An Introduction to Islamic Finance: Theory and Practice

272 AN INTRODUCTION TO ISLAMIC FINANCE

Table AC1 gives a summary of how a weighted composite index, which
represents equity returns in an Islamic economy, can be constructed. The
inclusion of a local stock - market index is natural, but not without certain
reservations. Depending on the degree of that market’s depth, breadth and
liquidity determining the competition and effi ciency of the market, the
domestic stock market index may or may not be included. In the case of a
shallow market, other factors infl uencing investment decisions, such as the
economy’s q ratio, price/earnings (PE) ratio and dividend yield or return on
equity (ROE), can be included.
Basing the index on the domestic stock market or local indicators alone
is not recommended because of the lower degree of development of domes-
tic equity markets in Islamic countries. In order to broaden the index, it
is advisable to include an external index representative of the regional or
international fi nancial environment. Given recent economic liberalization,
globalization and integration of the international capital markets, it is rea-
sonable to assume that the domestic rate of return will refl ect the returns
worldwide. It is desirable that the selected external index is easily moni-
tored, relatively stable and broadly in line with the domestic economy.

ENDNOTES

1. Jenkinson, Penalver and Vause (2009) identify fi ve areas of potential weakness
   during the crisis: incomplete information; alignment of incentives; liquidity in
   fi nancial markets; robustness of market infrastructure; and system dynamics.
   There may be insuffi cient information to gauge the risk in new fi nancial instru-
   ments. Indeed, information can get lost when a chain of parties is involved in the
   creation of new fi nancial instruments. If these parties do not retain an economic

TABLE AC1 Islamic index representing equity returns

I = w1WI + w2LSI + w3PPI + w4ROG

where

I = Index representing rate of return on the private sector

w1, w2, w3 and w4 are weights for each indicator. Weights to be determined by

each market to match individual market characteristics.

WI = An international stock market index such as the MSCI emerging - market

index.

LSI = Domestic market performance index, e.g. stock market index, average q

for the economy, return on equity (ROE), etc.

PPI = A weighted average of returns in commercial participation paper market as

it develops.

ROG = Measure of the rate of return on government investments in developmental

and infrastructure projects against which government paper is issued.