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CAPM under islamic finance principales

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The Authors

Tarek H. Selim, Department of Economics, The American University in Cairo, Cairo, Egypt

Abstract

Purpose The purpose of this paper is to describe the application of the Islamic financing method based on

direct musharakah to the conventional capital asset pricing model yielding several interesting hypotheses.

Design/methodology/approach Theoretical methodology, with maximin criteria, and rational economic

optimization.

Findings There are four major findings. First, an Islamic financing partnership based on complementary

capital is proven to necessarily yield a lower beta-risk of investments than that compared to the market.

Second, in order for the above conclusion to hold, capital lenders (such as banks) must abide by a maximum

partnership share inversely proportional to project risk and increasing with opportunity cost of capital. Third,

the sum of lender's share and relative risk level balances to unity at equilibrium. Hence, tradeoffs exist in

risk-shares and not in risk-returns. Fourth, without accounting for inflation, and in contrast to predetermined

fixed interest, a maximin strategy of financing partnerships (maximum return with minimum risk) imply an

existence of an optimum zero risk-free rate.

Research limitations/implications The paper's findings are limited to a Direct Musharakah Partnership.

Originality/value A comparison between Islamic risks and returns to conventional risk management is

deduced. Several implications on the conduct of Islamic financing are discussed.

Article Type: Research paper

Keyword(s): Islam; Economics; Finance; Asset valuation; Partnership.

Journal: Humanomics

Volume: 24

Number: 2

Year: 2008

pp: 122-129

Copyright Emerald Group Publishing Limited

ISSN: 0828-8666

Introduction

It is the ultimate purpose of this paper to outline theoretical foundations for an interest free investment

partnership based on Islamic profit/loss sharing (PLS). This is done by utilization of the capital asset pricing

model (CAPM) under strict conditions of Islamic financing, and by comparison with conventional methods

of interest based investments. Risk-return tradeoffs are undertaken for both Islamic financing based on

interest free sharing contracts and for conventional interest based conventional investments, and several

interesting commonalities and differences between the two methods are illustrated. The second section

prepares the reader with a general framework concerning important founding principles of Islamic finance

and their applicability to investment sharing. The third section discusses the conventional CAPM model, its

conditions, and methodology. The fourth section provides an explicit theoretical account of Islamic

financing by augmenting the CAPM model towards constraints found in the Islamic finance discipline, and

provides a rational comparative discussion. The fifth and last section summarizes the findings of the paper.

The founding principles of Islamic finance

The importance of a financial system in any society, whether Islamic or conventional, occurs in the vital role

that the financial system plays in creating incentives to reach an efficient allocation of resources, and to

provide the required financial service intermediation in order to channel funds from savers to borrowers and

to facilitate financial and money flow movements among agents in the economic system. Such facilitation

requires an efficient re-allocation of resources from agents who have a surplus of financial resources to

agents who have scarcity of financial resources.

Islamic finance is a mechanism for conducting such a facilitation. But, instead of direct transfer of funds

from surplus agents to agents of scarce resources, Islamic financing requires a sharing of risk and returns

between agents in the economy. Hence, whether agents have surplus or shortage of capital resources, all

have some degree of risk bearing when deciding to invest. This is the main concern of Islamic finance based

on binding PLS contracts. Agents are seen to complement each other in investment funding in an Islamic

society.

There are several instruments of Islamic finance, yet all are based on the PLS mechanism: musharakah

(capital-capital partnership), mudarabah (capital-labor partnership), murabahah (capital equipment joint

ventures), al-ijara (leasing), and al-salam sale (forward sales). All these partnerships depend on the

equivalent opportunity cost of capital by utilizing predetermined agreed upon margin of profit or subsequent

loss between different economic agents. The measure of the opportunity cost of capital in Islamic financing

is not measured by the neoclassical tradition (i.e. the internal rate of return on a project exceeding the market

interest rate), but rather, since the margin of expected net profit or loss is agreed upon and satisfies the utility

of both partners, then it is determined through equating the opportunity cost of capital with individual utility

preferences, and on aggregate, yield a complementary social welfare surplus for both parties in a neo-Pareto

efficient manner (Lotfy, 2005; El-Gamal, 2001). Such a principle has been pioneered by Ibn-Taymia in the

early works of his literature.

In the recent two decades, both the Islamic finance theory and Islamic financial industry has witnessed lots

of developments and progress. Nowadays, there exist 267 Islamic banks and financial institutions all over

the world working under the Islamic finance principle. Those institutions are located in about forty-eight

countries with value of assets of $260 billion and with an average growth rate of 23 per cent annually (Dubai

Islamic Bank, 2005). Hence, interest and promotion of Islamic financial products and institutions is

welcomed all over the world because it offers diversity of alternatives for investors and consumers alike

(Jomo, 1992).

There are three main principles that govern Islamic finance as it relates to Islamic economic fundamentals:

1. the Principle of Universal Complementarity;

2. the Principle of the Abolition of Usury; and

3. the Principle of Justice in Al-Hisba.

The Principle of Universal Complementarity provides the general society of savers and borrowers,

consumers and producers, government and private industry, etc., with a complementary role in achieving

maximal social welfare. Thus, missed opportunities are themselves social losses, whereas marginal rates of

substitution are not constant across different agents. Hence, there is no unified interest rate that acts as a

benchmark of opportunity cost, but rather, investment shares and corresponding risks are allocated for their

corresponding returns. This gives rise to the second principle: the Principle of the Abolition of Usury, which

basically abolishes predetermined fixed interest amongst agents in the economy. Hence, cooperative agents

would share profits and share losses depending on the actual performance of the investment. All economic

agents, including banks and financial service institutions, have to obey this rule. This gives rise to highly

differentiated investments pending their economic performance and no unified opportunity cost of capital.

Justice, in Al Hisba, provides the ruling body a high degree of authority in terms of regulation of the market

oriented economic system, such that agents have similar preferences through the Unity Precept of God and

adherence to the previous two principles, whereas the Executive branch is implemented through the

regulatory Al Hisba Institution, the Legislative is implemented through an Advisory Council (Al Shura),

and with an independent Judiciary system. This system of governance guarantees no confiscation of

property, all citizens having equal rights and equal entitlements, and agents receiving their appropriate

differentiated reward in terms of wages (based on effort and education), and rent (based on risk and

entrepreneurship). These principles are outlined in detail in Ibn Taymia's seminal writings, and recently put

in modern format, by several writings of El-Gamal.

The conventional CAPM

Asset pricing in terms of expected returns and forgone opportunities is the cornerstone for conventional

capital asset valuation. One of the core models interpreting asset behavior in terms of future rate of return

expectations, in comparison to a risk-free interest rate acting as a benchmark for forgone opportunities, is the

CAPM. The model framework is itself an extension of the net present value criterion which was based on

the original twin works of Irving Fischer (1930, 1965), and that of Hirschleifer (1958). The Fischer

Hirschleifer methodology of investment decisions were attacked immensely because of its omission of

financial risk as an explicit variable of exposition. Hence, inclusive of financial risk and investment returns,

the CAPM model was then developed by Sharpe (1964) and further extended by Lintner (1965), Fama and

French (1992) and Markowitz (1997). It gained fame after it was supported empirically based on a portfolio

of stocks from the 1930s to the 1960s by Fama and MacBeth (1973). Nevertheless, the CAPM methodology

is itself an implicit valuation technique for the P/E and M/B ratios (price-to-earnings ratio and market-tobook value ratio), the latter prime determinants of stock market indices. It has been well established that the

average return on a security is negatively related to these two ratios (Ross et al., 1999), and since these ratios

are themselves negatively related to investment risk, then it must be true that the average return on a security

is itself positively related to its relative risk to that of the market, or beta. The most widely accepted form of

the CAPM model is based on the following:(Equation 1) where (Equation 2)

In the above formulation of the CAPM methodology, R I is the expected return on an individual investment

(average return on investment), R M is the expected return on the market (average return on the market), R F

is the risk-free rate (minimum guaranteed rate of return with minimum risk), Cov (R I, R M) is the covariance

or correlation coefficient between the returns on a specific investment and the returns on the market, Var (R

M) is the variance of returns on the market, and I is the relative risk level of a specific investment in relation

to the risk level of the market.

Hence, I > 1 would imply a risky investment relative to the market, I < 1 implies a low risk investment,

and I =1 implies an equally risky investment.

Graphically, since the utility of a particular investor is increasing in average expected return and decreasing

in risk level, such that monotonicity is in the direction of U (R I ) > 0 and U ( I )< 0, then the security

market line (SML) can be drawn as in Figure 1 and must be tangent to maximum attainable utility due to

monotonicity.

In essence, CAPM can be derived from Figure 1 by equating the two slopes of the SML at points A and B

since the SML is assumed to be a straight line[1].

Interest-free CAPM based on Islamic financing

As discussed in the second section of this paper regarding the principles of Islamic finance, of which the

Principle of the Abolition of Usury is key, let us now examine an interest-free approach to the preceding

analysis of the CAPM based on investment partnerships and a sharing contract. Originally, it is seen that the

conventional CAPM methodology utilizes a risk-free rate, an expected rate of return on the investment and

an expected rate of return on the market, and the relative risk of the investment. Let the market premium be

represented by the excess returns of the market over the risk-free rate:(Equation 3) then (Equation 4) where

f( E ) denotes expected economic profits of the investment.

Assume a PLS contract between actual investors and their corresponding lenders, with being the share in

partnership capital of the lender (such as banks), and in which 0< < 1, such that the equivalent interest-free

(sharing) partnership would require a rate of return R^ I given by: (Equation 5) where K is the total amount

of investment in a certain project, (1 ) is the investor's share based on the PLS contract, and [E +REK] is

the amount of economic profits and its corresponding opportunity cost. In essence, Equation (5) states that

the required rate of return based on a PLS contract to an investor is his share of profits, inclusive of

opportunity costs, relative to initial investment capital.

The question now is: under what conditions would a PLS contract (interest free partnership) yield a rate of

return exceeding that of the conventional CAPM? i.e. under what conditions would the following

relationship hold: (Equation 6)

It can be shown[2] that equation (6). holds true, if and only if:(Equation 7)

Consequently, Equations (7-9) are the conditions needed for the rate of return of an interest free PLS

contract to exceed that of conventional interest bearing contract[3]. The key condition here is Equation (7):

the lender's share of capital must be strictly below a maximum threshold level which itself is a function of

project risk and the implicit opportunity cost of capital with (R F ) < 0. In essence, capital lenders (such

as banks) must abide by a maximum partnership share inversely proportional to project risk and increasing

with opportunity cost of capital.

An interesting dimension can be seen from the previous analysis. Specifically, if we normalize both returns

to be equal to each other, implying:(see equation 8) then it can be easily shown[4] that:(Equation 9)

Without any partnership, as in conventional methods, in which =0, Equation (11) states that =1 is a

necessary condition for Equation (10) to hold. With the existence of an Islamic partnership, > 0, which

necessarily implies < 1.

Hence,(Equation 10)

This finding is particularly strong. The existence of a sharing contract necessarily yield a lower beta-risk of

investments than that compared to the market. This is a pivotal finding in the field of Islamic finance.

But why is that the case?

I will attempt here several reasonings. The first reasoning is related to diminishing marginal productivity of

capital. Suppose you have two stocks of capital K 1 and K 2. Then, taking r(K 1) and r(K 2) as their returns:

r(K 1)+r(K 2) > r(K 1+K 2) due to diminishing returns to capital. The left hand side of this inequality is

equivalent to the Islamic rate of return based on a sharing contract (such as that of a PLS contract), whereas

the right-hand side is based on individual investment without a sharing partner, with the condition that the

total capital for both is the same. If returns are imposed as equal in magnitude, whereas the risk of a sharing

contract becomes inferior to that of the convention, then it is logical to argue that an Islamic sharing contract

yields an inferior level of risk to that of the market. The second reasoning is related to business risk. If

additive returns exceed their combined return, and return is positively related to business risk, then additive

risk must exceed combined risk, and with the latter representing a sharing partnership and the former

representing individual investments, then it is logical to conclude that combined risk of a single sharing

contract will be inferior to the additive sum of the risk of its components.

Another interesting dimension can be deduced. Considering further normalization of both returns (Islamic

and conventional) to equal each other, with Equation (10) binding, Equation (11) can be re-written

as:(Equation 11)

The imposed constraint in Equation (13) is a zero risk-free rate R F=0. Thus, when there are no opportunity

costs of capital based on no forgone interest, the sum of lender's share and relative risk level balances to

unity. In other words, under the constraint of a zero risk-free rate, economic tradeoffs exist in risk-shares and

not in risk-returns. Islamic sharing partnerships would entail a balance between contribution of shares in

capital and risk level of investment. Lenders, in their rational spirit, would be willing to provide a small

share in a risky investment, or conversely, a large share in a safe investment. The trade-off between degree

of capital participation and degree of investment risk is a major requirement in the conduct of Islamic

financing, with the strict condition of a zero risk-free rate of return.

The logical next question is: would a zero risk-free rate of return be optimal in the case of a sharing

contract? To answer that question, I use the maximin approach of maximum return with minimum risk based

on investment sharing and then deduce the first-order condition for a necessary solution followed by the

second-order sufficiency condition. A rational maximum return strategy for an investment sharing contract

is given by[5]:(Equation 12)

After maximizing returns, an investor would like to minimize his risk:(Equation 13)

Given a ^ corresponding to maximum returns as in Equation (14), what is the optimal R F that minimizes

^?

To minimize ^ relative to R F, we need to minimize:(Equation 14)

This yields[6]:(Equation 15)

Thus, a zero risk-free rate of return is optimal in the case of a sharing contract.

Conclusion

The paper establishes an Islamic finance approach to the CAPM, based primarily on the Principle of the

Abolition of Usury and the Principle of Universal Complimentarity. Taking Direct Musharakah (direct

investment partnerships with no predetermined fixed interest and a PLS agreement) as the baseline of

analysis, and with a pure theoretical methodology, the paper concludes the following:

1. The existence of a sharing contract necessarily yield a lower beta-risk of investments than that

compared to the market.

2. In order for the above to hold, capital lenders must abide by an established maximum partnership

share inversely proportional to project risk and increasing with equivalent opportunity cost of capital.

3. Under the constraint of a zero risk-free rate, economic trade-offs exist in risk-shares and not in riskreturns, i.e. the sum of lender's share and relative risk level balances to unity at equilibrium.

4. A zero risk-free rate of return is optimal in the case of a direct sharing contract.

These findings are particularly strong. However, they are limited by the assumptions of theory, and are only

valid for the case of a direct Islamic sharing agreement (direct musharakah). Extensions of these findings on

other Islamic financing instruments remain open.

Notes

1. Equating the slope of the SML at A and B, respectively, yield: R I R F / I 0 = R M R F / 1 0.

With minor mathematical manipulation, this yields the CAPM equation (1).

2. The required inequality is R^ I > R I with the left hand side the equivalent Islamic rate of return and

the right-hand side is the conventional rate of return. We can solve for * that obeys the above

inequality by setting: (1 *)( E + R F K)/ K > R F + E / K (since the actual investor's share of

profits is 1 * ). This leads to (1 * )> R F K+ E / E + R F K, hence, * < E (1 ) / E R F

K. Taking E as common and simplifying we get * < 1 / 1 R F K/ E . Knowing that R F K/ E

is necessarily less than unity, since the numerator is a component of the denominator, then it is

established that * < 1 / with 0 < < 1 with E R F K / E .

3. From Equation (8), < 1 is always binding since it is implicit here that business profits are the

numerator (equal to economic profits minus their corresponding opportunity costs), whereas the

denominator is total economic profits, and accordingly, their ratio is strictly less than unity and

strictly positive.

4. From Equation (10) and (Equation 7), by direct comparison, it is seen that:(1 )( E + R F K) = R F

K + E , hence proving Equation (11).

5. From Equation (11) and (Equation 13), =(1 ^ ) /( 1 R F K/ E ).

6. Let the ^ that maximizes returns be given by an investor's rational decision in Equation (14).

Then,(Equation 16) and 2 ^ / *2 = f(K ( ))> 0; hence, R F * =0 for K> 0 and K ( )> 0.

Equation 1

Equation 2

Equation 3

Equation 4

Equation 5

Equation 6

Equation 7

Equation 8

Equation 9

Equation 10

Equation 11

Equation 12

Equation 13

Equation 14

Equation 15

Equation 16

References

Dubai Islamic Bank (2005), Weekly Report, January, .

[Manual request] [Infotrieve]

El-Gamal, M.A. (2001), "An economic explication of the prohibition of riba in classical Islamic

jurisprudence", working paper, .

Fama, E., French, K. (1992), "The cross-section of expected stock returns", Journal of Finance, Vol. 47

pp.427-660.

[Manual request] [Infotrieve]

Fama, E., MacBeth, J. (1973), "Risk, return and equilibrium: some empirical tests", Journal of Political

Economy, Vol. 8 pp.607-36.

[Manual request] [Infotrieve]

Fischer, I. (1930), The Theory of Interest, Augustus M. Kelly, New York, NY, .

[Manual request] [Infotrieve]

Fischer, I. (1965), The Theory of Interest (a Reprint), New York, NY, .

[Manual request] [Infotrieve]

Hirschleifer, J. (1958), "On the theory of optimal investment decision", Journal of Political Economy,

August, Vol. 66.

[Manual request] [Infotrieve]

Jomo, K. (1992), Islamic Economic Alternatives, Macmillan, London, .

[Manual request] [Infotrieve]

Lintner, J. (1965), "Security prices, risk, and maximal gains from diversification.", Journal of Finance,

December, .

[Manual request] [Infotrieve]

Lotfy, A. (2005), "The foundations Islamic finance: a comparative study with conventional methods", The

American University in Cairo, research paper (unpublished), Economics Department, .

[Manual request] [Infotrieve]

Markowitz, H. (1997), "Travels along the efficient frontier", Dow Jones Asset Management, May/June, .

[Manual request] [Infotrieve]

Ross, S., Westerfield, R., Jaffe, J. (1999), Corporate Finance, Irwin McGraw Hill, pp.269-70.

[Manual request] [Infotrieve]

Sharpe, W. (1964), "Capital asset prices: a theory of market equilibrium under conditions of risk", Journal

of Finance, September, .

[Manual request] [Infotrieve]

Further reading

Ibn Taymia, Ahmed "Al-Hesba Fe El-Islam", Al-Sonna Library, Egypt, .

Ibn Taymia, Ahmed "Al-Siasa Al-Shareia Fe Eslah, Al-Rae We Al-Raeia", Dar Al Shaab, Egypt, .

[Manual request] [Infotrieve]

Corresponding author

Tarek H. Selim can be contacted at: tselim@aucegypt.edu

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