Time Value of Money in Islamic Finance

Summary of the Previous Lecture

In the previous lecture we studied

•The concept of factors of production under conventional economic system.

•The concept of factors of production under Islamic financial system, i.e. factor inputs, and consumed inputs and their role as HFP and EFP.

•Equilibrium in factors of production in Islamic economic system.

Learning Outcomes

After this lecture you will be able to

•Understand the concept of time value of money in conventional financial system•Understand the concept of time value of money in Islamic financial system.•To compare the features of conventional and Islamic concepts of time value of money

Time Value of Money in Conventional Financial System

• TVM is a basic concept in the contemporary monetary system.

• It originates from the concept of interest which is prohibited in Islam

• It impacts consumer finance, business finance, and government finance.

Time Value of Money in Conventional Financial System

Time value of money

Rs.10,000 today or Rs.10,000 in 5 years?

Obviously, Rs.10,000 today.

Suppose you can purchase a bicycle today for Rs.10,000, would you be able to purchase the same bicycle 5 years from now.

Conventional financial theory suggest that an efficient funds management requires a better funds allocation and arrangement.

e.g. there is always an opportunity to earn an interest rate on deposits instead of exposing them to other investment opportunities.

Time Value of Money in Conventional Financial System

• Simple Interest

Interest paid or earned on only the original principal amount borrowed or lent.

• Compound Interest

Interest paid or earned on the principal and any previous interest earned.

Time Value of Money in Conventional Financial System

Simple Interest Formula

Formula SI = P0(i)(n)

SI: Simple Interest

P0: Amount Deposited today (t=0)

i: Interest Rate per Period

n: Number of Time Periods

Simple Interest Example

Assume that you deposit Rs.100 in an account earning 8% simple interest for 2 years. What is the accumulated interest at the end of the 2nd year?

Simple interest = P0(i)(n)= Rs.100(.08)(2) = Rs.16

Future Value using Interest

What is the Future Value (FV) of the deposit?

FV = P0 + SI = 100 + 16= Rs.116

Future Value is the value at some future time of a present amount of money, or a series of payments, calculated at a given interest rate.

Compound Interest

• An interest rate that applies both on the principal amount and the interest earned on it during the previous year or years.

• Most of the deposits in financial institutions earn compound interest.

• Deposits grow exponentially in compound interest where as with simple interest they grow linearly.

Future Value of a Deposit

Assume that you deposit Rs.1000 at a compound interest rate of 7% for 2 years.

0 1 22

Rs.1,000

FVFV22

7%

Future Value of Deposit

FV1 = P0 (1+i)1

= Rs.1,000 (1.07)= Rs.1,070

During the first year of deposit simple and compound interest will remain the same i.e. Rs.70, but from second year the principal amount will become Rs.1070 for compound interest calculations.

Future Value of Deposit

FV1 = P0 (1+i)1 = 1,000 (1.07) = Rs.1,070

FV2 = FV1 (1+i)1 = P0 (1+i)(1+i) = 1,000(1.07)(1.07)

= P0 (1+i)2 = 1,000(1.07)2

= Rs.1,144.90

You earned an EXTRA Rs.4.90 in Year 2 with compound over simple interest.

General Formula of Future Value

FV1 = P0(1+i)1

FV2 = P0(1+i)2

General Future Value Formula:

FVn = P0 (1+i)n

Why Compound Interest?Growth pattern of Rs. 1 Lakh in 25 years with interest rate of 10% per year simple and compound.

The Time Value of Money in Islamic Finance

1. Money: An Islamic Viewpoint

2. Cash vs. Credit Price in Sale Transactions

3. The Monetary Valuation of Time in Credit Transaction

4. Economic Value of Time

5. Comparison between conventional and Islamic perspective.

1. Money: An Islamic Viewpoint

The Concept and Nature of Money in

Conventional system :

1.Money is a commodity and is used to obtain other goods.

2.Widely Marketable as it is highly in demand and valued good. Thus, it is sure that it can be used anytime and anywhere.

3.It can be transport easily. Money is made to make human life easier therefore to make sure that it’s convenience is important.

4.Relatively scarce as it is high in demand and high in value, which means it holds a high value in small quantities.

1. Money: An Islamic Viewpoint

Nature of money under

Conventional system

5.Money is relatively imperishable. It is durable and can be used for future purchases.

6.Easy to store.

7.Easily divisible

8.Money lasts forever.

9.All units of money are similar, meaning to say that it is easy to distinguish and estimate the value of the money.

1. Money: An Islamic Viewpoint

Nature of money under

Islamic system 1.Islam treats money as unit of account to determine the relative worth of goods and services.

2.A medium of exchange, and not a store of value.

3.All units of money of the same denomination are 100% equal to each other.

4.It becomes useful only when it is exchanged into a real asset or used to buy services.

5.Money cannot be sold or bought on credit.

1. Money: An Islamic Viewpoint

Money vs. Commodity

•Money has no intrinsic utility whereas a commodity has an intrinsic utility and can be utilized directly.

• Commodities can have different qualities, while money’s sole quality lies in the fact that it is a measure of value or a medium of exchange.

1. Money: An Islamic Viewpoint

Money vs. Commodity

Shariah treats money differently from commodities for two main reasons:

1. money is not allowed to be the subject matter of trade like other commodities.

2. if money has to be exchanged for money or is borrowed for exceptional reasons, the payment on both sides must be equal so that it is not used for any purpose for which it is not meant to be used (i.e., trading in money itself).

1. Money: An Islamic ViewpointMaking Money out of Money

1. Islam considers money to be no more than a medium of exchange and to have no value in itself, it should not be allowed to give rise to more money (via fixed-interest payments).

2. Money is treated as capital only when it joins hands with other resources to undertake a productive activity. Islam recognizes its time value only when it acts as capital, not when it is “potential” capital

Lending MoneyLike the capitalist financial system, Islam does not

recognize loans as income generating transactions.

2. Cash vs. Credit Price in Sale Transactions

The Permissibility of Sale on Credit: The Legal Evidences

• The following Quranic verses: “Allah has permitted trade and forbidden riba. (2:275) “O you who believe! When you deal with each other in transactions involving future obligations in a fixed period of time, record them in writing. (2:282)

• Ummul Momineen Syeda Ayshah reported that the Prophet (pbuh) bought some foodstuff on credit from a Jewish trader and mortgaged his armor to him. (Bukhari and Muslim)

2. Cash vs. Credit Price in Sale Transactions

There is consensus among the scholars on the permissibility of selling on credit if the due date is known and also the permissibility of increasing the prices of a sale on credit•The price may be increased based on deferment. Al-Kasani (Hanafi)•time has been given a share in the price. Ibn Rushd (Maliki) •Deferment earns a portion of the price. Al-Nawawi (Shafi`i) •Deferment takes share of the price. Ibn Taymiyah (Hanbali)

2. Cash vs. Credit Price in Sale Transactions

Reducing the Loan Amount for Early Repayment• The juristic consensus is that making such a reduction in the

case of a deferred debt conditional on earlier repayment is not allowable.

• However, some of the companions permit : Ibn al-Qayyim, and, more recently, has been adopted by the OIC Fiqh Academy, which states: Reduction of a deferred debt in order to accelerate its repayment, whether at the request of the debtor or the creditor, is permissible under the Shariah. It does not constitute a forbidden riba if it is not agreed upon in advance and as long as the creditor-debtor relationship remains bilateral. If, however, a third party is involved, it becomes forbidden, since it becomes similar to the discount of bills

3. The Monetary Valuation of Time in Credit Transaction

The Monetary Valuation of Time in Sale Transaction

Price differentials compensating for the delay in fulfilling a party’s contractual obligations or for the opportunity cost of the money used by a contractual party in providing goods, have been recognized as legitimate under traditional jurisprudence.

3. The Monetary Valuation of Time in Credit Transaction

The Monetary Valuation of Time in Lending Transactions

• Islam does not recognize any loan for deferral based on money’s time value designed to benefit the lender. It only recognizes a Qard e Hasan loan.

4. Economic Value of Time

• Shariah admits the concept of money’s time value to the extent of pricing in a credit sale, it does not endorse placing “rent” on money advances, as interest does in the case of credit and advances.

• Time valuation is possible only when goods are traded, not when exchanging monetary values and loans or debts

• While money’s time value is acceptable in the case of pricing assets and their usufruct, it is not acceptable in the case of any addition to the loan’s or debt’s principal.

• It is better to use term economic value of time instead of time value of money.

Comparison between Conventional and Islamic Perspective

Conventional

Money is a commodity besides medium of exchange and store of value. Therefore, it can be sold at a price higher than its face value and it can also be rented out.

Islamic

Money is not a commodity though it is used as a medium of exchange and store of value. Therefore, it cannot be sold at a price higher than its face value or rented out

Comparison between Conventional and Islamic Perspective

Conventional

Time value is the basis for charging interest on capital.

Islamic

Profit on trade of goods or charging on providing service is the basis for earning profit

Comparison between Conventional and Islamic Perspective

Conventional

Interest is charged even in case the organization suffers losses by using bank’s funds. Therefore, it is not based on profit and loss sharing.

Islamic

Islamic bank operates based on profit and loss sharing. In case, the businessperson has suffered losses, the bank will share these losses based on the mode of finance used (Mudharaba, Musharakah).

Comparison between Conventional and Islamic Perspective

Conventional

While disbursing cash finance, running finance or working capital finance, no agreement for exchange of goods & services is made.

Islamic

The execution of agreements for the exchange of goods & services is necessary, while disbursing funds under Murabaha, Salam & Istisna contracts.

Comparison between Conventional and Islamic Perspective

Conventional

Conventional banks use money as a commodity, which leads to inflation.

Islamic

Islamic banking tends to create link with the real sectors of the economic system by using trade related activities. Since, the money is linked with the real assets therefore it contributes directly in the economic development.

Summary of the Lecture

In this lecture we discussed

•the concept of time value of money in the conventional financial system.

•Its concept in Islamic financial system.

•A comparison between the conventional and Islamic perspective about time value of money.