Financial Markets and Institutions

MBA Financial Management

Islamic Financial Instruments

Daniel Gebreyohannes Woldu

Submission Date: 7/30/2021

 Table of Content

Musharakah………………………………………………………………………………....3

Mudarabah…………………………………………………………………….…………… 4

Murabahah…………………………………………………………………….…………….5

Sukuk………………………………………………………………………………………..6

Ijarah………………………………………………………………………………………..7

Takaful……………………………………………………………………….……………..8

Istisna’s……………………………………………………………………………………..9

Bay’ Al- Salam………………………………………………………………………..……10

Tawarruq………………………………………………………………………………… ...11

Wakalah…………………………………………………………………………………….12

Reference……………………………………………………………………………………13
Musharaka
Meaning and Definition

Musharaka is an Arabic term that means “Sharing”. Musharakah is defined as an agreement between two
or more persons to carry on a certain business with the intention of sharing profits through joint
investment. Musharaka comes from the Arabic shirkah, implies partnership in a venture and can be
defined as a form of partnership whereby two or more persons combine either their capital or labor
together, to share the profits, enjoying similar rights and liabilities (Kettell, 2011). It can take the form of
a “mufawada”, meaning an unlimited, unrestricted, and equal partnership in which the partners are treated
equally in terms of capital, management, and disposal rights.

Usage

Musharaka is primarily utilized to finance commercial and residential real estate developments. And it
has a wide range of applications in service sectors, Small business, domestic trade, Import for Goods, and
agriculture.

Advantage and disadvantage

Capital-Due to the nature of the business, the partners will fund the business with startup capital. This
means that the more partners there are, the more money they can put into the business, which will allow
better flexibility and more potential for growth. Flexibility- a partnership is generally easier to form,
manage and run. Partners shared responsibility and decision making of the running of the business.

Risks

One source of concern is the possibility that the active partner in a Musharaka will pass on company
losses to the funding bank or institution (Alrifai, 2015; Kettel,2011). The loss will subsequently be passed
on to depositors by the financing bank or institution. Depositors who are afraid of losing their money will
avoid putting their money in banks or financial institutions that provide this sort of financing, therefore
their money will either sit idle or be used in transactions outside of Islamic banking channels.
Mudarabah (Investment Partnership)
Meaning and Definition

The word Mudaraba comes from the Arabic term darb fi al-ard, which means those „who journey through
the earth seeking the bounty of Allah‟ (Kettell. B, 2011). Mudarabah is a sort of equity-based partnership
contract that is known as trust financing and is one of the important profit and loss sharing contracts in
Islamic finance. Mudarabah is referred to as a passive partnership because one individual simply
contributes funds and does not participate in the management of the business. It's similar to the
conventional limited partnership agreement, in which one partner invests capital and the other provides
management expertise, with profits shared according to an agreed-upon ratio. (Kettell, 2011; Iqbal,
Mirakhor, 2011).

Usage

Mudarabah is utilized to fund short duration projects, trade and financing of commerce and to fund real
estate projects and endowments. It is also used to finance the investment projects of companies.

Advantage and disadvantage

The investor and working partner decide to enter a business venture. The working partner is responsible
for running and managing the business using his expertise, while the investor provides the funds. One
major drawback of the Mudarabah form of finance is that there is no legal framework in the contemporary
commercial laws of most countries, especially non-Islamic countries, which can be relied upon in the case
of a dispute.

Risks

Mudarabah is a high-risk mode of finance ( Kettell.B, 2011). It's so risky that traditional bankers can't
imagine doing it. This is because, under this system, the bank is only supposed to give capital to the client
based on his honesty, skill, and excellent management. The bank is putting not only its projected return
on investment, but also its capital at risk. This high degree of moral hazard is present in the traditional
form of Mudarabah.
Murabahah (Cost Plus Sale or Mark-up financing)
Meaning and Definition
Murabahah is one of the most widely used Islamic finance instruments (Alrifai, 2015). The
instrument is used for trade financing. Cost-plus financing is also referred to as deferred payment
financing, which goes back to the concept of the time value of money.
Usage
According to Ernst et al. 2013, Murabahah is used for purchasing automobiles, electronics, land,
buildings, and machines. Murabahah has become the most widely utilized Islamic financial
instrument since the birth of contemporary Islamic banking in the 1970s, according to Alrifai
(2015), mainly due to its simple structure and ease of use. Shanmugam and Zahari (2010) stated
that Murabahah financing is mainly used to finance raw materials, manufacturing equipment, and
consumer goods.

Advantage and Disadvantage

One of the benefits of Murabahah is that it is not an interest-bearing loan, which is referred to as
riba. Murabahah is a sharia-compliant method of credit selling. The contract is similar to a rent-
to-own arrangement in that the intermediary retains ownership of the property until the loan is
fully paid off.
The fundamental disadvantage of Murabahah is that it is not always applicable. It cannot be
utilized, for example, when the price of the good cannot be determined.
Risk
The finance provider does not bear the risk for the entire period of the contract. The risk exists
only during the time when a spot sale is made and until the products are delivered to the
customer. For the remaining period of the contract, the amount of financing plus the agreed
mark-up is in the nature of debt and is risk-free, given that security is normally provided.
Sukuk (Markup-based bonds)

Meaning and Definition

The word Sukuk is derived from the Arabic word sakk, meaning“certificate” and it reflects
participation rights in the underlying assets (Iqbal; Mirakhor, 2011). The concept behind Sukuk
is simple, the ban of interest virtually eliminates the possibility of pure debt security, but an
obligation tied to the performance of a real asset is permitted. In another word, the Shari‟ah
recognizes the validity of a financial asset that derives its return from the performance of an
underlying real asset.
Usage

Sukuk provides an ideal way of financing large projects for the public good that would otherwise not be
possible. The use of Sukuk to fund large projects means that investors in Sukuk are incentivized to help
economies develop by creating and producing rather than by consuming or manipulating others.

Advantages and disadvantages

The development of the Sukuk market over recent years has provided opportunities for both borrowers
and investors who would be unable to access conventional bonds markets due to their non-compliance
with shariah principles (Iqbal, Mirakhor, 2011). One of the drawbacks of Sukuk is that, in certain
circumstances, the entry of the asset ownership issue into the Sukuk structure might result in increased
taxation or stamp duty costs for the issuer.

Risk

Sukuk are exposed to a variety of risks. Market risk, operational risk, and Shariah compliance risk are the
most significant. The issue for Sukuk issuing entities is to develop a risk management plan that is
consistent with Shariah standards.
Ijarah (leasing)

Meaning and Definition

The literal meaning of the word ”Ijarah” is to give something on rent; leasing in conventional
finance is similar to the Islamic concept of Ijarah (Ernst el al., 2013, 38). Ijarah is the transfer of
rights to use imbedded in a specific property or item to another person in exchange for rent
payments made for a specific amount of time. Ijarah is not a financing instrument but rather a
transfer of usufruct for an asset. Gradually, Islamic banks have begun to use it as one of their
core instruments.
Usage
The contract of Ijarah financing can be used by an Islamic bank to provide customers with short
to medium-term financing to lease items. These items may include equipment, machinery,
consumer goods, computers, motor vehicles, other suitable and acceptable assets.

Advantages and disadvantages

The flexibility-Financial agreement allows both parties to negotiate the amount of rental
payment. In a dynamic business world, this flexibility proves to be immensely beneficial by
allowing both the lessee and the lessor to modify the rental arrangement to account for economic
fluctuations and changes in fiscal and monetary policies.
Risks
Like the other Islamic financial instruments, where the entire amount of capital remains at stake
because the capital owner is responsible for all the risks attached to the life of the asset (Kettel,
2011). The capital will be at risk until the asset successfully completes its anticipated productive
life. The finance provider has at risk the entire amount of his capital as well as the opportunity
cost of capital for the entire period until the capital is received back.
Takaful (Insurance)
Meaning and Definition
Takaful is Arabic word meaning “guaranteeing each other“ or “joint guarantee” (Kettell, 2011;
Iqbal, Mirakhor, 2011). Each person who requires protection must be motivated by a genuine
desire to help other participants who are experiencing difficulties. Islamic insurance is a system
in which each person makes a contribution to a fund that is used to support other participants,
with each participant making a sufficient contribution to cover expected claims. The goal of
Takaful is to pay a certain loss from a predetermined fund. So Takaful is insurance practiced
under Sharia‟s principles.
Usage
It can be used to cover property like houses, factories, mosques, offices, Vehicles (cars,
motorcycles, etc...), Goods (like during import or export) Valuables, Health, accidents, and Life.

Advantages/disadvantage

Insurance participants have set the intention for mutual help among the participants in the event of
disaster. Participants get the insurance guarantee fund management services as well as Islamic insurance
company. It provides a form of financial protection for Muslims unable to access conventional insurance.

Risk

Five categories of business risks have been identified that are relevant to the Takaful company. The first
two categories of risks, underwriting and operational risks, are directly tied to the Takaful firms
operations, while the other three, credit, liquidity, and market risks, are linked to the company's
investment activities(Kettel, 2011).
Istisna’a (Construction Financing)
Meaning and Definition.

The word Istisna‟a comes from the Arabic term Sina‟a, meaning to manufacture a specific
commodity (Kettell, 2011). Istisna‟a is a sale contract between the ultimate purchaser and the
seller. Istisna‟a is an agreement whereby a customer requiring an item, equipment, a building or
a project, which needs to be constructed, manufactured, fabricated or assembled, approaches the
bank for financing (Ashfaq, 2017). The bank offers to have the item produced, made, or
assembled, and then sells it to the customer after deducting the profit margin. The buyer has the
option of paying the payment in full or in installments afterward.
Usage
Istisna‟a is an Islamic financing structure best suited to finance the construction of capital
equipment such as aircraft, oil rigs, and machinery. Unlike Murabaha, which allows an investor
to acquire things only after they have been made, Istisna'a allows an Islamic investor to purchase
equipment that is currently being built in advance. The equipment is completely owned by the
investor at the end of the construction period. The Islamic investor (owner) can then sell the
equipment on the spot, lease it, or sell it on a deferred basis to an end-user.

Advantage/disadvantages
The key advantage of an Istisna contract is that it can provide flexibility to the customer, where
payments can be made in installments linked to project completion, at delivery, or after project
completion.
Risk
Apart from the credit risk of the bank‟s client, in Istisna‟a the banks will carry performance risk
(Kettell, 2011). The bank is always liable for any failure because the bank's client has no
recourse or contractual link with the actual manufacturer or contractor. However, by obtaining
performance bond from the manufacturer or contractor, this risk can be reduced.
Bay’ Salam(Forward Sale)
Meaning and Definition

Bay' Salam is a form of advanced-sale contract, also known as a forward sale contract, and it is one of
Islamic finance's most unique instruments. A seller can sell a commodity for a predetermined price
without transferring ownership or control of the commodity to the buyer under this form of contract.
(Omar et al, 2013). Prophet Muhammad allowed this contract to enable farmers to receive money to use
to purchase necessary inputs of production for farming (Iqbal & Mirakhor, 2011). Bay' Salam was also
utilized to fund import and export by Arabian merchants who were permitted to sell their goods in
advance in order to get funds for their businesses.

Usage

It is employed not just in agriculture (farming), but also in manufacturing (manufacturing), where the
company needs funding to make items and/or purchase raw materials. In recent years, it has been utilized
to provide funding to SMEs to facilitate the acquisition of required manufacturing inputs.

Advantage and Disadvantage

Bay Al-Salam instruments help especially the farmers to receive advance payment to meet their day to
day expenses instead of waiting to sell the harvested commodity. The price in Salam may be fixed at a
lower rate than the price of those commodities delivered at spot. In this way, the difference between the
two prices may be a valid profit for the banks or financial institutions.

Risks

In addition to the credit risk, which is normal for any type of finance, the bank faces market risk.
Although prices at the time of delivery may be higher than that of the Salam price, the market price may
fluctuate in any direction. Unfortunately, not many strategies can be taken to mitigate this problem.
Tawarruq
Meaning and Definition

Tawarruq means to buy on credit and sell at spot value with the objective of getting cash, meaning that
the transaction is not the need of the buyer; he simply wants liquidity, which he gets by purchasing a
commodity on credit and selling the same forthwith for cash (Iqbal & Mirakhor, 2011). If he sells to any
third party, it is acceptable from the Sharia point of view, but if he sells to the person from whom he
purchased on credit, it is not Sharia compatible according to the majority view.

Usage

Tawarruq is being used by many Islamic banks for liquidity management and as a mode of financing,
especially for personal financing and credit cards.

Advantage/Disadvantage

Tawarruq is a product that has sparked considerable debate (Kettel, 2011; Usmani, 1999). Certain
scholars say the transactions aren't sharia-compliant since the commodity purchases aren't for the buyer's
use or possession. Their reasoning is that the lack of any genuine economic activities leads to the creation
of interest, which is forbidden in sharia.

Risk

Sharia Compliance Risk- Because cash is the primary goal in Tawarruq, the acquired asset serves merely
as a bridge for delivering cash to the consumer (Usmani, 1999). The final purpose of finance is quite
unknown to the Islamic Financial Institution which violates the realism principle.
Wakalah (Agency)
Meaning and Definition
The contract of Wakala entails designating a person or legal entity to act on one‟s behalf or as
one‟s representative. It has been a common practice to appoint an agent (wakil) to facilitate trade
operations. A Wakala contract gives a power of attorney or an agency assignment to a financial
intermediary to perform a certain task (Alrifai,2015; Iqbal,Z., Mirakhor, A. , 2011). There is no
much difference between a mudarabah and a wikala contract since both are principal-agent
contracts. However, under a mudarabah, the mudarib has full control and freedom to utilize the
funds entrusted. In the case of a wikala, the wakil merely serves as a representative to carry out a
certain task according to the instructions given.
Usage
Wakala can be used as a marketing tool(Kettel, 2011; Iqbal,Z., Mirakhor, A. , 2011). The market
can be expanded more rapidly by using the wakalah or takaful operator agent framework
concept. Agents who are driven by commissions and incentives will be working hard to get
business because their source of income is commissions and incentives. Companies with large
and high-quality agents would increase the number of contributions on time and allow the
business of the company to expand rapidly.

Advantage/Disadvantage
With the use of wakalah, the firm can lower its overhead costs while simultaneously lowering its
mandatory and fixed costs. The agency structure does not need the opening of branches in each
district.
Risk
No physical commodity is required under wakala contract. This raises the question of whether
Wakala is an efficient governance structure in terms of risk and control.
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