May 03 2011
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The traditional fixed income market is beginning to demand Shariah-like principles
The global financial crisis made it clear to investors and fund managers that the risk inherent in financial instruments is not necessarily indicated accurately by their pricing. It has become increasingly important that funds with exposure to the fixed income market understand a bond's various risks and the relationships between them - market and credit risk in particular - and evaluate how well the bond compensates an investor through its yield. It is a process that mirrors the Islamic finance principle of prohibiting gharar (excessive uncertainty), which requires clarity in not only the value of the asset purchased but associated risks as well.
Of course it is unlikely traditional fixed income markets will ever be Shariah-compliant - but Islamic lenders and investors will recognise aspects of the movement towards greater transparency. Demand for transparency accelerated when the possibility of a sovereign default in Europe spread fears of contagion risk - leading to increased caution by asset managers as they waited to see if Greece would default. Investors and managers had difficulty identifying where the true counterparty risk would belong should a ripple of defaults through a multiple event risk occur. The full implications of financial assistance from the European Union were also difficult to determine and remain so.
The strategy adopted by most fund managers to uncover the counterparty risk held by their investments involves analysing the credit health of a wider range of counterparties to their various transactions - as well as defining appropriate risk limits for investment purposes and how to adapt their allocation strategies to the new environment.
As the crisis continued investors turned to low risk assets such as guaranteed government-backed securities, cash and commodities, all of which have historically provided fairly consistent returns. Shorter duration corporate bond portfolios were also proving more attractive - with demand shifting the average portfolio duration from five years to three.
Investors need access not only to evaluated and/or model-based prices, but the underlying inputs that generate those prices and the market data used to generate those inputs. This is a vital step in restoring investor confidence in ABS in particular, where distressed sales have sometimes resulted in depressed valuations and confused the intrinsic, economic valuations when assets are held to maturity.
Combining loan-level data with robust credit models allows investors to effectively simulate defaults and recoveries that respect the unique circumstances of each pool of loans backing a structured asset. These and other similar tools will allow for a far greater depth of valuation and risk information - something market participants have been
Both ABS and bond investors have lacked the robust analytics and data sets required to perform sufficiently reliable analysis of the various risks within their holdings. Now it is not only Shariah that necessitates increasing investor awareness in this respect as the traditional fixed income and structured finance markets are also demanding similar standards.
These steps towards risk and value transparency might sound familiar to Islamic investors, but the global financial crises of recent years have opened the door to a new era of risk awareness worldwide. Market participants are increasingly likely to utilise cross-asset class analytics to improve how they measure correlation risk and how they stress test an increasing number of factors. Asset managers will continue to improve these techniques and look for more ways to evaluate whether they are being fairly compensated for the risks they are taking.
Omar Maursy is senior director of Standard & Poor's Valuation and Risk Strategies in Dubai
© The Gulf 2011
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