An Islamic Capital Asset Pricing Model

Purpose: In this paper, the Islamic financing method based on direct musharakah is applied to the conventional Capital Asset Pricing Model (CAPM) yielding several interesting hypotheses.Methodology: Theoretical methodology, with maximin criteria, and rational economic optimization.Findings: There are four major findings. First, an Islamic financing partnership based on complementary capital is proven to necessarily yield a lower beta-risk of investments than that compared to the market. Second, in order for the above conclusion to hold, capital lenders (such as banks) must abide by a maximum partnership share inversely proportional to project risk and increasing with opportunity cost of capital. Third, the sum of lender's share and relative risk level balances to unity at equilibrium. Hence, tradeoffs exist in risk-shares and not in risk-returns. Fourth, without accounting for inflation, and in contrast to predetermined fixed interest, a maximin strategy of financing partnerships (maximum return with minimum risk) imply an existence of an optimum zero risk-free rate. Limitations: The paper's findings are limited to a Direct Musharakah Partnership.Value: Theoretical conditions and a comparison between Islamic risks and returns to conventional risk management are derived. Several implications on the conduct of Islamic financing are discussed