75CHAPTER
4Financial Instruments
T
he economic activities in any economic system can be viewed as contracts
between economic agents. A fi nancial instrument is also a contract, whose
terms and conditions defi ne the risk - and - return profi le of the instrument.
The whole fabric of Divine Law in Islam is contractual in its conception,
content and application. Islam forcefully places all economic relations on the
fi rm footing of “contractus” — as discussed in Chapter 2. The preservation
of property rights and the commitment to obligations and responsibilities
associated with a contract are vital in determining the standards of behavior
expected of the economic agents and, ultimately, the nature of the economic
system in Islam.
In Islam, a contract is deemed legal and lawful by the Shari’ah if the
terms of the contract are free of any prohibition. In other words, if a con-
tract does not have or involve any of the prohibited elements, such as riba
or gharar, and does not violate any other rule or law it is considered valid.
For example, although a contract to invest in a company producing alcohol
may be free of riba and gharar, it would still be invalid in the eyes of the
Shari’ah, since it deals with the production of alcohol, which is prohibited
in Islam. Several commercial contracts have their roots in the pre - Islamic
period but have been further developed and widely practiced after their
compatibility with the principles of Shari’ah was ascertained and confi rmed.
The Islamic economic system has a set of core contracts, which serve
as building blocks for designing more sophisticated and complex fi nan-
cial instruments.^1 There is no established classifi cation of contracts in the
Islamic legal system as such, but from a business and commercial point of
view, certain contracts can be grouped together according to their function
and purpose in the economic and fi nancial system. Contracts dealing with
commercial and business transactions can be classifi ed into four broad cat-
egories as shown in Figure 4.1.
This demarcation and classifi cation based on the function and purpose
of contracts give us a framework to understand the nature of credit creation,
types of fi nancing instruments, intermediation and the different roles each
group plays in the economic system. In other words, theoretically, Islamic
commercial law would be able to satisfy the needs of economic agents
An Introduction to Islamic Finance: Theory and Practice, Second Edition
by Zamir Iqbal and Abbas Mirakhor
Copyright © 2011 John Wiley & Sons (Asia) Pte. Ltd.