Hedging Displaced Commercial Risk

Kenneth Baldwin, Maryam AlHalboni

Research output: Working paper

Abstract

Islamic banks invest in risky assets alongside unrestricted profit sharing investment account holders. For an Islamic bank which can hedge its resulting exposure to market risk using Shariah compliant hedging instruments, it will transfer unwanted risk to a derivative counterparty. However, determination of an optimal hedge ratio must take into consideration a phenomenon which skews the distribution of risk towards shareholders, that of displaced commercial risk. Displaced commercial risk arises because of the competitive need of Islamic banks to benchmark the rates of return they pay to profit sharing investment account holders with the deposit rates of conventional banks. As a result of displaced commercial risk, the shareholders of Islamic banks make up shortfalls in contractual returns payable to investment account holders. This paper derives the optimal size of a hedge to mitigate displaced commercial risk using a single-period Shariah compliant forward rate agreement. It also estimates the optimal hedge size for Islamic banks in Indonesia.
LanguageEnglish
Volumein review
Publication statusIn preparation - 2019

Fingerprint

Hedging
Islamic financial institutions
Hedge
Shareholders
Profit sharing
Risk transfer
Forward rates
Assets
Derivatives
Deposit rate
Rate of return
Market risk
Indonesia
Benchmark
Optimal hedge ratio

Bibliographical note

This is a pre-print of an article submitted for review to the Review of Financial Economics, 27 June 2015.

Keywords

  • Asset-liability management
  • Islamic finance
  • Islamic banking
  • displaced commercial risk
  • hedging

Cite this

Hedging Displaced Commercial Risk. / Baldwin, Kenneth; AlHalboni, Maryam.

2019.

Research output: Working paper

@techreport{9c5f95366ab743a9b8e33b6f4837a5b0,
title = "Hedging Displaced Commercial Risk",
abstract = "Islamic banks invest in risky assets alongside unrestricted profit sharing investment account holders. For an Islamic bank which can hedge its resulting exposure to market risk using Shariah compliant hedging instruments, it will transfer unwanted risk to a derivative counterparty. However, determination of an optimal hedge ratio must take into consideration a phenomenon which skews the distribution of risk towards shareholders, that of displaced commercial risk. Displaced commercial risk arises because of the competitive need of Islamic banks to benchmark the rates of return they pay to profit sharing investment account holders with the deposit rates of conventional banks. As a result of displaced commercial risk, the shareholders of Islamic banks make up shortfalls in contractual returns payable to investment account holders. This paper derives the optimal size of a hedge to mitigate displaced commercial risk using a single-period Shariah compliant forward rate agreement. It also estimates the optimal hedge size for Islamic banks in Indonesia.",
keywords = "Asset-liability management, Islamic finance, Islamic banking, displaced commercial risk, hedging",
author = "Kenneth Baldwin and Maryam AlHalboni",
note = "This is a pre-print of an article submitted for review to the Review of Financial Economics, 27 June 2015.",
year = "2019",
language = "English",
volume = "in review",
type = "WorkingPaper",

}

TY - UNPB

T1 - Hedging Displaced Commercial Risk

AU - Baldwin, Kenneth

AU - AlHalboni, Maryam

N1 - This is a pre-print of an article submitted for review to the Review of Financial Economics, 27 June 2015.

PY - 2019

Y1 - 2019

N2 - Islamic banks invest in risky assets alongside unrestricted profit sharing investment account holders. For an Islamic bank which can hedge its resulting exposure to market risk using Shariah compliant hedging instruments, it will transfer unwanted risk to a derivative counterparty. However, determination of an optimal hedge ratio must take into consideration a phenomenon which skews the distribution of risk towards shareholders, that of displaced commercial risk. Displaced commercial risk arises because of the competitive need of Islamic banks to benchmark the rates of return they pay to profit sharing investment account holders with the deposit rates of conventional banks. As a result of displaced commercial risk, the shareholders of Islamic banks make up shortfalls in contractual returns payable to investment account holders. This paper derives the optimal size of a hedge to mitigate displaced commercial risk using a single-period Shariah compliant forward rate agreement. It also estimates the optimal hedge size for Islamic banks in Indonesia.

AB - Islamic banks invest in risky assets alongside unrestricted profit sharing investment account holders. For an Islamic bank which can hedge its resulting exposure to market risk using Shariah compliant hedging instruments, it will transfer unwanted risk to a derivative counterparty. However, determination of an optimal hedge ratio must take into consideration a phenomenon which skews the distribution of risk towards shareholders, that of displaced commercial risk. Displaced commercial risk arises because of the competitive need of Islamic banks to benchmark the rates of return they pay to profit sharing investment account holders with the deposit rates of conventional banks. As a result of displaced commercial risk, the shareholders of Islamic banks make up shortfalls in contractual returns payable to investment account holders. This paper derives the optimal size of a hedge to mitigate displaced commercial risk using a single-period Shariah compliant forward rate agreement. It also estimates the optimal hedge size for Islamic banks in Indonesia.

KW - Asset-liability management

KW - Islamic finance

KW - Islamic banking

KW - displaced commercial risk

KW - hedging

M3 - Working paper

VL - in review

BT - Hedging Displaced Commercial Risk

ER -