Issues and Challenges 367
The development of a theoretical foundation of fi nance in Islam also
needs attention. Several areas — such as asset pricing, corporate fi nance,
derivatives, and hedging — require further research. For example, in the
absence of a risk - free asset, how will the Capital Asset Pricing Model
(CAPM) behave, or how will Black’s zero - beta model behave with restric-
tions on short selling?^1 Several such issues have not been researched. In
the development of conventional economics, fi nance was not seen as a sepa-
rate fi eld until relatively recently. In conventional economics the importance
of investment has been long recognized. Financial markets were seen as
important in attracting savings, and as a channel to allocate savings to
investors and to do this in the most effi cient way. The health of fi nancial
markets was appreciated largely in accommodating the fi nancing of the
real economy. The importance of fi nance was perceived from this very nar-
row perspective. Thus, earlier fi nance was not treated as an important and
separate fi eld of endeavor.
The appreciation of risk was a crucial building block in the develop-
ment of modern conventional fi nance. Early in the twentieth century, Irving
Fisher, one of the giants of economics, was the fi rst to appreciate the impor-
tance of risk in the functioning of fi nancial markets. In the 1930s a number
of renowned economists, most notably Keynes, saw the importance of risk
in the selection of a portfolio. But in their analysis and discussion, the role
of risk was largely limited to affecting expected capital gains and speculative
and hedging activities. This strain of analysis led to results covering the rela-
tionship of futures prices and expected spot prices (normal backwardation),
the price - stabilizing effect of speculation, the impact of risk on assessing the
value of future streams of income and, eventually, to the development of
portfolio theory.
These developments in turn led to the realization that arbitrage was one
of the two fundamental features of conventional fi nance; this is supported
by the Black - Scholes - Merton option - pricing model and by the Modigliani -
Miller Theorem. In the case of option pricing, if a portfolio of other assets
can reproduce the return from an option, then the price of the option must
be equal to the value of the portfolio; if not, there will be arbitrage oppor-
tunities. The Modigliani - Miller Theorem also uses arbitrage reasoning to
examine the impact of corporate fi nancial structures for arriving at a mar-
ket value for a fi rm. If the production outlook of two fi rms (with differing
fi nancial structures) is the same, then the market value of the fi rms must be
the same; if not, there is opportunity for arbitrage.
The second important development in the modern theory of fi nance
was initiated by the empirical fi nding that commodities and asset prices
behaved randomly. Paul Samuelson came up with an ingenious explanation
for this observation that asset prices had to behave randomly; if this was not
the case then arbitrageurs could exploit the opportunity to make a profi t.
For asset prices to behave randomly, all available and relevant information
would have to be immediately translated into price changes in markets that
behaved “effi ciently.” Thus the Effi cient Market Hypothesis was born. In