Saturday, November 20, 2010

Basic Terms & Concepts in Islamic Finance

The Islamic finance industry is full of terms and concepts that, while generally familiar to anyone with some experience in or knowledge of finance, are still difficult to understand. The use of Arabic names can be confusing to non-Arabic speakers. For a more detailed description of Islamic finance terms and concepts, I would recommend the Islamic Finance Wiki, hosted over at  Any suggestions on how to improve this "Basics of Islamic Fnance" piece should be dropped in the comments or emailed to me at

Basic Concepts

  • Riba: Riba is commonly equated with interest, although it is not an exact equivalent. It literally means 'increase' and the prohibition was originally prohibiting the pre-Islamic practice of doubling a debt in exchange for extending the maturity (riba al-nasiyah). The other main form of riba is an exchange where one commodity is exchanged for an unequal amount of the same commodity (riba al-fadl). For example, if one party gives one pound of high quality dates in exchange for two pounds of lower quality dates. The hadith concerning this type of exchange says that to avoid riba, the high quality dates should be sold for cash and then the cash should be used to purchase the lower quality dates. For the roots of the prohibition of riba and interest, there is a brief article on
  • Gharar: Gharar is generally described as impermissible contractual uncertainty. One example of gharar is a conventional insurance contract. In exchange for a series of insurance premiums, the insurer agrees to make a specified payment to the insured. This is considered to be impermissible because the payment of premiums is being made in exchange for payment based on the occurrence of an uncertain event.
  • Maysir: A contract is prohibited where the contract is based on an uncertainty where one party wins and the other party loses. For example, in a conventional options transaction, one party pays the other for the right to buy a security at a specified price before the expiration date. There are only two outcomes: the price is 'in the money' and the contract is exercised or the price is 'out of the money and the contract expires worthless with the option writer keeping the premium paid.
Basic Contracts
  • Murabaha: One party buys an asset and sells it to the other party for the cost plus a markup. The repayment is often deferred with either regular payments for a specified term or payment due at a specified date in the future. For example, if I want to buy a car, an Islamic bank will buy the car for $10,000 and sell it to me for $12,000. I will be responsible to pay the bank $1,000 per month for 12 months. If the car is destroyed or defective after the bank buys it but before I take possession, it is the responsibility of the bank.
  • Ijara: One party with ownership of an asset leases it to the other party for a defined amount per month, quarter or year. The lessor (owner) is responsible for maintenance and upkeep of the asset subject to the lease. The lease can cover a specified period where the owner retains ownership after the lease or it can be a lease to own or end with ownership being transferred to the lessee (ijara wa iqtina). For example, if I want to buy a home that costs $100,000, a bank will buy the house and lease it to me for $600 per month for 30 years and at the end of the lease, I will own the house (assuming financing cost of 6% per annum).
  • Istisna'a: One party wishes to finance the construction of a custom-designed asset. The project is created according to pre-designed specifications and the other party receives payments on a pre-designed schedule. The payment schedule is flexible and can be regular, due on delivery or paid over time after delivery. The schedule is often designed to match a conventional project financing schedule. A parallel istisna'a is designed where a third party steps between the two parties and the party manufacturing the asset is paid during manufacture with progress payment and the party buying the asset making regular payments to the third party in equal monthly payments. For example, if I want a piece of machinery built according to my specifications, I will contract with a bank to contract with a manufacturer to build the machinery according to my specs. The bank will make payments during the construction process to finance the parts for the machinery. When the machinery is completed, the bank will deliver it to me and I will pay the bank in monthly payments the amount the bank sells it to me for a greater amount than the bank paid the manufacturer.
  • Salam: One party purchases a commodity from another party with payment made at the time the contract is signed and with delivery of the commodity at a specified date in the future. For example, a farmer needing financing for his crops will sell his 10,000 bushels of wheat to a financier for $6 per bushel. The financier will provide the farmer with $60,000 and on a specified date after harvest, the farmer will deliver the 10,000 bushels of wheat.
  • Mudaraba: One party (rabb ul-maal) provides financing to another party (mudarib) who is responsible for managing the business. The parties split the profits from the business in a pre-specified ratio. The rabb ul-maal is responsible for all losses, while the mudarib loses only his work put into the business, except for cases of fraud. For example, if I want to open a business selling mangoes but I need capital I would approach a financier. He would provide me with $1,000 in capital to buy mangoes and we agree to share profits 60% to the financier and 40% to me. If in the first year, I use the capital to sell mangoes and make $250 in profit. I would keep $100 and pay $150 to the financier. If the business was not profitable and went out of business, I would lose the work I put in and the financier would lose his $250 investment.
  • Musharaka: Like a mudaraba, the contract is one of a joint-venture. However, in addition to the contribution from the financier, the entrepreneur also invests his own money. All profits and losses are shared . The profits can be shared according to any pre-agreed ratio while losses must be split in accordance with the ratio of capital contributed. Unlike a mudaraba where one party contributes capital and the other manages the business, both parties contribute capital and both are able to participate in the management of the business. For example, if I want to start a business selling mangoes, a financier will provide me with $750 in capital and I will contribute $250. We agree to share profits 60% to the financier and 40% to me. If the business generates a profit of $250, I keep $100 and pay $150 to the financier. If the business was not profitable and went out of business, I would lose my $250 and the financier would lose $750.
  • Wakala: One party (the wakil) with excess funds hires an investment firm as agent (muwakkil). The muwakkil invests the funds on behalf of the wakil and is paid a fee for the service, while the wakil receives profits and is responsible for bearing any losses. For example, if I had $1 million to invest, I would hire an investment manager for $10,000 per year. He would invest the $1 million and be paid his wakala fee of $10,000 per year regardless of the investment results.
  • Sukuk: This is an instrument similar to a bond. There are many forms of sukuk (e.g. mudaraba, musharaka, ijara, hybrid). Each form of sukuk is managed differently, but in general, the structure takes its underlying form where the role of financier is taken by a special purpose vehicle (SPV)--an entity set up specifically for the transaction--which issues certificates representing proportional interests in the SPV. The underlying structure functions as normal but the profits or losses accruing to the financier are passed through by the SPV to the investors in accordance with their share of the SPV.
General Prohibitions
  • Alcohol
  • Tobacco
  • Pornography
  • Pork products and related producer
  • Riba-based industries (e.g. banks, brokerages, conventional insurance)
  • Gambling
  • Weapons
  • Gold and silver trading on a deferred basis
  • Futures
  • Options
  • Derivatives
  • Companies with a high reliance on debt, those that hold cash in interest-bearing interest instruments, those that use their accounts receivable as collateral for loans, those with high interest expense or income and those with material income from prohibited activities.

No comments: