In modern financial system the risk free rate (on government securities) is the reference used in investment decision within a risk-return valuation framework. It reflects the opportunity cost of investments and is a useful policy tool for government. In most countries, theoretically and practically, the rate is not set based on real sector variables but on predominantly on financial variables; inflation rate, growth rate and targeted long run interest rate.
Such risk free rate subsequently serves as a component of asset pricing (such as in the classical asset pricing model i.e. the capital asset pricing model). However there is a consensus among Muslim finance and economic scholars that such risk free rate obtained in non-Islamic financial system is appropriate for the Islamic finance ((khan and mirakhor (1988), mirakhor (1996), (Askari, Iqball and Mirakhor (209), Shuber and Alzafiri (2008)). Many agree that such free rate hence forth referred to as the benchmark return should be derived from the real sector of economy (such as return from government project).
In the conventional financial system, the financial market dominates the role of real sector in the economy, in such a way that pricing benchmark is based on the financial market variables rather than real sector's. Because the financial market is highly related to the problem of using fiat money, the pricing of asset does not reflect the intrinsic value of the asset but due to the increasing money supply, speculative behavior and other related factors which cause instability in the economy. Therefore, the Islamic financial products must be appropriately priced not only the comply with sharia'ah but also to promote stability in economy.
Recent studies on financial crisis have looked into the alternative economic and financial system. Studies such as Ahaamed kamel (2002) and mohd. Yosuf et. Al. (2002) sugest that the god dinar might be used as replacement for fiat money.
Many Islamic scalars argue that gold monetary system (by introducing gold dinar) could be the best system that can enhance the monetary stability. However, changing the current monetary system to the gold system needs a drastic change that may be impossible to be achieved in either the medium or even the long term period. However, this should not be a deterrence to develop an appreciate bench mark return for Islamic financial assets. Thus, the main aim of this research is to develop this benchmark return taking into consideration Muslim economics/nations with different degree of shari'ah compliance (degree of Islamic permissibility).
Study Background
Researches and Studies on an Islamic Pricing Benchmark
Some refrences books which are based on Islamic jurisprudence and mention to Islamic pricing are listed as follow:
"Ma'alim al-qurbah fi ahkam"
"Nihayat al-ratibah fi tolab al-hisbah"
"Adab al-hisbah"
"al-hisbah"
"al-Hisbah fi Islam"
"al-Turuq al-hukmiyyah fi al-siyasah"
"al-syariyyah"
Furthermore there are some books which are written in Arabic language. However, recently few books on Islamic pricing benchmark, which were written in English, are:
Pricing of Murabahah and Ijarah Product in Malaysia73 (Muhd Ramadhan Fitri, MA thesis, Department of Fiqh and Usul al-Fiqh, International Islamic University
Malaysia)
"Indexation of Financial Assets an Islamic Evaluation", by S.M Hasanuz Zaman.
"An Introduction to Islamic Finance", by Muhammad Taqi Usmani
"Cost of Capital and Investment in a Non-Interest Economy", by Abbas Mirakhor.
In addition to these books and references, some studies regarding pricing benchmark from Shariah perspective have been done, however the numbers of these studies are much less than expected limit. On the other word this issue is a new topic. Due to the fact that, this subject is only an Islamic concern, therefore only Muslim scientist are studying about it.
In 2008 Tarek H. Selim in his study "An Islamic capital asset pricing model" comes up with following results:
Direct Sharing contract (Musharakah) returns lower beta-risk of investments than to the market.
Investors have to accept a given partnership share which has an inverse relationship with risk of project, when risk increases mutually opportunity cost of capital goes up.
According to the zero risk-free rate, economics activities are done between risk shares instead of risk-returns
In Direct Sharing contract (Musharakah), optimal rate is a zero risk-free rate of return
Kadom Shubber and Eid Alzafiri in their research "Cost of capital of Islamic banking institutions: an empirical study of a special case, 2008" define a new model to figuring cost of capital based on shari'ah compliance. They believe that, based on Islamic perspective, deposit account do not consider as a liability. They show that there is very weak relationship between market value of Islamic banks and the size of its deposits. As well as, Islamic bank's market value is significantly independent of its cost of capital. Finally the state that rate of return for shareholders must be higher than depositors.
Mohd. Yusof in his study suggests a new approach to apply the equilibrium property rental values instead of the current conventional interest rates (KLIBOR, LIBORand EURIBOR). Beseides, he presents a new model for retail property rental values to benchmark.
The other research in 2007, which is done by Omran introduces an alternative mortgage instruments as replacement of the fixed rate mortgage tools. He proposes his model to be used for inflationary environments.
The price of Murabahah and Ijarah (two Islamic contracts), which were offered by Islamic financial institutions in Malaysia, has been investigated by Fitri in 2007. Based on study results, he recommends to Islamic financial institution to offer a competitive price for their product, if they want to compete with conventional financial institutions. The base lending rate (BLR) is thought of benchmark for pricing the products of conventional banks. As it has not been a Islamic pricing benchmark up to now, the Islamic banks to somehow employ the BLR for fixing the prices. Finally, he emphasizes the setting and designing a new approach for pricing benchmark for Islamic banks.
Professor Mirakhor in his research (1996) represents that cost of capital and investment rate would be calculated without determining a fixed and given interest rate, but just in a non interest economy. He proposes his model by Tobin Q approach. He mentions that equity financing could be considered as only reference for financial capital, but without resort to a fixed interest rate. Consequently, the index of the cost of capital only would be provided by an equity market, due to that fact that the market is equity-based.
Usman in 2001 based on his studies suggests that a benchmark pricing could be making a portfolio consist of all asset backed financial tools in markets(such as musharakah, ijarah, etc.)
If majority assets are in tangible form, its units can be sold and purchased on the basis
of their net asset value determined on a periodical basis. If the portfolio' assets are in intangible forms, an Index based on this portfolio can be created which could be sold and purchased. The bank and financial institutions are able to purchase these units if they have surplus liquidity or sell them if they require liquidity. This unit can be served as inter-bank benchmark and its value can consider as an index for asset pricing and determining the profit.
Based on the AAOIFI, Islamic financial institutions and banks are allowed to employ interest-based borrowing and lending like LIBOR (London Interbank Offered Rate) or KLIBOR (Kuala Lumpur InterbankOffered Rate) as an Index to value Islamic banking products and services.
On the basis of Uthmani's studies, many banks and Islamic financial institutions serve current interest rate (such as LIBOR) to calculate their profit rate. For instance, assuming the LIBOR is 5 percent, so they consider the rate of Islamic products (such as Murabahah) equal or higher than LIBOR. This practice is in consistent with shari'ah compliance and often is criticized, because profit rate is determined by interest rate. However, Othmani believes that if the profit of Murabaha is calculated through rate of interest as a benchmark, it does not contain Haram or prohibited actions.on the other word, if claims that benchmark is not a determinant factor, which causes a transaction to be Halal or haram. He represents an example to support his assertion. Assuming there are two sellers in a market, one sells liquor (Haram Business) and the other one sells soft drink (Halal business). If the latter consider the Liquor as benchmark, to pricing his products, it does not mean that his pricing is inconsistent with shari'ah. He concludes that using a conventional benchmark for pricing or determining profit is permissible by Islamic rules.
A new approach for computation of return rate was established by Bank Negara Malaysia in 2001. The offered methodology has been employed for determining distributable profits and the calculation of the rates of return to the depositors.
The characteristics of mentioned approach are as follow:
Standardize the calculation of rate of return in all financial institutions
Determining necessary standards in estimating the rates of return
Providing an effective standard of measurement to evaluate the performance of the Islamic financial institutions.
Nadeem Ul Haque and Abbas Mirakhor in their paper "The Design Of Instruments For Government Finance In An Islamic Economy" investigate some approaches of calculating rate of return. As well as they show some practical methods for designing the government finance instruments under Islamic rules.
Afterward, they represent some methods of Market Indices which is ranged from most simple to most complex. They state that each country, depend on its financial markets development level, is able to select one of the methods. They add that, for calculation of rate of return based on government paper, the estimation of risk premium, which has relationship with private default, must be eliminated.
Ebrahim, Muhammed Shahid and Khan, Tariqullah, in 2002 wrote a paper "On the pricing of an Islamic Convertible Mortgage for infrastructure project financing". Based on the paper for financing infrastructure projects in Islamic countries by a default-free transformable facility a new model was submitted.
Review and criticize Islamic pricing benchmark models
Some of the previous suggested Islamic benchmarks are follow:
Profit rate approach
This method was introduced by Dr Abd Hamid Al-Ghazali. He proposed a rational mechanisim which is compatible by economical nature in term of concept. He explain that , analyzing rate of profit can be lead to a market benchmark.
This model was
However, Dr. Hussain Hassan Shahatah criticized the profit rate model, he explain that, although the offered model is acceptable in term of concept and definition, the model is not practical completely. He presents that for some activates, which consist of some dependent projects, the determining of the profit is difficult. Because there is no unique approach for the calculation of profit and the accountants employ different techniques for computation of profit. Hence, he offers for reaching the Islamic benchmark, the first step is having specific definition for the profit.
Dividend approach
Dr. Muhamad Abdul Halim Umar define rate of dividend which the Islamic financial institution and banks distribute to depositors in Deposits and Investment Accounts as benchmark.
But, this model has been questioned by some Islamic economists. They claim that,there is no fundamental changes between the this approach and conventional approach. They state that the rate of profit is equal to the rate of interest in reality and in this model just the name of interest was replace by profit as well as it might lead people think the Islamic model just a way for cheating them.
Inter Islamic bank market model
Sheikh Muhammad Taqi Usmani for having an Islamic benchmark, formation of the market of inter Islamic banks is necessary. He states that, creation of assets pools (the most part of asset pool must be tangible) enable Islamic banks and financial institutions to purchase assets units if they have surplus of liquidity as well as sell them if they have shortage of liquidity. He explains that the value of unit is determined by the net value assets. This unit can evaluate the Islamic instruments like musharakah, ijarah and musharakah.
Statement of the Problem
The benchmark is very important in asset valuation because it serves as a point of refrence for pricing the riskless of financial securities. In conventional financial markets, interest rate on government securities is a popular benchmark. Using the rate is obviously not permissible. However, some believe that the current asset valuation for Islamic financial securities implicitly base on the same benchmark. The islamization of the conventional approach to capital asset evaluation is claimed to be "double haram" by some Islamic scholars. Nonetheless, there is still no comprehensive shari'ah bench mark is inevitable in degree, this research aim to explore and later to derive different benchmark models of asset pricing under different Islamic degree of permissibility.
Objective of Research
To examine the problem of capital asset valuation from the shari'ah perspective;
To propose the possible solution of capital asset valuation under different Islamic degree of permissibility
To apply the proposed solution using economic and financial data in Malaysia, where Malaysian Islamic financial system
Question of Research
What is the problem of capital asset valuation from the shari'ah aspect;
What is the solution of capital asset valuation under based on shari'ah principles;
