Articles on Islamic Finance

Risk Aversion And Islamic Financial Economics

Salman Ahmed Shaikh

Risk aversion is an observed behavior and there is empirical evidence that people generally are risk averse. By risk averse, we mean to say that people are willing to pay a higher risk premia than what is necessary to compensate for undertaking given risk level. In other words, people demand higher expected return for the risk taken than they actually should based on expected value of outcome in terms of wealth.

The question arises that if people are generally risk averse, are interest based investments and lending not the safest option to these people in which except from default risk, people are safe from fluctuations in payoffs and there is less uncertainty in payoffs.

Risk aversion is a natural behavior and may differ across individuals. Now, we discuss how Islamic economic framework incorporates such diversity in risk preferences.

First, there is no compulsion in Islam that all people have to be entrepreneurs. People who want to take lesser risk can gain skills and then provide the use of their skills in labor market for wage. People who want to have regular stream of income can invest in physical assets or financial securities that are derivatives of these physical assets and have intrinsic value like gold, silver, other metals and real estate. Furthermore, real estate investment trust, energy funds, commodity funds and equity funds are useful means of indirect investments using an intermediary. Partial ownership in an enterprise with limited liability is also allowed in Islam and hence, the risk is minimized in such investments as compared to having unlimited liability in proprietorship and general partnership. Appropriate portfolio management and diversification and exposure to risk based on one’s risk tolerance is allowed in Islam.

We know that Islam does not allow interest based financial intermediation. Thus, the predominant basis of financial intermediation shall be based on equity participation in an Islamic economic framework. Equity based financial intermediation increases upside participation in business growth. Additionally, the real ex post returns to equity investments had been more than the returns from investments in fixed income securities as reflected in the ‘equity premium puzzle’.

As against equity based intermediation, interest based financing and investments create distributional inequity by providing fixed compensation to one party and uncertain payoffs to the other party. This way the risk is avoided by one party (the lender), but it is not neutralized in the economy. Someone has to take entrepreneurial risk. What Islamic principles do is that rather than concentrating this risk taking with only one particular agent in the economy, Islamic principles encourage widespread risk sharing with equity participation. This way the distributional justice is ensured as the payoffs are linked with productive enterprise and are shared mutually in a just manner.

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