Humanomics

An Islamic capital asset pricing model

Tarek H. Selim

Article information:

Downloaded by INCEIF At 23:43 06 November 2016 (PT)

To cite this document:

Tarek H. Selim, (2008),"An Islamic capital asset pricing model", Humanomics, Vol. 24 Iss 2 pp. 122 - 129
Permanent link to this document:
http://dx.doi.org/10.1108/08288660810876831
Downloaded on: 06 November 2016, At: 23:43 (PT)
References: this document contains references to 15 other documents.
To copy this document: permissions@emeraldinsight.com
The fulltext of this document has been downloaded 2142 times since 2008*

Users who downloaded this article also downloaded:

(2007),"A review of capital asset pricing models", Managerial Finance, Vol. 33 Iss 10 pp. 821-832 http://
dx.doi.org/10.1108/03074350710779269
(2008),"Is Capital Asset Pricing Model (CAPM) the best way to estimate cost-of-equity for the lodging
industry?", International Journal of Contemporary Hospitality Management, Vol. 20 Iss 2 pp. 172-185 http://
dx.doi.org/10.1108/09596110810852159

Access to this document was granted through an Emerald subscription provided by emerald-srm:517822 []

For Authors
If you would like to write for this, or any other Emerald publication, then please use our Emerald for
Authors service information about how to choose which publication to write for and submission guidelines
are available for all. Please visit www.emeraldinsight.com/authors for more information.

About Emerald www.emeraldinsight.com

Emerald is a global publisher linking research and practice to the benefit of society. The company
manages a portfolio of more than 290 journals and over 2,350 books and book series volumes, as well as
providing an extensive range of online products and additional customer resources and services.
Emerald is both COUNTER 4 and TRANSFER compliant. The organization is a partner of the Committee
on Publication Ethics (COPE) and also works with Portico and the LOCKSS initiative for digital archive
preservation.
*Related content and download information correct at time of download.

The current issue and full text archive of this journal is available at
www.emeraldinsight.com/0828-8666.htm

An Islamic capital asset

pricing model

H
24,2

Tarek H. Selim
122

Department of Economics, The American University in Cairo, Cairo, Egypt

Abstract

Downloaded by INCEIF At 23:43 06 November 2016 (PT)

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 lenders 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 papers 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.
Keywords Islam, Economics, Finance, Asset valuation, Partnership
Paper type Research paper

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.

Humanomics
Vol. 24 No. 2, 2008
pp. 122-129
# Emerald Group Publishing Limited
0828-8666
DOI 10.1108/08288660810876831

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

Downloaded by INCEIF At 23:43 06 November 2016 (PT)

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 alsalam 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

An Islamic
capital asset
pricing model
123

H
24,2

Downloaded by INCEIF At 23:43 06 November 2016 (PT)

124

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 Taymias 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
FischerHirschleifer 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-to-book 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:



M
RF

I RF
I R
1
R
where

I

CovRI ; RM
VarRM

I is the expected return on an

In the above formulation of the CAPM methodology, R

M is the expected return on the
individual investment (average return on investment), R
market (average return on the market), RF is the risk-free rate (minimum guaranteed rate
of return with minimum risk), Cov (RI, RM) is the covariance or correlation coefficient
between the returns on a specific investment and the returns on the market, Var (RM) 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.

Downloaded by INCEIF At 23:43 06 November 2016 (PT)

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 0 RI > 0 and U 0
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:

M
RF f E
PM R

I RF
f E
R

An Islamic
capital asset
pricing model
125

then

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
^ I given by:
require a rate of return R
^ I 1
E RF K 
R
K

Figure 1.
Graphical illustration of
the conventional CAPM

H
24,2

126

where K is the total amount of investment in a certain project, 1
 is the investors

share based on the PLS contract, and E RF K  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:
^ I > RI
R

It can be shown[2] that equation (6) holds true, if and only if:
1



 E
RF K

E
0<<1

Downloaded by INCEIF At 23:43 06 November 2016 (PT)

 <

7
8
9

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 lenders 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  0 RF < 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:
^ I RI
R

10

then it can be easily shown[4] that:

1


E RF K
 E RF K

11

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,

^I < 1

12

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?

Downloaded by INCEIF At 23:43 06 November 2016 (PT)

I will attempt here several reasonings. The first reasoning is related to diminishing
marginal productivity of capital. Suppose you have two stocks of capital K1 and K2.
Then, taking r(K1) and r(K2) as their returns: r(K1) r(K2) > r(K1 K2) 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:

^ 1

13

The imposed constraint in equation (13) is a zero risk-free rate RF 0. Thus, when
there are no opportunity costs of capital based on no forgone interest, the sum of
lenders 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]:


RF K
RF K
1

^  1

14


E
E
After maximizing returns, an investor would like to minimize his risk:
Max
Min

^ I 2 RI
^
R

^RF

15

Given a
^ corresponding to maximum returns as in equation (14), what is the optimal

RF that minimizes
^?

An Islamic
capital asset
pricing model
127

H
24,2

To minimize
^ relative to RF, we need to minimize:



RF K
^
Min
1

E
RF

16

This yields[6]:

128

RF 0

17

Downloaded by INCEIF At 23:43 06 November 2016 (PT)

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 riskshares and not in risk-returns, i.e. the sum of lenders 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:

M
RF =1
0. With minor mathematical manipulation, this yields

I
RF =
I
0 R
R
the CAPM equation (1).
^ I > RI with the left hand side the equivalent Islamic rate of
2. The required inequality is R
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 RF K=K > RF
E =K
(since the actual investors share of profits is 1
 ). This leads to
1
 > RF K
E =E RF K, hence,  < E 1

=E
RF K. Taking E as
common and simplifying we get  < 1

=1
RF K=E . Knowing that RF 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
RF 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 equations (10) and (7), by direct comparison, it is seen

that:1
E RF K RF K
E , hence proving equation (11).
5. From equations (11) and (13),  1

^=1
RF K=E .
6. Let the
^ that maximizes returns be given by an investors rational decision in equation
(14). Then,


RE K
Min
^ 1

E
RF j
@
^ RF K

0
@
E
2

Downloaded by INCEIF At 23:43 06 November 2016 (PT)

and @ 2
^=@ f K 0  > 0; hence, RF 0 for K > 0 and K 0  > 0.

References
Dubai Islamic Bank (2005), Weekly Report, January.
El-Gamal, M.A. (2001), An economic explication of the prohibition of riba in classical Islamic
jurisprudence, working paper.
Fama, E. and French, K. (1992), The cross-section of expected stock returns, Journal of Finance,
Vol. 47, pp. 427-660.
Fama, E. and MacBeth, J. (1973), Risk, return and equilibrium: some empirical tests, Journal of
Political Economy, Vol. 8, pp. 607-36.
Fischer, I. (1930), The Theory of Interest, Augustus M. Kelly, New York, NY.
Fischer, I. (1965), The Theory of Interest (a Reprint), New York, NY.
Hirschleifer, J. (1958), On the theory of optimal investment decision, Journal of Political
Economy, Vol. 66, August.
Jomo, K. (1992), Islamic Economic Alternatives, Macmillan, London.
Lintner, J. (1965), Security prices, risk, and maximal gains from diversification. Journal of
Finance, December.
Lotfy, A. (2005). The foundations Islamic finance: a comparative study with conventional
methods, research paper (unpublished), Economics Department, The American
University in Cairo.
Markowitz, H. (1997), Travels along the efficient frontier Dow Jones Asset Management, May/June.
Ross, S., Westerfield, R. and Jaffe, J. (1999), Corporate Finance, 5th ed., Irwin McGraw Hill,
pp. 269-70.
Sharpe, W. (1964), Capital asset prices: a theory of market equilibrium under conditions of risk,
Journal of Finance, September.
Further reading
Ibn Taymia, Ahmed (n.d.), Al-Hesba Fe El-Islam, Al-Sonna Library, Egypt.
Ibn Taymia, Ahmed (n.d.), Al-Siasa Al-Shareia Fe Eslah, Al-Rae We Al-Raeia, Dar Al Shaab,
Egypt.
Corresponding author
Tarek H. Selim can be contacted at: tselim@aucegypt.edu
To purchase reprints of this article please e-mail: reprints@emeraldinsight.com
Or visit our web site for further details: www.emeraldinsight.com/reprints

An Islamic
capital asset
pricing model
129

Downloaded by INCEIF At 23:43 06 November 2016 (PT)

This article has been cited by:

1. GharbiLeila Leila Gharbi KhamoussiHalioui Halioui Khamoussi Department of Accounting, Higher
Institute of Finance and Taxation of Sousse, Tunisia Department of Accounting, University of Imam
Muhammed at Riyadh, Riyadh, Saudi Arabia . 2016. Fair value and banking contagion. Journal of Islamic
Accounting and Business Research 7:3, 215-236. [Abstract] [Full Text] [PDF]
2. GharbiLeila Leila Gharbi Department of Accounting, Higher Institute of Finance and Taxation of Sousse,
Sfax, Tunisia . 2016. A critical analysis of the use of fair value by Islamic Financial Institutions. Journal of
Islamic Accounting and Business Research 7:2, 170-183. [Abstract] [Full Text] [PDF]
3. Bibliography 359-382. [CrossRef]
4. M.G. Nthoesane, J.W. Kruger. 2014. Market reaction to chief executive officers (CEOs) appointments
on Johannesburg securities exchange (JSE): stock price and volume approach. Journal of Economics and
International Finance 6:5, 91-102. [CrossRef]
5. Mohamad Hafiz Hazny, Haslifah Mohamad Hashim, Aida Yuzi YusofRevisiting Markowitz's Mean
Variance analysis: A review from shariah perspective 1-6. [CrossRef]