SHARIAH REVIEW OF ISLAMIC PROFIT RATE SWAPSTRATEGIES IN ISLAMIC FINANCIAL

INSTITUTIONS: THE CASE OF MALAYSIA

BY

SYED EHSANULLAH AGHA

A research paper submitted in fulfillment of the requirementfor the degree of Master of Science in

Islamic Banking and Finance

IIUM Institute of Islamic Banking and FinanceInternational Islamic University Malaysia

AUGUST 2015

ii

ABSTRACT

“Nothing ventured, nothing gained” is the first principle of investment. The possibilityof an adverse outcome is an essential part of business activities. This uncertainty aboutfuture outcomes is defined as risk. The broad perspective on risk and its managementis embodied in the essential objectives of Shari’ah, which is wealth protection.However, in the light of the Shari’ah legal maxim that states ‘al-ghurm Bi al-ghunm’(liability accompanies gain) and ‘al-kharaj Bi al-Daman’ (benefit goes with liability)risk cannot be isolated from economic affairs. The legitimacy of revenue generationrequires that it has to be created based on real economic activities that involve realbusiness risk and liability. On the other hand, exposing to excessive risk not onlyhurdles investment, but also deters economic growth, which might be against themaqasid al-Shari’ah (objectives of Shari’ah). As Islamic finance industry grows 15 to20 percent annually, the need of hedging tools to mitigate certain risks in a volatilemarket increases. For instance, with a rapidly emerging market of Sukuk, bothinvestors and issuers are exposed to currency fluctuation risk. Similarly, in the case ofIslamic REITS, if the fund is invested in overseas properties. Islamic Profit Rate Swap(IPRS) is a contract designed as a hedging mechanism to minimize marketparticipants' exposure to the risk of inflation and rate of return. By nature Swapproducts are derivatives which violate Shari`ah principles. According to Sami Al-Suwailem 97.30% of derivatives products are being used for speculation. Thisresearch aims to review from Shariah perspective the legality of the structure andmechanism of Islamic profit rate swap as currently offered by many Islamic financialinstitutions in Malaysia. Specifically the paper highlights the Shariah parameters andguidelines in structuring IPRS. It is observed that IPRS products may involve thefollowing Shariah Issues: Combination of Several Contracts, Use of the samecommodity for various Murabaha transitions, Organized Twarruq, PrematureTermination and Mark to Market. Finally, an improved new structure of IPRS isproposed to reduce operational cost and Shari`ah non-complaint risk for Islamicfinancial institutions.

iii

ملخص البحث

وهي سمة لايمكن أن ينفك عنها أى ،الاستعداد لتحمل المخاطرة هو المبدأ الأول للاستثمارلامي. ومع النمو نشاط اقتصادى. تشهد الساحة المالية نموا ملحوظا للتمويل والاستثمار الاس

ت ومن ابرزها المخاطرة. وقد نجحت ، المطرد تبرز الحاجة لادوات تعالج مايواجهه من الصعوالمؤسسات المالية الاسلامية في تطوير هذاالغرض.هذه الورقة تدرس من منظور شرعي ح كما هي المستخدمة في المؤسسات الاساليب والادوات التي تعالج مخاطرة التضخم والار

ح". وهي اتفاقية لتبادل المالية الاسلامية الماليزية. هذا المنتج يعرف "بمبادلة معدلات الاربت وطرف معدل ربح متغير ح بين طرف معدل ربح أو العكس. ويتم معدلات الأر

تنفيذها من خلال تنفيذ سلسة من العقود الأساسية المتفقة مع مبادئ واحكام الشريعة التالية: الجمع بين العقود، استخدام تايلاكشلااظ أن هذا قد ينطوي على ولوحالإسلامية.

اء المبكر. وأخيرا، يقترح هيكل نفس السلعة لمختلف عقود المرابحة، التورق المنظم والإمتطور لهذا المنتج .

iv

APPROVAL PAGE

I certify that I have supervised and read this study and that in my opinion, it conformsto acceptable standards of scholarly presentation and is fully adequate, in scope andquality, as a research paper for the degree of Master of Science in Islamic Bankingand Finance.

………….……………………………….Younes SoualhiSupervisor

This research paper was submitted to the Institute of Islamic Banking and Finance andis accepted as a partial fulfillment of the requirements for the degree of Master ofScience in Islamic Banking and Finance.

…………………….…………………….Khaliq AhmadDean, IIUM Institute of Islamic Bankingand Finance

v

DECLARATION

I hereby declare that this research paper is the result of my own investigations, except

where otherwise stated. I also declare that it has not been previously or concurrently

submitted as a whole for any other degrees at IIUM or other institutions.

Syed Ehsanullah Agha

Signature …………………………… Date ……………………..

vi

COPYRIGHT PAGE

INTERNATIONAL ISLAMIC UNIVERSITY MALAYSIA

DECLARATION OF COPYRIGHT AND AFFIRMATION OFFAIR USE OF UNPUBLISHED RESEARCH

Copyright © 2015 by International Islamic University Malaysia. All rights reserved.

THE EFFECTS OF DEBT ON VALUE OF THE FINANCIALFIRMS AND THEIR BANKRUPTCY COSTS: A CASE OF

MALAYSIA

I hereby affirm that the International Islamic University Malaysia (IIUM) holds all

rights in the copyright of this work and henceforth any reproduction or use in any

form or by means whatsoever is prohibited without the written consent of IIUM. No

part of this unpublished research may be reproduced, stored in a retrieval system, or

transmitted, in any form or by any means, electronic, mechanical, photocopying,

recording or otherwise without the prior written permission of the copyright holder.

Affirmed by Syed Ehsanullah Agha

…………………… …………………

Signature Date

vii

DEDICATION

This work is dedicated to the most pious and loving woman I have ever known, my

mother. For all her sacrifices, love and the way she takes care of me in my student

life, I will always be grateful. May Allah Almighty give her healthy long life.

viii

ACKNOWLEDGEMENTS

All praises be to Allah Almighty, Lord of the Universe, and Peace and blessing ofAllah be upon His final Messenger Prophet Muhammad (P.B.U.H), his Family andCompanions.

I take this opportunity to express my deep regards and profound gratitude tothose who have contributed and helped me both directly and indirectly in thecompletion of this research. Firstly, I would like to give special appreciation to myfavorite lecturer and my respected supervisor, Associate Professor Dr.Younes Soualhifor his exemplary guidance, diligence and continuous monitoring throughout thecourse of this research and I am also grateful for the time he gave me, without whichcompletion of this research in due time would not have been possible.

Finally, I would also like to acknowledge my special gratitude and appreciationto my parents for their continuous support and prayers, my brothers and sisters fortheir kind words of encouragement. May Allah Almighty reward all of them for theircontinuous support.

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TABLE OF CONTENTS

ABSTRACT............................................................................................................. iiAbstract in Arabic .................................................................................................... iiiApproval Page.......................................................................................................... ivDeclaration ...............................................................................................................vCopyright Page.........................................................................................................viDedication ................................................................................................................viiAcknowledgements..................................................................................................viiiList of Tables ...........................................................................................................xiList of Figures ..........................................................................................................xii

CHAPTER ONE: INTRODUCTION .................................................................11.1 Background of the Study ........................................................................11.2 Statement of the Problem........................................................................31.3 Research Objectives................................................................................31.4 Research Questions.................................................................................41.5 Research Methodology ...........................................................................41.6 Structure of the Study .............................................................................51.7 Limitations..............................................................................................61.8 Significance of the Research ..................................................................6

CHAPTER TWO: LITERATURE REVIEW....................................................72.1 Introduction.............................................................................................72.2 General discussion on derivatives ..........................................................7

2.2.1 Institutional level...........................................................................72.2.2 Individual level .............................................................................8

2.3 Swap products.........................................................................................9

CHAPTER THREE: RISK MANAGEMENT IN ISLMAIC FINANCIALTRANSACTIONS..................................................................................................11

3.1 Introduction.............................................................................................113.2 Risk management....................................................................................12

3.2.1 An Overview of Risk Management from ConventionalPerspective....................................................................................12

3.2.2 Risk Management from Maqasid al-Shari’ah Perspective ............143.2.2.1 Risk Management in Qur’an .............................................153.2.2.2 Risk Management in Prophetic Tradition .........................17

3.3 Risk taking and risk sharing: Reconciliation ..........................................193.3.1 The Essential risk ..........................................................................213.3.2 The Forbidden risk ........................................................................233.3.3 The tolerable risk to be avoided....................................................24

3.4 Conclusion..............................................................................................25

CHAPTER FOUR: ISLAMIC PROFIT RATE SWAP ....................................274.1 Introduction.............................................................................................274.2 Swap as a Risk Management Tool .........................................................28

x

4.3 Mechanism of Swap Product..................................................................294.4 Main Objectives of Swap Instruments....................................................294.5 Islamic profit rate swap ..........................................................................304.6 Murabaha structure of IPRS...................................................................324.7 Conclusion ..............................................................................................36

CHAPTER FIVE: Discussion ..............................................................................375.1 Introduction ............................................................................................375.2 Wa`ad......................................................................................................375.3 Validity of Tawarruq in Swap................................................................415.4 ISSUES of speculation ...........................................................................435.5 Combination of Several Contracts..........................................................445.6 Premature Termination and Mark to Market ..........................................465.7 Proposed Model for IPRS (Single Commodity Murabaha) ...................475.8 Conclusion ..............................................................................................49

REFERENCES.......................................................................................................52

xi

LIST OF TABLES

Table No. Page No.

4.1 Profit Rate Swap Cash flows 36

xii

LIST OF FIGURES

Figure No. Page No.

1.1 OTC Interest Rate Derivatives Turnover 29

1.2 Profit Rate Swap 35

1

CHAPTER ONE

INTRODUCTION

1.1 BACKGROUND OF THE STUDY

“Nothing ventured, nothing gained” is the first principle of investment (Al-Suwailem,

2006). The possibility of an adverse outcome is an essential part of business activities.

The broad perspective on risk and its management is embodied in the essential

objectives of Shari’ah, which is wealth protection. However, in the light of the

Shari’ah legal maxim that states ‘al-ghurm bi al-ghunm’ (liability accompanies gain)

and ‘al-kharaj bi al-daman’ (benefit goes with liability) risk cannot be isolated from

economic affairs. The legitimacy of revenue generation requires that it has to be

created based on real economic activities, which involve real business risk and

liability. Thus the element of risk and liability is essential for the legitimacy of profit

entitlement. On the other hand, exposing to excessive risk not only hurdles

investment, but also deters economic growth, which might be against the maqasid al-

Shari’ah.

There are two types of risks: business risk and financial risk. Business risk

deals with the uncertainty of future sales or the cost of inputs, while financial risk

deals with the uncertainty of interest rates, exchange rates, stock prices, and

commodity prices (Vishwanath, 2007). Hedging through derivatives is one of the

means by which financial risks can be reduced. Derivatives are financial instruments

that drive its returns and prices from other financial instruments. By employing

derivatives, companies and individuals can hedge their risks (Bingham and Kiesel,

2013).

2

Swaps and other derivatives were initially viewed to be among the prohibited

areas of Islamic finance (Ayub, 2011). However, as a business entity Islamic financial

institutions are exposed to all kinds of financial risks as their counter parties. As

Islamic investments grow, the need of hedging tools to mitigate certain risks in a

volatile market increases (Khan and Ahmed, 2001). With about $2 trillions of assets

(Islamic Finance Outlook, 2014), the international divergence of Islamic finance

business will definitely necessitate advance and flexible tools to manage financial and

business risks (Jobst and Sole, 2012). With increasing use of derivatives in the

conventional finance during late 1990s as hedging and speculation tools, Islamic

economists came into the grey area of Islamic hedging tools. On the basis of maslahah

(public interest), Kamali (1996) discussed for the first time the possibility of options

and futures in Islamic Commercial Law (Ayub, 2011).

Islamic finance practitioners tried to develop ‘Islamic’ derivatives during

2000-2007. Theoretically, initial Islamic derivatives products were supposed to be

based on the contract of Salam, Murabaha, Wakalah, ‘Urbun, ba`u al-khiyar.

However, financial engineers could not develop any financial derivative structures

acceptable to the overwhelming majority of the contemporary jurists. Most of the

products introduced, were using W`aad and Commodity Murabah as underlying

contracts which are controversial (Ayub, 2011).

It is argued that the development of risk management tools in Islamic

financial institutions was a relatively difficult task. Numerous reasons were discussed

by scholars. According to Rosly and Bakar (2003) classical Islamic risk management

strategies were rigid compared to conventional. Because Islamic commercial law puts

some constraints for innovators in order to be in line with Sharia`h (Mohamad and

Tabatabaei, 2008). There was a lack of robust demand for risk management tools

3

(Ismal, 2010 and Bacha 1999).The absence of a central supervisory board also

impacted the development of risk management in Islamic finance (El-Hawary, 2004).

1.2 STATEMENT OF THE PROBLEM

The global Islamic finance industry is growing at 15 to 20 per cent annually. As

Islamic investments grow, the need of hedging tools to mitigate certain risks in a

volatile market increases. For instance, with a rapidly emerging market of Sukuk, both

investors and issuers are exposed to currency fluctuation risk. Similarly, in the case of

Islamic REITS, if the fund invests in overseas properties.

To hedge rate of return and inflation risk, Islamic financial institutions are

using Islamic profit rate swap (IPRS). This tool is structured based on Tawarruq and

Wa`ad as underlining contracts which are controversial, according to some scholars.

In addition, a fundamental question is how Sharia`h boards will ensure that these

products can be only used for the pure hedging purpose. There is a need to critically

review the operation and mechanism of IPRS from Shraih perspective.

1.3 RESEARCH OBJECTIVES

This study aims to analyse “how” Islamic financial institutions hedge profit rate risk.

The objectives of the paper are as follow:

1- To discuss briefly the concept of Risk management in Islamic financial

transactions.

2- To analyse currently available Islamic profit rate Swap arrangements.

3- To highlight the challenges and constraints in innovating Islamic Risk

management tools.

4- To propose an effective structure for profit rate swap.

4

1.4 RESEARCH QUESTIONS

1. Dose Hedging business risk, contravene with the legal maxim “الغنم بالغرم

Loss entails gain”?

2. Is Islamic profit rate swap as introduced by IF in Malaysia in line with

Sharaih principles?

3. How to ensure the usage of Islamic hedging tools for hedging purposes?

1.5 RESEARCH METHODOLOGY

This study employs qualitative method of research. Inductive approach will be

adopted to abstract what has been written about swaps practically and theoretically. It

also adopted a deductive approach to derive legal provisions applied in derivative

contracts from Quran and Sunnah. In order to produce an innovative and genuine

piece of research work primary and secondary data available on the subject will be

used as below:

1. Primary data: Bank documents, offer letters, contractual agreements and

other Legal documentations used in executing IPRS in Malaysian Islamic

banks. In addition, banking manuals and operating procedures will also be

the source of primary information for the study. In the same way, the

fatwas/guidelines issued by Sharia`h Advisory Council (SAC) (AAOIFI),

and OIC Fiqah academy will remain crucial foundation for the study.

2. Secondary data: Textual references from the Quraan and Sunnah,

Literature of Islamic jurisprudence, academic texts on the application of

the IPRS, academic journals, thesis, internet resources and conference

proceedings will be used as secondary data.

5

For the purpose of Sharia`h critical review, the functional procedures in

executing IPRS and its legality will be analyzed. The results would be reviewed with

the Sharia`h standards of AAOIFI, SAC’s Fatwas and finally will be evaluated in the

light of Maqasid al-Sharia`h.

1.6 STRUCTURE OF THE STUDY

This paper is structured over five chapters.

The first chapter presents a sketch of the research as a whole, it contains following

main titles:

1. Introduction

2. Problem Statement

3. Research Objectives and Questions

4. Research Methodology

5. Limitations

The second chapter will discuss Literature Review. In the third chapter, the

following topics will be discussed briefly:

1. Concept of Risk

2. Risk Management in Islamic financial transaction

3. Risk Management from Maqasid Sharia`h perspective

4. The mechanism of Hedging

The fourth chapter will review Islamic profit rate swap, mainly focusing on the

following areas:

1. An introduction to Swap

2. Islamic Profit Rate Swap strategies

3. The operation of IPRS

6

In chapter five; findings, challenges and conclusion will be presented.

1.7 LIMITATIONS

Academic research always has its limitation; this research is not an exemption. This

study is focusing on critical Sharia`h review of Islamic profit rate swap Strategies of

Islamic financial institutions. The scope of the study will be on the current practice of

Islamic profit rate Swap in Islamic financial institutions of Malaysia.

1.8 SIGNIFICANCE OF THE RESEARCH

The area of financial derivatives is comparatively a new field in Islamic finance and

banking. Extensive research in this area has yet to be done. Particularly, there is a lack

of literature on Islamic swap products that critically review the compliance of

Malaysian practice. The relevant past studies have focused primarily on the Shari’ah

permissibility of Swap products and structuring of them in line with Islamic Law,

without identifying Shari’ah issues and challenges in structuring Swap products.

Therefore, the researcher believes that this research will contribute meaningful

insights in relevant field and will highlight challenges and constraints in innovating

Islamic profit rate swap products. It will also provide guidelines for Islamic financial

institutions in structuring Islamic profit rate swap products.

7

CHAPTER TWO

LITERATURE REVIEW

2.1 INTRODUCTION

Numerous studies and researches have discussed conventional “derivatives” from

Islamic point of view. This paper will organize the review of earlier research work

into two parts. In the first part, forward, futures and options contracts will be

discussed, while the second part will explain swap contracts only.

2.2 GENERAL DISCUSSION ON DERIVATIVES

2.2.1 Institutional level

The first institutional research work regarding derivatives was initiated by a group of

Shari’ah scholars for a jurisdictional discussion in the Islamic Fiqh Academy (branch

of the Jeddah based Organization of Islamic Conference OIC). The Academy in its 7th

conference in 1992 discussed the legality of derivatives contracts specifically forward,

future and options contracts. In its resolution academy unanimously acknowledges the

financial and commercial advantages of future and forward trading. However,

according to Academy’s resolution derivatives contracts violate the tripartite

requirements of Islamic commercial law, i.e. existence, ownership and possession of

the asset. In addition, they are involved in speculation and gharar (uncertainty) which

lead to monopoly and price distortion. After highlighting the advantages and

disadvantages of future markets, the Academy declared that in the light of provided

relevant information future and forward transactions are not Sharia`h compliant

(Qarārāt Majlis al-Majmāʿ al-Fiqhī al-Islāmī, 1984).

8

The other study was undertaken by the Accounting and Auditing Organization of

Islamic Financial Institutions (AAOIFI) Sharia`h board in 2004. The board eventually

passed a resolution supporting the earlier decision of OIC International Fiqh Academy

(AAOIFI Shari’ah standards, 2008).

2.2.2 Individual level

Kamali`s (1996) work is considered to be the earliest individual attempt to resolve the

issue of derivatives contracts in Islamic finance industry. The paper discuses only the

issue of futures and options. He came up with a new perspective based on the

principle of Muslaha with legal evidence proving the legality of conventional futures

and options. He supports his opinion by arguing that most of the arguments presented

by scholars against futures and options contracts are not that much stronger to prove

the impermissibility of derivatives transactions.

Bacha (2004) discussed derivatives instruments and its pricing mechanism

generally from a conventional perspective. In the end of the book he specified a

chapter naming “Derivatives Instruments and Islamic Finance”. The author attempted

to come up with alternatives of conventional derivatives, based on different classical

Shari’ah contracts, i.e. Bay’ al-Salam, Istisna’, Istijrar and Ju’alah. However, having

expertise in the conventional field of finance only, his opinion regarding Islamic

financial transaction is not considered a big authority. Due to not being a Shari’ah

specialist, his proposal is insufficient from Islamic point of view.

Al-Bashir (2010) supported overall Kamali’s arguments regarding derivatives

discussion. Indeed, his work is an extension of his teacher Kamali’s discussion in a

greater detail explaining everything very comprehensively.

9

Kunhibaya (2010) summarized the overall scholarly discussion regarding

derivative instruments, i.e. futures and options. She explained five major Shari’ah

objections pertaining conventional derivatives. They are as follow:

a) Deferment of both counter values in future sell, involves (Bay' al-Kali bil

Kali, i.e. sales of one debt for another).

b) Nonexistence of counter values in futures and options at agreement date.

c) Trading of option is trading of mere right and charging of fee is not

permissible for it.

d) Future transactions do not follow the requirements of “possession of the

item” prior to resale.

e) Mostly derivatives are being used for speculative activities involving

gambling and Gharar.

The author merely quoted the arguments and counterarguments of different

scholars without her own contribution.

2.3 SWAP PRODUCTS

Badlisha (2004) elaborated currently available derivatives products from a

practitioner’s point of view without discussing any Shariah issues (Zaharuddin, 2010).

Bakar (2004) focused on issues and product structuring of Profit rate Swaps and

Forward Forex.

Al-Suwailem(2006) discussed Sharia`h-compliant hedging techniques and

associated financial engineering tools. We will explain some of his ideas in coming

chapters. Dusuki and Mokthar (2010) discussed Hedging, speculation and Swap

products in conventional context providing Islamic perspective for each of them. The

main objective of the paper was to present the current practice of Islamic FX, Profit

10

Rate Swap and cross currency Swap. The authors raised a very fundamental question

regarding Swaps. In international markets most of the derivatives products are used for

speculative purposes. So how will the Shari’ah board ensure that these products are

not being used for speculative activities? The paper didn’t provide a proper solution

and the issue of speculative activities remains unsolved. Zahruddin (2010) analyzed

conventional derivatives products from Islamic point of view, focusing on Options and

Swaps. In chapter four, he discussed in detail Swap products from an Islamic

perspective. Since my focus in this paper is only on Swaps, I will discuss his work on

Swaps products only. He did not shed light on a very significant issue of Maqasad al-

Shari’ah to justify the profit rate swap and cross currency swap products offered by

Islamic financial institutions. My research paper will be an extension of his work and

will try to incorporate some of the existing gaps.

The latest academic work in the area of Islamic Swap products is written by

Alwi and Aznan Hasan in 2013. It is a book named “A mini guide to Islamic

Derivatives: A primer to Islamic FX Forwards, Profit Rate Swaps and Options”. After

discussing financial derivatives from Islamic perspective the authors explained in

detail how Islamic Swap products can be structured in Islamic finance. This mini

guide is a new addition to Islamic swaps as it describes Islamic swap products in a

simple approach providing practical examples for each product. However the

discussion is mostly from Malaysian Shari’ah scholar’s points of view and they did

not discuss about guidelines of international Islamic financial market Swaps products.

11

CHAPTER THREE

RISK MANAGEMENT IN ISLMAIC FINANCIALTRANSACTIONS

3.1 INTRODUCTION

The possibility of an adverse outcome is the essential part of business activities.

Uncertainty is a natural component of activities that involve the future as it traverses

across different levels. The existence of uncertainty about future outcomes is defined

as risk (Damodaran, 2007). Risk is often linked with undesirable event that produces

negative outcome. Holton (2004) argues that uncertainty is related to the potential

outcomes of an experiment and that the outcomes have to be measured in terms of

providing utility.

Be that as it may, in finance risk is defined in terms of variability of actual

returns on investment around an expected return, even if the returns represent positive

outcomes (Damodaran, 2007). Risks in economics and finance are classified in

various ways. One way is to distinguish between business risk and financial risk.

Business risk is due to the uncertainty arising from the nature of a company’s or an

individual’s business. It is related to factors affecting the product market, i.e. the

uncertainty of the cost of inputs or the future sales. Financial risk is the uncertainty

arising from possible losses in financial markets due to movements of financial

variables, i.e. uncertainty of commodity prices, stock prices, exchange and interest

rates (Jorion & Khoury, 1996).

On the other side, Muslim jurists used the word khatar and mukhatarah for

business risk. Mukhatarah is defined as “possibility of unexpected outcomes” (Al-

Sharbasi, 1981). Khatar and mukhatarah are interchangeably used with gharar

12

(Uwaidah, 2010). According to Al-Mawsu’ah al-Fiqhiyyah Al-Kuwaytiyyah (1983-

2006) mukhatarah is the doubtful status of a business transaction in which gain and

loss are unknown. By analysing various definitions of khatar and mukhatarah from

juristic perspective, Muhammad (2008) concludes that the concept of risk according to

Muslim jurists is almost similar to what is defined by conventional economists.

3.2 RISK MANAGEMENT

Operating in a dynamic environment, every business entity requires an active risk

management strategy to protect itself from unexpected results. Sound risk

management is the key responsibility of the management and should be part and

parcel of the overall corporate governance structure. An effective risk management

system comprises of identifying, measuring, monitoring and limiting risks. These

processes depend on appropriate control and auditing procedures. In the following

section, the concept of risk management will be deliberated briefly.

3.2.1 An Overview of Risk Management from Conventional Perspective

Risk management according to Cumming and Hirtle (2001), is attributed to “the

overall process that a financial institution follows to define a business strategy, to

identify the risks to which it is exposed, to quantify those risks, and to understand and

control the nature of risks it faces”. Damodaran (2007) distinguishes between risk

management and risk reduction. Risk management refers to a strategy for an

organization’s advantage by seeking it out to exploit uncertainty and risks through

various proactive policies to create value. Risk reduction on the other hand, is a

defensive process to protect organizations from risk by using insurance, hedging and

derivatives. Examining the likelihood and impact of the risk can assess the implication