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.
|Publication status||In preparation - 2019|
Bibliographical noteThis is a pre-print of an article submitted for review to the Review of Financial Economics, 27 June 2015.
- Asset-liability management
- Islamic finance
- Islamic banking
- displaced commercial risk