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Working With Islamic Finance – Mark Ross, CFA, CFP May 28, 2007

Posted by islamicfinanceaffairs in Uncategorized.
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Working With Islamic Finance – Mark Ross, CFA, CFP

Islamic finance refers to the means by which corporations in the Muslim world, including banks and other lending institutions, raise capital in accordance with Shari’ah, or Islamic law. It also refers to the types of investments that are permissible under this form of law. A unique form of socially responsible investment, Islam makes no division between the spiritual and the secular, hence its reach into the domain of financial matters. Because this sub-branch of finance is a burgeoning field, in this article we will offer an overview to serve as the basis of knowledge or for further study.

The Big Picture
Although they have been mandated since the beginnings of Islam in the seventh century, Islamic banking and finance have been formalized gradually since the late 1960s, coincident with and in response to tremendous oil wealth which, fueled renewed interest in and demand for Shari’ah-compliant products and practice.

Central to Islamic banking and finance is an understanding of the importance of risk sharing as part of raising capital and the avoidance of riba (usury) and gharar (risk or uncertainty). (To see more on risk, read Determining Risk And The Risk Pyramid and Personalizing Risk Tolerance.)

Islamic law views lending with interest payments as a relationship that favors the lender, who charges interest at the expense of the borrower. Because Islamic law views money as a measuring tool for value and not an ‘asset’ in itself, it requires that one should not be able to receive income from money (for example, interest or anything that has the genus of money) alone. Deemed riba (literally an increase or growth), such practice is proscribed under Islamic law (haram, which means prohibited) as it is considered usurious and exploitative. By contrast, Islamic banking exists to further the socio-economic goals of Islam.

Accordingly, Shari’ah-compliant finance (halal, which means permitted) consists of profit banking in which the financial institution shares in the profit and loss of the enterprise that it underwrites. Of equal importance is the concept of gharar. Defined as risk or uncertainty, in a financial context it refers to the sale of items whose existence is not certain. Examples of gharar would be forms of insurance, such as the purchase of premiums to insure against something that may or may not occur or derivatives used to hedge against possible outcomes. (To read more about insurance or hedges, see A Beginner’s Guide To Hedging, Understand Your Insurance Contract and Exploring Advanced Insurance Contract Fundamentals.) 

The equity financing of companies is permissible, as long as those companies are not engaged in restricted types of business – such as the production of alcohol, pornography or weaponry – and only certain financial ratios meet specified guidelines. [read more]

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