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KembaraXtra-Islamic Finance-Islamic Capital Market
Unsystematic Risk
Meaning of Unsystematic Risk
Unsystematic risk refers to risk that is specific to a particular company or a specific industry. It is also known as diversifiable risk because it can be reduced or even eliminated through proper diversification of investments.
Why It Is Diversifiable
Unlike market-wide risk, unsystematic risk affects only certain firms or sectors. By investing in different companies across various industries, the negative impact of one company or sector can be offset by better performance in others.
Sources of Unsystematic Risk
This type of risk may arise from factors such as poor management decisions, labour strikes, technological failure, regulatory issues, or a decline in demand for a specific product. These risks do not affect the entire market.
Industry and Company-Specific Nature
Unsystematic risk is tied closely to individual stocks or industries. For example, investing in oil stocks exposes an investor to risks related to oil price fluctuations, environmental regulations, or operational problems specific to oil companies.
Simple Example
An investor buys shares in an oil company. If oil prices fall sharply, the company’s profits may decline, causing the stock price to drop. This loss is specific to the oil industry and does not necessarily affect other sectors such as retail or airlines.
Risk Mitigation Through Diversification
To reduce unsystematic risk, the investor can diversify by investing in companies from different industries. For instance, holding retail or airline stocks alongside oil stocks helps balance the portfolio. If oil prices fall, gains in other sectors may reduce overall losses.
Use of Hedging
An investor may also hedge unsystematic risk by using put options on crude oil or the company’s stock. This provides protection against price declines while keeping exposure to potential upside gains.
Importance of Risk Management
Without proper diversification or hedging, an investor may suffer significant losses if a company or industry performs poorly. Effective risk management helps protect the investment portfolio from sudden and severe losses.
Key Point to Remember
Unsystematic risk is company- or industry-specific and can be reduced through diversification and hedging strategies.
Unsystematic Risk
Meaning of Unsystematic Risk
Unsystematic risk refers to risk that is specific to a particular company or a specific industry. It is also known as diversifiable risk because it can be reduced or even eliminated through proper diversification of investments.
Why It Is Diversifiable
Unlike market-wide risk, unsystematic risk affects only certain firms or sectors. By investing in different companies across various industries, the negative impact of one company or sector can be offset by better performance in others.
Sources of Unsystematic Risk
This type of risk may arise from factors such as poor management decisions, labour strikes, technological failure, regulatory issues, or a decline in demand for a specific product. These risks do not affect the entire market.
Industry and Company-Specific Nature
Unsystematic risk is tied closely to individual stocks or industries. For example, investing in oil stocks exposes an investor to risks related to oil price fluctuations, environmental regulations, or operational problems specific to oil companies.
Simple Example
An investor buys shares in an oil company. If oil prices fall sharply, the company’s profits may decline, causing the stock price to drop. This loss is specific to the oil industry and does not necessarily affect other sectors such as retail or airlines.
Risk Mitigation Through Diversification
To reduce unsystematic risk, the investor can diversify by investing in companies from different industries. For instance, holding retail or airline stocks alongside oil stocks helps balance the portfolio. If oil prices fall, gains in other sectors may reduce overall losses.
Use of Hedging
An investor may also hedge unsystematic risk by using put options on crude oil or the company’s stock. This provides protection against price declines while keeping exposure to potential upside gains.
Importance of Risk Management
Without proper diversification or hedging, an investor may suffer significant losses if a company or industry performs poorly. Effective risk management helps protect the investment portfolio from sudden and severe losses.
Key Point to Remember
Unsystematic risk is company- or industry-specific and can be reduced through diversification and hedging strategies.
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KembaraXtra – Islamic Banking-The Objectives of Islamic Law
Q1: What is the main purpose of the objectives of Islamic law (Maqāṣid al-Sharīʿah)?
The main purpose is to protect five essential elements: faith, life, intellect, posterity (lineage), and property.
Q2: How many levels are the objectives of Islamic law divided into?
The objectives of Islamic law are divided into three levels.
Q3: What is the first level of the objectives of Islamic law?
The first level is ḍarūriyyāt, which refers to necessities related to life and death and is essential for human survival.
Q4: What does the second level of the objectives of Islamic law mean?
The second level is ḥājiyyāt, which focuses on removing hardship and difficulty from people’s lives.
Q5: What is the third level of the objectives of Islamic law?
The third level is taḥsīniyyāt, which refers to beautifying life, promoting good morals, and enhancing quality of life.
Q6: What are the salient features of Sharīʿah that accompany these levels?
The salient features include rabbāniyyah, ʿālamiyyah, ʿumūmiyyah, and shumul.
Q7: What does rabbāniyyah mean in the context of Sharīʿah?
Rabbāniyyah means that Sharīʿah is divinely ordained and promises rewards in both this world and the Hereafter.
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Q8: What is meant by ʿālamiyyah and ʿumūmiyyah?
ʿĀlamiyyah and ʿumūmiyyah mean that Islamic law is universal and permanent, suitable for all people and all times.
Q9: What does shumul mean?
Shumul means that Islamic law is complete and comprehensive, covering all aspects of human life.
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KembaraXtra – Islamic Finance: Sukuk (Foundations, Rationale & Global Impact)
Background and Early Development
- Discussions on the Islamic capital market began seriously during the 1980s and 1990s, mainly within fiqh (Islamic jurisprudence) councils.
- Scholars examined how modern financial instruments could be aligned with Shari’ah principles, particularly:
- Equity-based instruments, and
- Alternatives to fixed-income securities, which are prohibited due to riba (interest).
- From these deliberations emerged the concept of Sukuk, designed as an investment-based certificate rather than a debt obligation.
The emergence of Sukuk was driven by two key needs:
- Liquidity Management for Islamic Financial Institutions (IFIs)
- Islamic banks and takaful operators often face excess liquidity.
- Conventional money-market instruments (e.g. treasury bills, bonds) are not Shari’ah-compliant.
- Sukuk provide a halal, tradable instrument backed by real assets or services, enabling effective liquidity placement.
- Shari’ah-Compliant Project Financing
- Governments and corporations required a large-scale financing tool that avoids interest.
- Sukuk allow funds to be raised for infrastructure, development, and corporate expansion through:
- Asset ownership,
- Leasing (ijarah),
- Profit-sharing (musharakah / mudarabah), or
- Sale-based structures (murabahah, istisna’).
- Since the 1990s, Sukuk have evolved from a theoretical concept into a widely accepted financial instrument.
- Today, Sukuk serve dual functions:
- A capital-raising mechanism in the Islamic capital market.
- A liquidity management tool for Islamic financial institutions
- Their structured link to real economic activity strengthens financial stability and investor confidence.
Global Expansion and Recognition
- After the early 2000s, Sukuk became a flagship product of the Islamic finance industry.
- They attracted the attention of major international institutions such as:
- Sukuk issuance expanded beyond Muslim-majority countries to include:
- Muslim-minority nations,
- Developed and emerging economies,
- Ethical and socially responsible investors.
Who Uses Sukuk Today
- Sovereign issuers (e.g. governments funding infrastructure)
- Corporate issuers (energy, real estate, aviation)
- Small and Medium Enterprises (SMEs)
- Conventional and Islamic investors seeking diversification
- Global fund managers interested in ethical and asset-backed investments
Practical Examples of Sukuk
- Government Infrastructure Sukuk
- A government issues Sukuk Ijarah to finance highways or airports.
- Investors earn returns from lease rentals, not interest.
- Corporate Sukuk
- An energy company issues Sukuk Musharakah to build a power plant.
- Investors share in the profits generated by the project.
- Bank Liquidity Sukuk
- An Islamic bank invests surplus funds in short-term sovereign Sukuk to manage liquidity while remaining Shari’ah-compliant.
Conclusion
Sukuk have transformed from a scholarly response to Shari’ah concerns into a globally recognised financial instrument. By combining ethical finance, real economic activity, and capital market efficiency, Sukuk have significantly expanded the reach and credibility of the Islamic finance industry, positioning it as a viable component of the global financial system.
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KembaraXtra-Islamic Finance-Islamic Capital Finance-Significance of Islamic Equity Investments
- Equity represents ownership and profit sharing
Islamic equity investments give investors ownership in a company, allowing them to share directly in profits and business growth rather than earning fixed interest.
Example: When a Shari’ah-compliant firm earns higher profits, shareholders benefit through dividends or rising share prices. - Long-term wealth creation
Islamic equity investments help grow surplus income over time when funds are not needed for immediate consumption. This supports sustainable wealth accumulation.
Example: Investing savings in Shari’ah-compliant stocks instead of holding idle cash. - Risk–return relationship
Investors prefer higher returns with lower risk. Risk-averse investors require extra returns as compensation for taking additional risk.
Example: A volatile stock must offer higher expected returns to attract cautious investors. - Primary investment objective
Investors aim to either maximise returns for a given level of risk or minimise risk for a targeted return. This principle applies equally to Islamic equity investing. - Types of risk (Markowitz Portfolio Theory, 1952)
- Diversifiable (unsystematic) risk: Company-specific risk that can be reduced through diversification.
Example: Poor performance of one firm is offset by gains in another. - Non-diversifiable (systematic) risk: Market-wide risk that cannot be eliminated.
Example: Economic downturns affecting the entire stock market.
- Diversifiable (unsystematic) risk: Company-specific risk that can be reduced through diversification.
- Importance of diversification
Increasing the number of stocks in a portfolio reduces unsystematic risk. A well-diversified portfolio mainly carries systematic risk.
Example: Holding stocks across different industries lowers overall portfolio volatility. - Role of asset correlation
Combining assets that are not perfectly correlated improves risk–return outcomes compared to holding a single stock.
Example: When one sector declines, another may rise, balancing overall returns. - Investor preferences and indifference curves
Investors evaluate combinations of risk and return that provide equal satisfaction. Higher indifference curves reflect preference for higher returns at the same risk level. - Efficient portfolios and efficient frontier
An efficient portfolio offers the highest return for a given risk or the lowest risk for a given return. The efficient frontier represents all such optimal portfolios. - Optimal portfolio selection
The optimal portfolio occurs where an investor’s indifference curve touches the efficient frontier, depending on individual risk tolerance. - Relevance to Islamic equity funds
Islamic portfolios often include growth and small-cap Shari’ah-compliant stocks, reflecting varied investor risk preferences, while conventional portfolios often focus on value or mid-cap stocks. - Risk moderation and ethical stability
The asset-backed and ethical nature of Islamic equity investments reduces exposure to excessive volatility and extreme risks, contributing to the steady growth of Islamic finance. - Key distinguishing features of Islamic equity investment
- Mandatory risk sharing
- Strong ethical and Shari’ah screening
- Emphasis on real economic activity
- Limited speculative exposure
- Investment avenues for Islamic investors
Islamic investors can allocate surplus funds into Shari’ah-compliant equities, Islamic mutual funds, and other approved equity-based instruments, balancing risk, return, and ethical compliance.
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KembaraXtra–Islamic Finance–Islamic Capital Market – Price and Valuation of Equity
Using the Price-to-Earnings (P/E) Ratio to Evaluate Stocks
Meaning of the P/E Ratio
The price-to-earnings (P/E) ratio is a commonly used measure to value a company’s shares by comparing the current market price of a share with its earnings per share (EPS). EPS is calculated by dividing the company’s net profit by the number of outstanding common shares. The P/E ratio is also referred to as the price multiple or earnings multiple because it shows how many times earnings investors are willing to pay for a stock.
Formula and Calculation
The P/E ratio is calculated using the formula: P/E Ratio = Market Price per Share ÷ Earnings per Share (EPS). This calculation indicates the amount investors are paying today for one unit of the company’s earnings.
Purpose of Using the P/E Ratio
The P/E ratio helps investors assess whether a stock appears undervalued, fairly valued, or overvalued. However, it is not meaningful when used alone. It becomes useful only when compared with the company’s historical P/E, similar companies in the same industry, or a relevant market benchmark.
Example: Dubai Islamic Bank
Assume Dubai Islamic Bank reports an earnings per share (EPS) of US$0.40 and its share price is US$5.20. The P/E ratio is calculated as 5.20 ÷ 0.40 = 13.0. This means the bank’s shares are trading at 13 times its annual earnings.
Interpretation of the Result
A P/E ratio of 13 indicates that investors are willing to pay US$13 for every US$1 of earnings generated by Dubai Islamic Bank. This reflects market expectations regarding the bank’s profitability, stability, and growth prospects, but it does not automatically mean the stock is cheap or expensive
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Comparison with Market and Industry Peers
If the broader market average P/E is around 15, Dubai Islamic Bank’s P/E of 13 appears slightly lower. A more accurate assessment comes from comparing it with peer Islamic banks. If similar banks trade within a P/E range of 12 to 14, then Dubai Islamic Bank would be considered fairly valued within its industry
.
Key Insight
The P/E ratio is a relative valuation tool rather than a standalone indicator. Its real value lies in comparison across time, peers, and markets. When combined with other financial measures and Shari’ah compliance considerations, it provides a clearer picture of whether a stock’s price reasonably reflects its earnings potential.
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KembaraXtra–Islamic Finance–Islamic Capital Market – Price-to-Earnings Ratio (P/E) and Return on Equity (ROE)
Understanding the Relationship Between P/E and ROE
Meaning of the Price-to-Earnings (P/E) Ratio
The price-to-earnings (P/E) ratio reflects how much investors are willing to pay for every dollar of a company’s earnings. A higher P/E generally indicates that shareholders expect strong future performance, growth, or stability from the company. In simple terms, the P/E ratio captures investor confidence in a firm’s ability to generate profits for shareholders.
Meaning of Return on Equity (ROE)
Return on equity (ROE) measures how efficiently a company uses its equity to generate profits. Equity here refers to shareholders’ funds, which include paid-up share capital and retained earnings. ROE shows the return earned on the owners’ investment in the company and is calculated as net profit divided by total equity.
How P/E and ROE Are Connected
Companies that generate higher returns for shareholders usually enjoy higher P/E ratios. This is because investors are willing to pay more for shares of firms that use their equity efficiently to produce profits. A strong ROE signals good management performance and effective use of shareholder funds, which in turn raises investor willingness to pay a premium price for the company’s earnings.
Simple Example
Suppose an Islamic bank generates a high ROE of 18%, meaning it earns 18 cents for every dollar of equity invested by shareholders. Investors may view this as strong performance and future potential, leading them to accept a higher P/E ratio, such as 15 or 16. In contrast, another bank with a low ROE of 8% may only attract a lower P/E ratio because shareholders are less confident about its profit-generating ability.
Key Insight
ROE reflects how well a company creates value from shareholder equity, while the P/E ratio reflects how the market values that performance. In general, higher ROE supports a higher P/E, as investors are willing to pay more for companies that consistently generate strong returns on equity—especially when those returns are achieved through Shari’ah-compliant, ethical, and risk-sharing business activities.
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KembaraXtra–Islamic Finance–Islamic Capital Market – Return on Equity (ROE) and Shareholders’ Equity Explained
What is Shareholders’ Equity?
Yes, shareholders’ equity DOES include retained earnings. Shareholders’ equity represents the owners’ claim on the company and is made up of:
• Share capital (money originally invested by shareholders)
• Retained earnings (profits kept in the business over time instead of being paid out as dividends)
So, equity is not only the money shareholders first put in, but also the profits the company has reinvested.
Definition of Return on Equity (ROE)
Return on Equity (ROE) measures how efficiently a company uses total shareholders’ equity (including retained earnings) to generate profit.
Formula
ROE = Net Profit ÷ Shareholders’ Equity
Detailed Example (Including Retained Earnings)
Assume a Shari’ah-compliant company has the following:
• Share capital = USD 300 million
• Retained earnings = USD 200 million
Total shareholders’ equity = USD 500 million
Now assume:
• Net profit for the year = USD 50 million
ROE = 50 ÷ 500 = 10%
What This Means
The company earns 10% return on the total money that belongs to shareholders, including:
• the money they originally invested, and
• the profits the company kept and reinvested over time.
Why Retained Earnings Matter in ROE
Retained earnings show how past profits are used to grow the business. When a company reinvests profits wisely, equity increases, and future profits may grow. ROE helps investors judge whether these retained profits are being used efficiently.
ROE in Islamic Finance Context
In Islamic finance, ROE is especially meaningful because profits must come from real economic activity and risk-sharing, not interest. A healthy ROE in a Shari’ah-compliant firm reflects fair profit generation for shareholders under Musharaka-style ownership.
Key Takeaway
Shareholders’ equity always includes retained earnings, and ROE shows how well the company uses both invested capital and accumulated profits to create value for shareholders.
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KembaraXtra–Islamic Finance–Islamic Capital Market – Growth in Islamic Funds Assets
-Global expansion of Islamic funds:
-The number of functional Shari’ah-compliant mutual funds worldwide has exceeded 1,410 funds
-These funds operate within the broader framework of Shari’ah-compliant asset management
-The global Islamic assets under management (AUM) are estimated at approximately US$110 billion
-Role of Sukuk in Islamic finance:
-Sukuk are Shari’ah-compliant debt-like instruments that represent proportionate ownership in underlying tangible assets,not pure debt
-Unlike conventional bonds,Sukuk are backed by real physical assets
-These assets are typically financed using Islamic trade-based contracts or leasing (Ijarah) modes
-Structure of Sukuk financing:
-Funding is raised by issuing participation certificates (Sukuk) to investors
-Investors become partial owners of the underlying asset
-Returns are generated from profits on sale or rental income from asset usage,not interest
-These returns are distributed to Sukuk holders according to agreed terms
-Contribution of Sukuk to Islamic finance industry:
-Sukuk form a significant component of total Islamic finance assets
-The value of outstanding Sukuk reached approximately US$426 billion in 2017
-Global Sukuk issuance activity:
-In 2017,a total of 19 countries issued Sukuk
-The total value of Sukuk issued globally amounted to US$85 billion
-Breakdown of Sukuk issuances (2017):
-Agency Sukuk: 6% of total issuance
-Sovereign Sukuk: 31% of total issuance (issued by governments)
-Corporate Sukuk: 63% of total issuance (issued by companies)
-Key takeaway:
-The rapid growth of Islamic funds and Sukuk highlights the increasing global acceptance of asset-backed,Shari’ah-compliant investment structures that link financial returns to real economic activity rather than interest-based lending
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KembaraXtra–Islamic Finance–Islamic Capital Market – Murabahah Funds and NAV
-Meaning of Murabahah funds:
-A Murabahah fund is a Shari’ah-compliant investment fund that uses Murabahah (cost-plus sale) contracts as its core investment activity
-The fund pools money from investors and uses it to purchase assets or commodities, which are then sold to clients at a pre-agreed cost plus profit margin
-The profit margin is fixed at the time of the contract and disclosed upfront
-Nature of assets in Murabahah funds:
-The fund primarily holds receivables (debts) created from Murabahah sales
-Once the sale is executed, the fund no longer holds physical assets but outstanding payment obligations from buyers
-Source of return:
-Returns are generated from the mark-up embedded in Murabahah transactions
-The income is trade-based,not interest-based
-Profits are distributed to investors according to their units in the fund
-Shari’ah compliance conditions:
-The fund must own the asset before selling it to the client
-The sale price and profit margin must be fixed and known in advance
-No interest,risk-free guarantees,or speculative activities are allowed
-Risk profile:
-Risk is relatively lower compared to equity or commodity funds
-Main risks include credit risk (buyer default) and operational risk
-There is no price fluctuation risk after the Murabahah sale is completed
-Closed-ended nature of Murabahah funds:
-Murabahah funds are usually closed-ended
-Trading of Murabahah fund units in the secondary market is not permissible,because most assets are debts
-Shari’ah prohibits trading of debt at a price other than par
-Does a Murabahah fund involve NAV?
-Yes,Murabahah funds still use NAV for valuation purposes
-NAV is mainly used for internal valuation,profit calculation,and redemption at maturity
-Why NAV is used in Murabahah funds:
-NAV reflects the outstanding Murabahah receivables plus cash balances
-It ensures accurate distribution of profits among investors
-NAV helps determine the value of investor units at fund closure
-NAV calculation in Murabahah funds:
-NAV = (Outstanding Murabahah receivables + cash − liabilities) ÷ total units
-Liquidity aspect:
-Murabahah funds offer low liquidity during the fund tenure
-Investors usually exit only at maturity,not through secondary market trading
-Key takeaway:
-Murabahah funds generate halal returns through cost-plus trade transactions,and although their units are not tradable, NAV remains essential for fair valuation and profit distribution
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KembaraXtra–Islamic Finance–Islamic Capital Market – Characteristics of Islamic Equity
-Halal nature of business (core requirement):
-The primary characteristic of Islamic equity is that the core business activity must be halal
-Companies must not be involved in prohibited (haram) activities such as:
– Gambling (maisir)
– Alcohol production or sale
– Interest-based financial dealings (riba)
– Excessive uncertainty or speculation (gharar)
-Practical challenge of full Shari’ah compliance:
-In modern economies,it is extremely difficult to find companies that are 100% Shari’ah compliant in every operational aspect
-Many companies may have a halal core business but still engage marginally in interest-based financing or other non-permissible activities
-A very strict interpretation would drastically limit the universe of investable stocks
-Scholarly debate on partial non-compliance:
-Some Shari’ah scholars disapprove investing in companies with any non-permissible activities,as they believe shareholders indirectly endorse such practices
-Other scholars distinguish between joint-stock companies and partnerships
-In joint-stock companies,individual shareholders:
– Have limited control over management decisions
– Cannot directly influence day-to-day business conduct
-Therefore,non-compliant activities cannot always be fully attributed to shareholders
-Contemporary Shari’ah approach:
-Many scholars accept that partial non-compliance does not automatically render the entire company haram
-Shari’ah rulings on equities consider modern economic realities
-Regulators in well-developed markets clearly define acceptable thresholds
-Role of Shari’ah screening standards:
-Regulatory and index-based standards help determine compliance
-Examples include:
– Dow Jones Islamic Market Index (USA)
– Meezan Islamic Fund standards (Pakistan)
-Although these standards differ in stringency,the final list of compliant stocks is usually similar
-Shari’ah compliance beyond business activity:
-Compliance is not limited to what the company does,but also how funds are structured
-Financial products must align with Shari’ah-approved contracts and principles
-This includes:
– Proper structuring
– Shari’ah endorsement
– Formal certification by Shari’ah boards
-Profit-and-loss sharing principle:
-Islamic equity does not allow fixed or guaranteed returns
-Profits must be shared on a pro rata basis
-No guarantee on capital or profit rate
-Returns are structured under mudarabah or musharaka contracts
-Asset composition and tradability of shares:
-Trading of shares depends on the nature of the company’s assets
-If assets are largely liquid (cash or receivables):
– Shares can only be traded at par value
-If assets include real and tangible assets:
– Shares may be traded at market value
-This ensures that share trading reflects ownership of real business activities
-Key Shari’ah principle on money:
-Money must function as a medium of exchange,not as a commodity
-Money itself cannot be traded for profit
-Returns must arise from real economic activity and asset ownership,not from money generating money
