Islamic Capital Markets: Theory and Practice

Chapter 1

Capital Theory and Islamic Capital Markets

The purpose of this chapter is to present elements of capital theory that are necessary for understanding Islamic capital markets. It lays out the objective of investment, which is economic growth. It defines the notions of capital, interest rate, and profit rate. It presents the classical intertemporal consumer and producer theory; it describes the determination of the equilibrium rate of return on investment, based on the supply of saving and demand for investment. The chapter presents a model of capital as a subsistence fund, the role of capital as an engine of growth, and describes the relationship of the capital market with the rest of the economy. In this connection, the chapter studies the relationship between real flows and financial flows in a flow-of-funds model. Finally, the chapter describes the intermediary role of capital markets.

The capital market deals with a commodity called capital. A transaction in the capital market consists of an act of saving met by an act of investment. It involves an exchange of money as a capital (saving) for a security (investment; e.g., bond, equity, or sukuk, an Islamic securitized asset). The commodity traded in the capital market is different from the commodity that is exchanged in the goods market. A consumer who buys an apple, a tangible good, takes ownership of the apple with no further obligation on the part of the seller of the apple. In the case of a security, besides the ...