The first chapter provides an epistemological analysis of conventional finance and Islamic finance. Epistemological questions are important because of public perceptions that Islamic finance industry has developed over the recent years on the platform of the conventional financial system. The aim was to address “market failures,” where demand for Sharīa'h-compliant products was not satisfied by conventional financial services. This chapter traces the roots of the ideal conventional system back to Adam Smith's The Theory of Moral Sentiments and The Wealth of Nations. The rigorous model of general equilibrium by Kenneth Arrow and Gérard Debreu embodies Smith's vision of a competitive economy and represents a theoretical framework for risk sharing. Within an ideal Islamic financial system, the full spectrum of risk–return profiles would be also covered by risk-sharing instruments that allow for optimal risk allocation.
This chapter also describes the main institutional features of Islamic finance and argues that there are three central threads running through the ideal conventional and Islamic financial systems: These financial systems are consistent with human nature, they are based on general rules of morality and justice, and they are conducive to optimal allocation of resources through risk sharing. It is important that the reader gains an essential understanding of these epistemological issues, because they have some important bearing on the discussion in subsequent chapters about the analytics of finance, corporate finance, derivatives trading, financial regulation, and much of the remainder of the book.
Chapter 2 is a natural extension of the epistemological analysis, given the foundation of Islamic finance on Islamic virtues, and the moral and ethics systems underlying Adam Smith's vision of competitive economy. The chapter discusses the importance of ethics, and considers a virtue theory of ethics based on the Golden Rule widely accepted across major philosophies, religions, and traditions. The focus is also made on the exposure of Islamic finance in practice to the same ethical issues faced in conventional finance, and the need to reconsider ethical teachings in the areas of corporate governance, financial engineering, economic development, and corporate social responsibility.
In light of the fundamental understanding of the relation between Islamic finance and conventional finance, ethical content, and risk-sharing principle in the two opening chapters, Chapter 3 is, in contrast, technically more demanding. It presents a review of the analytics of finance, focusing on the theory of interest, the concept of time value, utility theory, optimal consumption and investment choices, and market efficiency. These fundamental concepts shall facilitate a better understanding of the cornerstones of finance theory, including portfolio selection theory, capital asset pricing model, arbitrage pricing theory, capital structure theory, efficient markets hypothesis, and option pricing theory. The implications of these theoretical advances are also discussed in relation with the concept of risk-sharing, which underlies Islamic finance. The analysis is not limited to the prohibition of ribā, as it also provides some explanation about the economic rationale behind the impermissibility of lottery purchases and their distinction from permissible forms of investment into risky assets. The focus on risk sharing puts into perspective not only the linkage between the financial sector and the real economy, but also the existence of alternative solutions to the central contradiction of capitalism as argued by Thomas Piketty's Capital in the Twenty-First Century. As with Chapter 1, it is also important that the reader gains a solid understanding of concepts discussed in Chapter 3, which can be regarded also as another opening chapter for the analytical approach in discussing issues related to corporate finance, derivatives, securitization, and structured finance in subsequent chapters.
Chapter 4 builds on the knowledge and understanding gained in the previous chapter about the behavior of agents in a competitive economy governed by general rules about utility maximization. The focus is made on firm behavior in a dynamic Islamic economy, where the profit maximization postulate is discussed in relation to equity. This chapter explains the usefulness of the profit maximization postulate as an efficiency criterion in the nascent development of a theory of the firm in Islamic economics. It presents a theoretical construct of equity and allocative efficiency and considers a distributive rule based on the profit-sharing principle that achieves both efficiency and equity. This analysis is also important from the perspective of social and economic justice that underlies both the conventional and Islamic financial systems, as discussed in Chapter 1, because it crucially demonstrates that profit maximization does not necessarily mean a sacrifice of equity.
Chapter 5 draws also upon the analytics of finance discussed in Chapter 3. It provides some explanation about equilibrium pricing models and theoretical issues in corporate finance. The chapter focuses on the capital asset pricing model and arbitrage pricing theory, showing that in the absence of risk-free assets, models of asset pricing based on single or multiple risk factors are consistent with the defining principle of risk sharing in Islamic finance. The fundamental message that no reward should be expected without bearing undiversifiable risk is thus shared with Islamic finance. Theoretically, there should be no risk premium for assets that have no correlation with the real economy. However, the only market that has no correlation with the market portfolio or other risk factors and indeed no correlation with the rest of the economy is the market for risk-free assets. Debt plays therefore an important role in shaping the financial system.
Thus, Chapter 5 also explains Modigliani's and Miller's theorems, including the proposition that debt–equity policy is irrelevant for firm valuation. This is to some extent similar to Ricardian equivalence, which suggests that funding government expenditure with tax levies or government bonds does not affect household consumption and capital formation. The derivation of the debt–equity irrelevance theorem is made under strict assumptions, such as complete markets and the absence of agency costs and asymmetric information (gharar). It is the tax deductibility of interest payments that provides strong incentives for debt over equity financing. Thus, the nature of the firm is intrinsically related to its financing modes.
Chapter 6 considers the issue of risk hedging and the scope of financing engineering and derivatives in Islamic finance. Whereas the previous chapters focus on the essence of risk sharing, this chapter centers on risk-hedging instruments. It explains the properties of derivatives securities, including forward, futures, and options contracts, and their theoretical pricing. The application of option pricing theory to the valuation of financing instruments can provide useful insights, for instance, about the conceptual difference between debt and ijārah. Option pricing theory recognizes a risk-sharing element in ijārah but not in debt-financing, which may constitute the economic rationale behind the permissibility of the former and prohibition of the latter in Islamic finance.
This chapter offers also some explanation, rather detailed, about the use of futures and options in relation with the underlying asset. The distinction is made between futures and options strategies for risk hedging and speculative purposes. The analysis