Salam Contract With Credit Risk Model by Partial Differential Equation Approach

Abstract

In the acute phase of global financial crisis, the risk management issue has become a major subject that attracts the interest of many financial institutions. Risk management in Islamic finance is proven to be more challenging than the conventional due to shariah principals and regulations. Therefore, there is a need for an alternative Islamic derivative product that can compete with the existing conventional derivatives. This study proposes a traditional Islamic contract, which is salam, that can be built as a new Islamic derivative product. Since there is lack of quantitative study regarding salam contract implementation, this study introduces a mathematical model of commodity salam contract by considering credit risk element. The structural approach is the best credit risk model to describe the structure and properties of salam contract. However, because of the unique structure and boundary condition of salam contract, some adjustments need to be considered. In deriving the partial differential equation that describes the dynamic behaviour of commodity salam contract with credit risk, the risk neutral valuation was employed.