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Islamic Finance Basics – What is Murabaha, Ijara, and musharakah/mudarabah? May 25, 2007

Posted by islamicfinanceaffairs in Uncategorized.

Islamic Finance Basics

article is intended as an introduction to some of the key types of
Islamic contracts and how they are applied to provide alternative
Islamic financing options.

Murabaha, Ijara, and musharakah/mudarabah
contract types form the basis of a variety of Shariah compliant
substitutes to conventional corporate and trade financing solutions
today. The basic premise of Islamic finance lies in the need to
eliminate both interest (Riba) and uncertainty (Gharar) from financial
The following sections gives the most basic outline of the key types of Islamic contracts applied today.

is often referred to as ‘cost-plus financing’ and frequently appears as
a form of trade finance based upon letters of credit. In its simplest
form, this contract involves the sale of an item on a deferred basis.
The item is delivered immediately and the price to be paid for the item
includes a mutually agreed margin of profit payable to the seller. In
this contract, the market cost price (true cost) of the item is shared
with the buyer at the time of concluding the sale.
According to Tarek al-Diwany (Islamic-finance.com), Murabahah
is a form of ‘trust sale’ since the buyer must trust that the seller is
disclosing his true costs. After discussing the true costs, a profit
margin may be agreed either on a percentage of cost basis or as a fixed
amount. It is very important to remember that the amount of profit
earned in this transaction is not a reward for the use of the
financier’s money. In other words, a financier cannot take money if
he/she does not perform any service other than the use of his/her money
for the transaction. Such an occurrence would cause this type of deal
to resemble the charging of interest. Today, Murabahah is used most to assist short-term trade transactions.

The use of leasing is represented by the Ijara
contract in Islamic law. The contract represents a transaction in which
a known benefit (usufruct) associated with a specified asset is sold
for a payment. In the course of this sale of usufruct, ownership of the
asset is not transferred – the bank maintains ownership of the asset.
The Ijara contract can be designed to return the fixed assets
to the lessor at the end of the lease period, in which case the lease
takes on the features of an operating lease in which the bank takes
title of the asset at the end of the lease term. The other mechanism
would be to allow the lessee to agree, at the outset, to buy the assets
in question at the end of the lease period. The lease here takes on the
nature of a hire purchase known as ijara wa iqtina
(literally, lease and ownership). In simple terms, this means that the
asset can be sold to the lessor at the end of the lease.

Mudarabah and Musharakah
Since the inception of Islamic economic theory and its outgrowth into
Islamic finance, scholars have lauded Mudarabah and Musharakah
as the ideal forms of permissible contract in Islamic thought. The
basic reasoning is that these contracts pool resources and expertise as
well as spread the inherent risk in a project among the various parties
involved. Here we present some salient features of both contract types.

In the Mudarabah model, a mudarib or entrepreneur usually provides management expertise which is treated as a form of capital. The investor is known as the rabb al-mal. The share of expected future profits between the mudarib(s) and the investor(s) is agreed at the outset in any ratio mutually agreed to by the parties involved. The rabb al-mal
bears all losses of invested assets (be they cash or other forms of
capital). In the case there is more than one investor losses are to be
shared according to the investment share of each investor. The
entrepreneur must not bear any of the loss(es) attributable to invested
capital. The entrepreneur is not allowed to take any form of
remuneration other than profit-share. Technically, the entrepreneur has
no recompense for his efforts unless the project is profitable; unless
there is a guaranteed wage.

The Musharakah
model is essentially a sharing model. Parties involved in a partnership
arrangement contribute funds to and have the right to exercise
executive powers in that project in accordance with an agreed formula.
All partners are obligated to contribute capital to the venture. These
contributions can be subject to profit sharing in a ratio mutually
agreeable to all the investing parties. Just as with mudarabah,
a fixed amount of payment can not be agreed at the outset. As with most
joint ventures partners must receive regular accounting information as
well as other information on business activities.

Source: Ansar Group

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