes an overview on the other four comparable indexes along with
Gold Market. The first index is Dow Jones Corporate bond index which became one of
the most popular indexes in the U.S. This daily calculated index is used to measure the
performance and total return of the tradable high-quality U.S. corporate bonds (CME
Group Index Services 2012). The Dow Jones Corporate index was primarily created to
solve liquidity and pricing problems of corporate bonds indexes with some unique
http://en.wikipedia.org/wiki/Share_pricehttp://en.wikipedia.org/wiki/Shares_outstanding- 10 -
features that differentiate it from other types of indexes. First, the index is divided into
three main sectors; financials, industrials and utilities. Each sector is composed of 32
bonds, making a total of 96 bonds in the index. In addition, the selection process of the
bonds is based on some basic rules including rating and liquidity. Finally, the bonds are
issued only in four maturity dates which are 2,5,10 and 30 years (CME Group Index
Services 2012).
There are some specific criteria that a bond must possess in order to be included in the
Dow Jones Corporate bond index. The bond has to be issued in US dollars only and the
maximum number of bonds to be issued should not exceed four bonds with no more
than one in each maturity date. Moreover, the maturity date for the bond should be
higher than the minimum maturity horizon for that bond by at least six months. For
example, in order for the bond to be included in five years maturity date, the bond
should have at least five years and six months maturity date. In addition, only option
free bonds and coupon bonds are permitted, which means that bonds with embedded
puts or call provisions along with zero coupon bonds should be excluded. Finally, the
quality grade of the bond should be sustainable (CME Group Index Services 2012).
Since its inception in November 27, 2006, the method of calculating Dow Jones
Corporate Bond Index is equally weighted index where each bond is weighted equally
regardless its market capitalization or economic size. The advantage of this method is
that the index is highly diversified and it does not overweight the overpriced bonds and
underweight underpriced bonds as in price weighted method. However, this method
might result in difficulty of keeping a bond in the index due to constant price
fluctuations (CME Group Index Services 2012).
The equally weighted index method divides the 96 bonds into 32 bonds in each
industrial sector and 24 bonds in each maturity date (2,5,10 and 30 years), this makes 8
bonds with similar maturity date in each of the three industrial sector. For example, a 2
years maturity date bond has weight of one eighth in its sector maturity date, one twenty
fourth in its maturity date , one thirty second in its sector and lastly one ninety sixth in
the overall index (CME Group Index Services 2012). The equally weighted index
- 11 -
method makes it easy for Dow Jones Corporate Bond Index to calculate its price
fluctuations by taking the average of the percentage return of the 96 bonds then
multiplying it with the index price of the previous day (CME Group Index Services
2010).
The second comparable index is Dow Jones CBOT Treasury Index. It is used as a
benchmark for the market performance of default-free U.S. fixed income markets. The
index is updated in real time every 15 seconds providing transparent prices through
CBOT futures transactions (CME Group Index Services 2012). There are some basic
features that differentiate Dow Jones CBOT Treasury Index from any other index. The
index components are constant which makes returns over time comparable and easy to
calculate. In addition, Dow Jones CBOT Treasury Index is accurate as it is not "mark to
market" but it reflects the actual transactions of the market. Furthermore, CBOT has
narrow bid/ask spreads, high liquidity and trading over $100 billion in notional values
of 5-year notes, 10-year notes and bonds daily (CME Group Index Services 2012).
The weighted-average price of CBOT 30-year T-bond, 10-year T-note, and 5-year T-
note futures contracts using November 30th
1999 as a base year has been the method of
calculating Dow Jones CBOT Treasury index since its inception in April 1st 2004. This
means that the value of the index is calculated through adding the value of the
components then dividing them by the total number of those components. The prices
used in the index are weighted by modified duration (i.e. modified Macaulay duration).
This method takes both coupon and maturity into consideration (CME Group Index
Services 2010).
The third comparable index is S&P 500 (SPX). It is considered to be one of the most
widely watched indexes in the world. S&P 500 includes shares of 500 American Large-
Cap corporations in which all these shares must be tradable in the largest two US stock
markets; the New York Stock Exchange and Nasdaq. Furthermore, it was indicated that
this index is owned and controlled by Standard & Poor's, a division of McGraw-Hill
(Standard & Poors Financial Services 2012).
- 12 -
In order for a stock to be included in the S&P 500 index, it has to follow certain criteria.
Similar to Dow Jones Corporate Bond Index, the stock must be issued in US dollars
only, in addition, the minimum market capitalization of any company in the index
should be USD5 billion. Moreover, the minimum public floating must be 50% which
means that at least half of the company's stocks are traded in the stock market. As for
the profitability requirements, the company should have four consecutive quarters of
positive net income on an operating basis (net income less discontinued operations
and extraordinary items). However, companies which generated a loss due to merger or
acquisition might be included in the index. Additionally, the stock included in the index
should have suitable liquidity and reasonable price per share, the liquidity is calculated
through dividing the monthly average trading by total outstanding stocks; the minimum
liquidity measurement to be included in the index should be at least 0.3. Lastly, the
index must reflect almost all sectors of the economy, even if the stock passed all the
requirements, it might not be selected if it operates in a sector that is already represented
in the index (Standard & Poors Financial Services 2012).
The method of calculating S&P 500 has been the same since its inception in March 4th
1957; which is the weighted average market capitalization. The first step in this method
is to calculate the market capitalization of each stock by multiplying the number of
outstanding shares by the market share price, then adding the market capitalization of all
stock together. In order to calculate the weight of each stock, the market capitalization
of the stock should be divided by the total market capitalization. Some investors believe
that the main disadvantage of market capitalization method is that it overweighs large
companies which in turn make high influence on the fluctuations of the index prices. On
the contrary, others believe that it is acceptable because larger companies usually have
larger number of shareholders (The McGraw-Hill Companies 2012).
The last comparable index is Dow Jones Global Index; it is a broad type of index used
to indicate the performance of global stock market. This index covers almost 95% of
markets which are open to foreign investments. The index monitors the movement of
the stock markets of 46 countries, including 25 developed markets and 21 developing
markets. Furthermore, Dow Jones Global Index includes a wide range of regional,
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country, size-segment and sector indexes. Examples of the regional indexes are; Dow
Jones Developed Markets Index, Dow Jones Emerging Markets Index, Dow Jones
Americas Index and Dow Jones Latin America Index. While examples of country
indexes are; US, UK, Spain and Italy as developed countries, and Egypt, Brazil, India
and Chile as developing countries. Concerning Size-Segment Indexes, Dow Jones
Global Index includes large-cap, mid-cap and small-cap indexes for each country and
region. Finally, the index covers global sector indexes, as well as sector indexes for
each country and region. The index mainly includes 10 different sectors, 19 super
sectors, 41 sectors, and 114 subsectors (CME Group Index Services 2012).
Dow Jones Global Index has been introduced in September 18, 2000 and the method
used for calculating the index is float-adjusted market capitalization. This method is
similar to market capitalization where number of shares is multiplied by market share
price. However, float-adjustment takes market capitalization one step further by only
multiplying market price by shares that are available for purchase in the open markets
rather than multiplying market price by total shares outstanding. Finally, since the index
has been calculated for the global world, the frequency of its calculation is every 5
minutes, 24 hours daily (CME Group Index Services 2012).
According to Dow Jones Global Index Fact reports dated April 30th
2012, Dow Jones
Mid-cap Index has the highest return since inception with a return of 8.11% while the
lowest is Dow Jones Large-cap Index with a return of 6.46%. Regarding the industries,
Oil & Gas has the highest return of 10.83% among all other industries On the other
hand; financials suffered the lowest return of 5.01% since inception. The average annual
return for Dow Jones Global Index since inception is 6.75%. Finally, financials have the
highest weight in the index around 19.78%, while utilities have the lowest weight of
only 3.77% (CME Group Index Services 2012).
The fifth market which will be compared with Sukuk market in terms of risk and return
is Gold market. Gold market is one of the most liquid markets compared to other
commodity markets. The primarily demand for gold was for fabrication purpose as
jewelry, electronics, dentistry and medals. Moreover, central banks and financial
- 14 -
institutions could buy gold bullion for investments or store of value. The usage of gold
to store value is used mainly in periods of inflation and monetary crisis periods
(Christian Personal Finance 2010).
Bordo, Humpage and Schwartz (2007) mentioned that Gold standard has been
introduced as a monetary policy in nineteenth and twentieth century where many
countries followed Britain and applied gold standard as financial monetary system.
Meissner (2002) added that for any country to follow gold standard, it should follow the
law of fixing a price between the domestic currency and a quantity of gold and
mandating the free coinage of gold and convertibility into gold. Simply, the national
currency is valued according to a certain quantity of gold; this enabled currencies to be
more stable on the long run due to the dependence on a stable commodity like gold.
Helleiner (2010) stated that in 1971 countries started to use floating currency instead of
gold standard through leaving their currency to float without any intervention.
The official US government gold prices has changed only four times during the period
of 1792 to 1973, starting at $19.75 per troy ounce in 1792, increasing to $20.67 in 1834,
then $35 in 1934 and finally reaching $38 in 1972. After introducing two-tiered pricing
system in 1968 and monetary systems started to follow floating policy instead of gold
standard in 1971, gold prices started to fluctuate harshly and severe increase in gold
prices occurred. The price of gold was stable from 1833 till 1967, ranging from $18.93
per ounce to $34.95 per ounce. However there was a huge increase in the average value
of gold from $19.31 per ounce in 1968 till it reached $1,571.52 per ounce in 2011
(World Gold Council 2012).
Many people prefer to invest in gold as it has unique characteristics. Gold can be
purchased as a safety instrument where it could be bought or sold in crisis while storing
its value, as it does not rely on borrowers promise to pay as the case in bonds.
Moreover, gold could be used as a tool to protect the investors from inflation,
historically, inflation proved to be gold's friend, as currencies decrease in value over
time while gold keeps its purchase power. In addition, some investors use gold as
- 15 -
hedging tool for US dollar, for instance, if US dollar value decreases relative to other
currencies, gold prices will increase (Christian Personal Finance 2010).
This section gave an overview on the variables used in analyzing market risk and
correlation of Sukuk compared to other markets. The detailed analyses and tools used as
well as the empirical results will be discussed in the next section
- 16 -
4 Market Risk Analysis
In order to reach the main purpose of the research, which is measuring the risk
analysis of Sukuk market compared to other different markets as Corporate bonds,
Treasury bonds, Stocks and gold, along with their correlation with Sukuk market,
standard deviation and value at risk analysis were performed to measure the market risk
of each of the markets explained in the previous chapter. Moreover, regression analysis
was conducted to examine the correlation between different markets with Sukuk market.
4.1 Value at Risk and Regression Analysis
This section includes an overview on the main tools used in the analysis; value at
risk and regression analysis. Value at Risk (VaR) calculates the worst expected loss of
value of a risky asset over a period of time at a specific confidence level, where
confidence level is defined as the probability of loss that will not be higher than VaR.
For example, If VaR is $1 million and confidence level is 99%, this means that there is
a probability of 99% that the loss would be within $1 million, and only a probability of
1% that the loss would be higher than $1 million (Sollis 2009).
There are mainly three approaches used to measure VaR; Historical Simulation,
Variance-Covariance Approach and Monte Carlo Simulation of VaR. Historical
simulation is the most common method used to estimate value at risk in banks based on
the historical data of the asset. In order to calculate the one day 99% VaR through using
historical simulation for $100 Million, analyst should collect the historical daily returns
for a period of time for the required asset, then these historical returns should be sorted
in descending order, subsequently the return value at the first percentile should be
selected and multiplied by the current price. The main advantage of historical
simulation is the simplicity of usage and implementation, while the main disadvantage
is that the assumption is based on the past which is not an accurate indicator for the
future (Sollis 2009).
The second approach used to calculate value at risk is Variance-Covariance Approach
(Parametric VaR), this approach assumes that the assets returns are normally distributed
and independent across time. From statistical theories, the 5% probabilities for random
- 17 -
variable in normal distribution is more negative than -1.645 and a 1 percent probability
of observing random variable in normal distribution is more negative than -2.326. If a
bank invested $100 Million and wanted to calculate 99% VaR using Variance-
Covariance Approach, assuming that the standard deviation is 0.5% and the average
return is 0%, this approach will assume the standardized return is normal and 0%
(mean) is the peak of the graph. Then the actual return should not be worse than -2.326
multiplied by standard deviation plus the mean (-2.326*0.005= -0.01163). The
maximum loss for the bank will be -1.16% (Olson & Wu 2010).
The third and the last approach is Monte Carlo Simulation Approach, Monte Carlo
simulation is a computer simulation of "Pseudo" asset returns from an assumed
probability for the returns, and these returns need to be defined by probability
distributions with precise parameters. Probability distribution may include normal
distribution, exponential distributions, lognormal or any other distribution, unlike
Variance-Covariance Approach which uses only normal distribution. Then the
simulation run with huge number of possibilities and random results are selected. To
calculate the one day 99% VaR using Monte Carlo method, the analyst starts by
choosing the probability distribution for daily returns, then the computer predicts the
results through conducting 5,000 trials, subsequently, returns are reordered as historical
approach in a descending pattern and the analyst chooses 1st percentile (99%) from the
returns and multiply it with the current price (Olson & Wu 2010).
The second main tool used in the analysis is Regression analysis; this tool is used to
estimate the correlation between Sukuk market and each of the other five markets
(Corporate bonds, Treasury bonds, Stocks and Gold). Basically, regression analysis is a
statistical tool for the investigation of relationships between variables. Usually, this
method is used to measure the effect of one variable on the other as price on demand of
the product. Moreover, this model is used to evaluate the statistical significance of the
relationship, which shows whether the actual numbers are explained or not. Mainly,
there is one dependent variable "y" which is affected by independent variables "Xk", the
input is dataset consisting of dependent and independent data, in addition, it was
declared that the prime aim of the regression equation is estimate the regression
- 18 -
coefficients (,1,2,,k), making an equation:
Equation 1: Regression Equation
is the residual term, which represents the composite effect of all other types of
individual differences not explicitly identified in the model.
After identifying the regression coefficients, the equation could be:
Equation 2: Regression Equation
The analyst can then examine the "statistical significant" which is the degree of
confidence that the true relationship is close to the estimated relationship. The model is
preferred to have lower significance level as this means that the model has higher
accuracy and better presentation of the actual results. Regression techniques have been
the main tools in econometrics techniques, these techniques include simple and multiple
linear regression models, the multivariate general linear model, the polynomial model,
and the nonlinear regression model (Kleiber & Zeileis 2008).
4.2 Empirical Results
The methodology is divided into two main parts. The first part examines the risk of
Sukuk market compared to five different markets; Corporate Bonds, Treasury Bonds,
US Stocks, Global Stocks and Gold. Dow Jones Sukuk index has been used as an
indicator for the Sukuk market performance. While, Dow Jones Corporate Bond index,
Dow Jones CBOT Treasury Index, S&P 500, Dow Jones Global Indexes and Gold
bullion market prices have been used as indicators for the other five markets. Risk
analysis have been measured through standard deviation and value at risk (Historical,
Parametric and Monte Carlo VaR) using Microsoft Excel except Monte Carlo
Simulation which is measured through Solver Software (Add in Excel). The
Significance levels used in value at risk are 1% and 5%.
The second part in the methodology explores the relation between Sukuk market with
other five markets as mentioned earlier. There were two methods used to measure the
relation; the first method is the correlation where historical daily return of Sukuk market
- 19 -
is correlated with each of the other five markets through using Microsoft Excel
program. The second method is the regression analysis, calculated through Eviews
software. The dependent variable used is Sukuk market while other five markets are
independent. The equation is formulated as follows:
Equation 3: Regression Equation
Where Suk= Sukuk, CB= Corporate Bond, TB= Treasury Bond, SP= S&P500, GS=
Global Stock.
The website used to get the historical prices of these Dow Jones indexes is
finance.yahoo.com while Islamic Finance Information Service from
library.aucegypt.edu was used to get Sukuk historical data. Finally, www.onlygold.com
was used to get gold bullion prices. The data used in the methodology starts from the
first of January 2007 until 30 March 2012. The frequency of the data was calculated on
daily basis.
When calculating the standard deviation of each market, Sukuk proved to be the third
lowest among the other five markets. It has higher standard deviation than corporate
bonds and Treasury bonds while lower standard deviation than US stocks, Global stocks
and Gold. Regarding the Value at Risk (95% & 99%), there are three methods used as
stated earlier, it was noticeable that those methods also showed the same results as
standard deviation and proved that Sukuk is ranked the third among the others.
However, the historical method stated that Sukuk market has the lowest risk among the
other five markets. It was concluded that Sukuk has higher risk than bonds whether
corporate or treasury while lower risk than gold and Stocks whether global or US.
Table 1: Risk Analysis Results
http://www.djindexes.com/http://www.onlygold.com/- 20 -
On the other hand, when calculating the annual return of each market, Sukuk proved to
be the third highest among the other five markets. It has lower annual return than
Treasury bonds and Gold but higher annual return than Corporate bonds, US stocks and
Global stocks. In order to assess which market is better to invest in, return/risk has been
calculated, Sukuk also ranked the third among the other markets. It was verified that
Sukuk is a better investment than corporate bonds, US stocks and Global stocks while
less appealing investment than Treasury bonds and Gold.
Table 2: Return/Risk Results
Concerning the second part in the methodology; correlation and regression analysis
were used to investigate the relation between Sukuk and other five markets. It was
observed that Sukuk has negative correlation with Corporate and treasury bonds while
positive correlation with US stocks, Global stocks and Gold. Regarding regression
analysis, regression coefficients were calculated to examine the relation between all
markets with Sukuk.
Table 3: Correlarion
From the data above, the regression equation is:
Equation 4: Regression Equation
Where Suk= Sukuk, CB= Corporate Bond, TB= Treasury Bond, SP= S&P500,
GS= Global Stock
Regression analysis has proved to provide similar results as correlation calculated
earlier. Regression analysis proved that Sukuk has negative correlation with corporate
bonds and treasury bonds while positive relation with S&P500, global stock and gold.
Therefore it is concluded that, if the market of the corporate bond or Treasury bond is in
crisis or recession period, it is advisable to invest in Sukuk as it will provide better
investment and higher returns.
- 21 -
The data analyzed have some limitations that could affect the accuracy of the results
related to the analysis. One limitation of the data used is that, different indexes have
different methodologies, as Dow Jones Sukuk index is calculated based on market
capitalization while Dow Jones Corporate Bond is based on equal weight. In addition,
different holidays and working days between the indexes lead to different number of
observations, so comparison between indexes and their correlation might be misleading.
Additionally, for a component to be included in the index it should follow specific
criteria, this makes the index an indicator of number of components not the whole
market, in addition to the exclusion of low performing components. Finally, dividends
and coupon payments are neglected in the analysis as they were neglected in the
indexes, as a result, analyses of returns and standard deviation might be misleading and
inaccurate.
- 22 -
5 Conclusion
To conclude, the aim of this paper is to study the risk analysis and correlation of
Sukuk market compared to other markets (Corporate bonds, Treasury bonds, US Stocks,
world stocks and Gold), starting by the literature review which highlighted the
definition of Sukuk and explored its different types, including Ijara Sukuk, Istisn'a
Sukuk, Salam Sukuk, Mudardabah Sukuk and Musharakah Sukuk. Moreover, Sukuk
Sharia standards were explained through covering its characteristics, ownership,
issuance and redemption. Furthermore, different types of risks facing Sukuk were
analyzed as Credit risk, Market risk, Operational risk and liquidity risk. The second part
in the literature review focused on Market risk facing Sukuk and compared it with
different markets. The five markets were presented through their indexes; as Dow Jones
Sukuk Index was used as an indicator for the Sukuk market while, Dow Jones Corporate
bond Index, Dow Jones CBOT Treasury Index, S&P 500, Dow Jones Global Index and
Gold bullion prices have been used as an indicators for other five markets (Corporate
bond, Treasury bond, US Stock, Global Stock and Gold). Furthermore, an overview on
different indexes used along with their criteria and methodologies were included in the
literature.
The last part in the paper aims to answer the research question "What is the risk analysis
of Sukuk market compared to other markets in addition to their correlation". This part
started by giving an overview on the main tools used in analyzing market risk of Sukuk
as well as examining the correlation; Value at risk (Historical, Parametric and Monte
Carlo) and Regression Analysis. After that, the methodology was conducted by
calculating Standard deviation, value at risk and returns of all indexes as well as
regression equation and correlation. It was concluded that Sukuk has third highest
market risk among the other comparable markets after Treasury bond and corporate
bond, as well as the third highest market in "return/risk" after Treasury bonds and Gold.
On the other hand, it was observed Sukuk has negative correlation with bonds whether
Treasury or Corporate while positive relation with Stocks and Gold.
- 23 -
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the Faculty of Management & Technology at the GUC.
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