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

Table of Contents
Table of Contents ............................................................................................................. ii Table of Figures ............................................................................................................... iii Table of Tables ................................................................................................................ iv 1 2 Introduction .............................................................................................................. 1 Sukuk Overview ....................................................................................................... 2 2.1 2.2 3 Definition and Types of Sukuk..................................................................... 2 Sharia Standards and Types of Risks ........................................................... 5

Sukuk Market Risk ................................................................................................... 8 3.1 3.2 Analysis of Sukuk Market ............................................................................ 8 Indexes Overview ......................................................................................... 9

Market Risk Analysis ............................................................................................. 16 4.1 4.2 Value at Risk and Regression Analysis ...................................................... 16 Empirical Results........................................................................................ 18

Conclusion .............................................................................................................. 22

References ...................................................................................................................... 23 Declaration...................................................................................................................... 26

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Table of Figures
Figure 1: Sukuk Market .................................................................................................... 3

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Table of Tables
Table 1: Risk Analysis Results ....................................................................................... 19 Table 2: Return/Risk Results .......................................................................................... 20 Table 3: Correlarion........................................................................................................ 20

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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.

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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 noncompliant 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.

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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 noncallable 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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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

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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

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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

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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 Tnote 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 LargeCap 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).

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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

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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

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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

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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

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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 VarianceCovariance 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

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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

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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

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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.

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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.

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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.

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Declaration

I herewith declare that this report is in full accordance with the Plagiarism Guidelines of the Faculty of Management & Technology at the GUC.

Signature

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