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A glossary of contracts used in Islamic finance

Riba, Gharar, Murabaha, abba, Ijarah, Salam, Istina, Sukuk, Mudarabah, Musharaka, Takaful

Financial engineering for ethical investors

Basic principles of Islamic finance Risk sharing partnership: The fundamental principle in Islamic finance is partnership. Financial institutions and entrepreneurs should be partners and share in any profits or losses.

Riba (interest, usury): Interest is forbidden in Islam because a loan is considered a humanitarian act. To charge interest on money you lend to someone in need would turn a moral act into a money-making and exploitative venture. So Islamic financing tends to be structured around partnership or asset-based leasing contracts instead.

Forbidden activities: Investments should only support halal (permissible) activities. Forbidden (haram) activities include gambling, pornography, alcohol production and sale, pork production and conventional financial institutions.

Gharar (uncertainty): Transactions should be free from uncertainty so that they are precisely defined to participants. Uncertainty can also introduce an element of gambling, a forbidden activity, into a contract.

The role of money: Islamic finance does not recognize any intrinsic value in money. Money is a medium of exchange and a store of value but not the subject of trade.

Financing structures  

Murabaha (cost plus financing): The most widely used and flexible contract in Islamic finance. Used in consumer, corporate, subordinated, and term financing. The bank purchases a good at the request of a client. The client makes deferred payments that cover the cost of the good plus a mark-up to provide the bank with an agreed profit margin. The title of the good is transferred to the client at the time of purchase but the client normally provides the same or other assets as collateral to the bank over the period of financing.

Al-bai bithaman ajil (abba): Abba is the most widely used contract for Islamic financing in Malaysia and is the preferred choice for long-term projects. It is not, however, recognized by many Islamic authorities outside Malaysia. Abba is similar to murabaha except that ownership is transferred at the start of the financing period. The bank arranges the purchase of an asset and then transfers ownership to the client who repays the bank the purchase price plus an agreed profit margin. The obligation can then be securitized into tradable debt certificates called shahadah al-dayn.   Ijarah (leasing): In an ijarah contract the bank purchases capital equipment or property and leases it to the client. The bank either rents the asset to the client or takes a share of the profits earned through its use. Ijarah can be structured either to pass the title on to the client or to be retained by the bank.

Salam (sometimes called salaf - forward contract): A salam is a short-term deferred delivery sale contract usually used for commodity finance. The financial institution makes full prepayments for a specified quantity of goods to be delivered on a specified date. The customer repays the bank the purchase price plus an agreed profit margin on receipt of the good.

Istina (work-in-progress financing): Istina is similar to salam and conventional work-in-progress financing. It is normally used for construction and trade finance such as pre-shipment export finance.

The bank pays the construction company or exporter and receives payment from the client equal to the purchase price plus a profit margin once delivery has been received.

Sukuk (asset-backed bond): The issuer places assets in a special purpose vehicle. Sukuk bonds are issued from the SPV and are sold to investors like conventional asset-backed bonds.

Equity financing Although equity financing contracts are considered ethically superior from a Shariah perspective they are less commonly practised today than other types of contacts because they are considered more risky.

Mudarabah (profit-sharing agreement): In a mudarabah contract the financial institution invests in a commercial activity as a silent partner for an agreed portion of the profits. Mudarabah can be structured as a single investment or on a continuing basis. Mudarabah investments can be arranged through negotiable instruments called mudarabah certificates, which are similar to conventional shares. Normally the client provides management expertise or entrepreneurship but not capital. This means that if the activity makes a loss the financial institution bears all the loss unless the loss resulted from management negligence.

Musharaka (equity participation): A musharaka is a partnership between a financial institution and an enterprise. The financial institution supplies working capital and notes of participation are sold to investors to supply financing. In what is known as a diminishing musharaka, the client buys out the financial institution's share over time.

Takaful (literally joint guarantee) Takaful is a form of mutual insurance in which members agree jointly to guarantee themselves a defined benefit against loss or damage from the fund. European marine insurance is derived from the traditional Islamic practice. All commercial contracts in takaful must be Shariah-compliant so there is no role for interest. Contracts tend to be based on the mudarabah profit-sharing contract.

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