Basic of Islamic Finance

Basic of Islamic Finance

Islamic finance represents finance activity that is consistent with the principles of Islamic Law or the Shariah, which prohibits unethical, immoral, and speculative activities including interest (riba), gambling (maysir), and uncertainty (gharar). The basic principle of Islamic Finance is based on risk-sharing which is component of trade rather than risk-transfer which is seen in conventional banking. Islamic Finance introduces shariah compliant contractual instruments in Islamic financing. They are Murabaha (Cost-plus financing), Ijarah (Lease financing), Mudaraba (Partnership financing) and Musharaka (Equity financing).

Murabaha (Murabahah)

Murabahah is often referred to as ‘cost-plus financing’ and frequently appears as a form of trade finance based upon letters of credit. In its simplest form, this contract involves the sale of an item on a deferred basis. The item is delivered immediately and the price to be paid for the item includes a mutually agreed margin of profit payable to the seller. In this contract, the market cost price of the item is shared with the buyer at the time of concluding the sale. Murabahah is a form of ‘trust sale’ since the buyer must trust that the seller is disclosing his true costs. After discussing the true costs, a profit margin may be agreed either on a percentage of cost basis or as a fixed amount. It is very important to remember that the amount of profit earned in this transaction is not a reward for the use of financier’s money. In other words, a financier cannot take money if he/she does not perform any service other than the use of his/her money for the transaction. Such an occurrence would cause this type of deal to resemble the charging of interest. Today, most Murabahah is used to assist most short-term trade transactions.

Ijara (Ijarah)

The use of leasing is represented by Ijara contract in Islamic Law. The contract represents a transaction in which a known benefit (usufruct)...