Salman Ahmed Shaikh
One issue that arises in using asset pricing models developed in mainstream financial economics literature is that can one use these asset pricing models in the security analysis of Islamic equity investments. It must be acknowledged that asset pricing models do not prescribe a particular rate of return to an investment project or in financial contracts. They are just an ex-ante means of analysing investment options available to the investors. Hazny and Yusof (2012) discuss the assumptions of Markowitz’s Mean Variance Analysis and CAPM from the Shari’ah perspective and conclude that some of these assumptions are simplistic only for the purpose of facilitating analysis. Rosley (2005) and Hazny and Yusof (2012) argue that Islamic principle of Al Ghunm bil Ghurm means that returns are justified by taking risks. Furthermore, Al-Kharaj bil Dhaman bases the entitlement to profits on corresponding liability for bearing losses. These maxims are broadly consistent with the positive ex-ante relationship between risk and return in investment literature. In addition to that, divisible investments are possible in real Islamic financial assets through Sukuk, Islamic mutual funds, and Shari’ah compliant common stocks. Thus, the assumption of marketability and divisibility of investment assumptions are also tenable.
Other assumptions which apparently look conflicting with Shari’ah can be modified for bringing consistency with Islamic capital market norms and practices. For instance, the risk-free rate can be replaced with Sukuk profit rate or to the benchmark with which Sukuk profits are linked. Iqbal (2002) argues that the assumption of short selling might be solved by assuming complete markets. In recent developments in Islamic capital markets, Bai Salam, Bai Arboun and Ready Buy Deferred Sale products have facilitated Islamic investors and Islamic capital markets to reach equilibrium price level through liquid transaction possibilities in over-priced and under-priced stocks.
In conventional finance, the interest rate on sovereign debt serves as a proxy for risk-free rate (Askari et al. 2011). Hanif (2011) suggests that inflation rate can be included in place of the risk-free rate in Islamic security analysis. Nonetheless, Ayub (2007) cites the Fiqh Academy of the OIC which has ruled out indexation of a lent amount of money to the cost of living indicators. Furthermore, in actual practice, there are no products in either conventional finance or Islamic finance in Pakistan which guarantee inflation-protected returns.
El Ashker (1987) suggests using Zakāt rate in place of risk-free rate. As per this proposal, investors would demand at least 2.5% return to keep intact their net value of the investment after payment of Zakāt. A question arises that can the investment companies or the government offer such a particular return on investment. As per Islamic injunctions, Zakāt is due on Muslims who own assets and resources equal to at least the minimum value of Nisāb. Risk-free rate implies return on safe investments; whereas, Zakāt is a religious obligation to pay a part of wealth and produce provided that the aggregate sum of wealth in ownership exceeds the value of Nisāb. Zakāt on wealth is on the stock of Zakāt eligible resources rather than on flow.
In searching for a better alternative for risk-free rate in Islamic capital markets, the return offered by the government on its sovereign Sukuk could be a suitable choice. Financial claims to the government have the highest security in terms of default risk. For market competitiveness, the ex-post return on Sukuk and interest based Treasury securities can be closely linked; however, the underlying structure of the transaction is different in both. Treasury bills involve loaning of money on interest. On the other hand, the government pays rent on the assets which are owned by investors in the commonly used Ijarah Sukuk structure. Investors owning a proportionate share of the assets get periodic returns in the form of rents. In fact, Sukuk are safer than Treasury bills for investors since investors have recourse to the real assets underlying the Sukuk. Schoon (2011) argues that as sovereign Sukuk issuance rises across countries, the rate of return on Sukuk solves the problem of the alternative of risk-free rate in security analysis for Islamic investors.
On the other hand, Hakim et al. (2016) argue that Zero-beta CAPM does not require a security paying fixed return. Thus, Zero-beta CAPM could also be applicable for Islamic capital market. On the other hand, the multi-factor models which use internal factors of the company to explain ex-post returns are empirical models based on facts without strong assumptions. The choice of factors in multi-factor models depends on observed relationships between internal factors of the company and the ex-post realized returns on stocks. By delinking interest as fixed return on investments, Islamic risk-sharing philosophy in financial investments is more aligned with the approach of focusing on internal factors of the company for financial decision making. Factors which represent financial standing of the company in terms of capitalization, book value to market equity, profitability and investment style focus on the nature and quality of companies in which investments are contemplated. Therefore, some of the mainstream asset pricing models can be used for security analysis in Islamic equity investments from the Shari’ah perspective. However, the choice of particular asset pricing models in practical use must depend on their ability to better explain returns on Shari’ah compliant stocks.
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