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Islamic Banking and Finance

New Perspectives on Profit Sharing and Risk

Edited by Munawar Iqbal and David T. Llewellyn

Islamic Banking and Finance discusses Islamic financial theory and practice, and focuses on the opportunities offered by Islamic finance as an alternative method of financial intermediation. Key features of profit-sharing (as opposed to debt-based) contracts are highlighted, and the ways in which they can facilitate improved efficiency and stability of a financial system are explored.
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Chapter 6: How informal risk capital investors manage asymmetric information in profit/loss-sharing contracts

Mohammad Abalkhail and John R. Presley


Iqbal 02 chap 5 9/11/01 3:09 pm Page 111 6. How informal risk capital investors manage asymmetric information in profit/loss-sharing contracts Mohammad Abalkhail and John R. Presley 1. INTRODUCTION Islamic banks have existed for almost 30 years but the use of profit/loss-sharing methods is not yet widely established. The constraints on the development of these methods are believed to be caused not only by the asymmetric information that the contract involves but also by the nature of banks as short-term finance institutions. It is argued here that the practices of profit/loss-sharing (PLS) contracts in the informal markets could provide lessons for the application of these contracts in Islamic financial institutions. Recently, informal venture capital investors have been recognized as an important source of finance for small and mediumsized enterprises (SMEs) through the application of venture capital financing. Unfortunately, very little research, if any, has been devoted to understanding how these investors fund particular investments in Muslim countries. In the conventional paradigm, capital markets are perfect. Individuals and firms are assumed to be able to obtain as much funding as they want at the market interest rate. The theory also often assumes that capital markets are informational efficient, when prices perfectly reflect all the available information (Stiglitz, 1985). Fama (1970) introduced a model of capital markets in which he assumed the existence of three types of efficiency: strong form, semi-strong form and weak form. The strong form exists when the value of a firm is a reflection of all information...

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