Space value of money and Islamic finance

Category: Life & Society Topics: Economy, Islamic Finance, Money Views: 7582
7582

Across the theory and practice of finance and financial valuation, the two most important principles used to value instruments and investments are time value of money and risk and return. This is a textbook fact, and is also true in theoretical and applied financial valuation models.

I propose the concept of space value of money as the abstract and universal parallel to a key principle of Islamic finance, ie, the principle that prohibits interest, and seeks to incorporate real activity into its instruments and transactions.

Interest is earned via two basic components, capital and civil calendar time. Thus, the principle of banning interest within Islamic finance is based on the idea of having more than just time and capital in the cooking pot.

An investment project of whatever nature has space value of money when it has an impact on the physical space and its inhabitants. Such a project achieves its earnings by using, alongside time and capital, real people and real assets.

The real activity involved gives the project a community impact that would otherwise be absent if the earned return was to be interest on time and capital alone. Thus, when a project or instrument is structured in such a way that it involves real activity, it has a space value of money.

Space value of money is the aggregate real asset impact of a project. Asset is here understood to include everything, from people to buildings, resources to products, factories to ships and airplanes, and innovations to institutions. In other words, it is possible to measure the real impact of a project, either in monetary terms, or in terms of quantity and types of assets used.

Islamic finance requires projects and instruments to have a space value of money. Indeed, existing products achieve this on a variety of levels. Some involve real activity in the legal sense, and the impact on real people and real assets is relatively insignificant, others engage real assets directly and have a larger asset footprint.

Space value vs time value of money

One of the most important pillars of modern conventional finance is the principle of time value of money. It is based on the basic observation that a dollar today is worth more than a dollar tomorrow, due to the fact that a dollar today will earn interest, and by tomorrow, it will be worth more than a dollar. The key variables that make this relationship possible, are time and interest applied to capital.

Islamic products and investments do not pay an interest, but they do have expected future cash flows. Thus, one can always discount future cash flows with an appropriate opportunity cost. The opportunity cost will be the return on an alternative investment that has the same level of risk. Fundamentally, this will be a percentage that will be applied to calculate the present value of future cash flows.

One important difference to be introduced when a project is Islamic in nature, or when a project has space value of money as well as time value of money, is that initial investment will have an asset footprint that will by itself generate additional value creating economic and financial transactions.

To give a simple example, a bond earns its return due to capital, time, and the interest charged. The earning mechanism of a bond does not involve real assets and real people. Sure, bankers manage and arrange for the execution of a bond, but the coupon earnings are due to the investors simply because time has passed, and interest is owed on capital.

An Islamic bond is expected and required to involve real assets and real people in its earning mechanism. Thus, it has a space value of money, which can be assessed based on the aggregate asset impact of the transaction. In other words, the discounting of future cash flows alone will not give a full picture of the economic benefit of the project, until the space impact of the instrument is also taken into account.

Sukuk

Sukuk are fixed return investments that have a space value of money. The fixing of return based on a pre-agreed equation of risk and reward does not in itself contradict the principles. The unacceptable element within the value framework of Islamic finance is the fixed interest on money plus time.

The key clarification to be made here is that the shape of the cash flow is not really relevant. In other words, just because an Islamic bond has a conventional bond cash flow does not mean that it is not Islamic. After all, whether we are talking of a fixed, open ended, or variable cash flow, what makes the cash flow Islamic is not its time patterns, but its source and impact.

To fulfil the spirit of the principles, we need to ensure the return is not earned simply on time and capital, but also through real activity, productive resources, and an ethical contribution to society and economy, which means the instrument has a space value of money.

A number of sukuk structures aim to achieve exactly that. The complexities of these structures are the direct result of these efforts. However, we need to ensure that sukuk complexities do not become merely legal complexities, and the initial purpose of introducing them, which is to involve more than just time and capital, is achieved.

In other words, sukuk should be instruments that have both a bond cash flow and a space value of money, with a real asset footprint.

Conclusion

This article proposed the concept of space value of money as a universal parallel to the Islamic principle that prohibits interest, and seeks to incorporate real activity into its instruments and structures. Islamic finance requires products and investments to have a space value of money, thus requiring a positive, real, and ethical contribution to society and economy.

Sukuks are unique instruments that have a typical bond cash flow, but also offer a space value of money. As such, they clarify an important issue: it is not the time patterns of cash flows that make an instrument Islamic, but the source and impact of cash flows.

Space value of money does not replace the principle of time value of money. It comes to complement its basic proposition of time value with space value. Indeed, time-space is a more complete representation of our reality than time alone. Moreover, taking into account time and space parameters is bound to make us more relevant to our current moment.

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Armen Papazian  is an industry expert specializing in financial economics, capital markets, Islamic finance, and monetary and fiscal policy

The Art of Islamic Banking and Finance: Tools and Techniq...

IslamiCity Bazar


  Category: Life & Society
  Topics: Economy, Islamic Finance, Money
Views: 7582

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Older Comments:
SAJ FROM UK said:
Are you talking about the social opportunity cost of capital and valuing a project's economic impacts together with its financial impacts? In the UK we have a discount rate of 3.5% for the time value of money for social projects. The social impact is then captured by undertaking a cost benefit analysis of the project intervention.
2010-04-14

MAYA V FROM AK said:
It is confusing as always - atleast for me. Why is that, then the fixed return from a conventional bank cannot be considered as Sukuk - bank lends to businesses which utilizes money to have a space value. Ofcourse, it could be lending to haram businesses too. But the model itself is no wrong by this artcile, I guess.
It is appreciated the people are thinking more halal ways of investing so that common man can invest comfortably.
2010-03-30

ABDUL FROM USA said:
Sir,In this economy where investing is too unpredictable,what would you suggest,what can a coomon muslim do,to increase the value of money which is in bank.Please give some realistic answer for an every day person who would like to adhere to islamic principles of increasing the value of money.
What would be your answer for devaluation of money,if kept in the bank over a length of time.
Best regards,
Abdul
2010-03-26