Debt and equity in a primary financial market : a theory with Islamic implications

Abstract EN

Emphasizing risk averse nature of fund suppliers in an uncertain environment, this paper establishes the possibility of a riba-free Pareto optimality in a primary financial market, explaining real life dominance of the mixed debt/equity system in terms of deviation from informational efficiency.

Risk premia normally associated with equity returns are definite indicators of risk-aversion on the part of demand side real investors.

Under totally undiversifiable risk, a financial investor may prefer equity to risk free asset even though he is more risk-averse than the demand side issuer of equity.

It concludes that free market dynamic forces generate a financial order giving privileges to active demanders of funds rather than sympathizing' with risk-averse suppliers of funds as conventional analysis implies.

Theoretical claims of efficiency losses in the financial supply process due to Islamization appear to be groundless.