Income ratio, risk-sharing, and the optimality of mudarabah

Abstract EN

Little attention in the current literature is given to the analysis of interest-free Islamic financing tools within the framework of riskreturn portfolio analysis.

This paper adopts the standard tools to establish interesting optimal properties of mudarabah within a twoparty contractual model of an income generating economic activity.

‘Income ratio’ is defined as the percentage of expected income that goes to each of the two parties whereas the ‘risk-sharing structure’ refers to how risk is shared between the two parties.

The key question is how these two parameters are related through alternative two-party contracts.

This paper is an extension to another one where the risksharing structure is shown to be perfectly proportionate to income ratio in the case of mudarabah.

The Shariah-prohibited interest-rate financing is a manifest disproportionate case as the income ratio of lender is totally insensitive to the contract’s risk.

Adopting the same competitive set-up within an informational efficient environment, this paper sets out to establish two more findings: First, a negative relationship proves to exist between income ratio and the risk-sharing structure in terms of an optimal contracts curve (OCC).

The mudarabah contract emerges at an optimal breakeven point where the OCC coincides with pure profit-sharing but fixed return financial leverages also co-exist with mudarabah.

Hence, a pure equity-based Islamic order is theoretically inconceivable even under ideal information efficiency.

Second, the optimal mudarabah income ratio (i.e.

profit-sharing ratio) is shown to depend crucially on the extent to which the two parties differ in their attitude towards risk (i.e.

the risk-attitude differential).

The paper goes further to examine the impact of risk-attitudinal differentials on the optimal profit-sharing ratio.

These findings are shown to have useful practical and policy implications.