9time_value_of_money_in_islamic_finance 35.ppt

islamic banking and finance

1. Time Value of Money in
Islamic Finance

2. 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.

3. 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

4. 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.

5. 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.

6. 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

7. •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

8. Simple Interest Formula
FormulaSI = P
0(i)(n)
SI:Simple Interest
P
0
:Amount Deposited today (t=0)
i:Interest Rate per Period
n:Number of Time Periods

9. 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 = P
0
(i)(n)=
Rs.100(.08)(2) = Rs.16

10. 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.

11. Future Value using Interest
What is the Future Value (FV) of the deposit?
FV = P
0 + 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.

12. 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
FVFV
22
7%

13. 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.

14. 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.

15. General Formula of Future Value
FV1 = P0(1+i)
1
FV2 = P0(1+i)
2
General Future Value Formula:
FVn = P0 (1+i)
n

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

17. 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.

18. 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.

19. 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.

20. 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.

21. 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.

22. 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).

23. 1. Money: An Islamic Viewpoint
Making 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 Money
Like the capitalist financial system, Islam does not recognize
loans as income generating transactions.

24. 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)

25. 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)

26. 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

27. 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.

28. 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.

29. 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.

30. 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

31. 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

32. 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).

33. 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.

34. 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.

35. 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.