Arbitrage outcome between conventional and Islamic finance of yield and forward rates in bond market

Abstract

Purpose

In this research, arbitrage opportunity is tested between the yield rates computed by the NSS model, and the computed forward rates between conventional and Islamic finance to see any arbitrage opportunity. The research questions are the conventional and Islamic finance yields at the same level and equal to each other to avoid arbitrage? Whether conventional and Islamic forward rates differ significantly and thus create any arbitrage opportunity. This study aims to find the presence or absence of arbitrage between conventional and Islamic finance yield rates.

Design/methodology/approach

The NSS model is the latest model in calculating yield and forward rates. In the method the error level is minimized so expected yield rate and given yield rate both converged (Vahidin and Anastasios, 2020). When they converged it gives the researchers all six months’ yield rates. For the Nelson Siegal method, all the six months’ yield rates are available and these yield rates can be used to compute the forward rates.

Findings

The authors concluded there is a significant difference between the conventional yield rate and the Islamic yield rate. It suggests that because there are significant differences, its suggest arbitrage is possible. So anyone interested in making a guaranteed profit. The conventional yield rates are lower; hence, anyone can borrow from the conventional finance system and invest the money in the Islamic financial system because investments are getting higher rates of income in the form of yield rate in Islamic Finance. So, one can make money because of this difference. Statistically, it is possible to make money, but practically, the authors observed the difference, however it is very meager. The arbitrage opportunity between Islamic finance and conventional finance will not affect the economy because the significant difference is too small. The disturbance in the arbitrage opportunity due to the values is very meager and insignificant.

Research limitations/implications

This research does not address the derivative contracts’ role in risk management; future researchers could take up this as another research.

Practical implications

This research will be beneficial for financial institutions, especially institutional investors. Besides, this research will help the regulators and investment bankers in assisting where and future losses especially bond portfolios in conventional finance and Islamic finance. This study will also contribute and help the asset manager of mutual funds in the mutual fund industries.

Social implications

In effect, this research will strengthen the financial system, capital market and bond market, derivative contracts such as options contracts, futures contracts, swap contracts and forward contracts will use computed forward rates for assessing future losses (value at risk [VaR]) and to hedge them (Balakrishnan, 2020).

Originality/value

As this topic is rarely studied it will increase the literature present in this domain.