Chapter Three

Literature Review

3.1 Introduction

3.2 Empirical Studies

3.3 Summary of the Previous Studies

3.4 What Distinguish the Current Study from Previous

Once?

3.5 Summary
3.1 Introduction

This chapter will discuss the related literature that has discussed the

effect of Islamic Asset Pricing Model (ICAPM), several researchers

investigate this effect. Sharia funding required the Sharia system

required, so the traditional CAPM developed in the interest-based

environment (riba) is incompatible with the Islamic financial system.

Sweet Indonesia. The method of this survey is exploratory through the

objective of studying the literature on the model. CAPM model. This

research should contribute in terms of assessing the Sharia risk and return

on investment, in particular in the pricing model. Compliance with the

Sharia Model (Islamic Capital Asset Pricing Model (ICAPM).

Appropriate Asset Pricing Model of Shariah. The results of this study

show that the Islamic Capital Asset Pricing Model (ICAPM) is a capital

asset model Pricing model (CAPM), which has been described as one of

the basic concepts of CAPM in which there is no inflation. The following

sections will review related studies in details.

3.2 Empirical Studies

Ferdian et al., (2011). "Firm Size, Book to Market Equity, and

Security Returns: Evidence from the Indonesian Shariah Stocks"

Examine the firm size, book to market equity, and security returns.

Capital market is one of the indicators that may give measurement on the

economic growth of a country, including Indonesia. In the country, the

main reference for any investment decisions related to Islamic capital

market instruments is based on Shariah Securities List (SSL) issued by

Bapepam-LK. Investors who put funds in the Indonesian Shariah Stocks

can make investment decisions by monitoring the performance of these

stocks. This can be done by using return measurement methods such as

the Capital Asset Pricing Model (CAPM) proposed by Sharpe (1964).

However, Fama and French (1992) argue that size, EPR, debt-to-equity,

and book-to-market ratio have explanatory power to stock returns.

Further, Fama and French (1993) find that the most significant variables

among those mentioned above in explaining the stock returns are size,

book-to-market ratio, and market beta. The results show that the market

beta alone is not sufficient to describe the variation in average equity

returns for Indonesian Shariah Stocks over the period of 14 September to

25 September 2009. Additionally, the results show that even though size

and value premium exist in the Indonesian Shariah Stocks; the market
factor is still the most important factor among the Fama & French Three

Factors Model.

Hanif (2011). "Risk and Return under Shariah Framework: An

Attempt to Develop Shariah Compliant Asset Pricing Model

(SCAPM)"

Investigates to understand conventional asset pricing models,

document any mismatching with Shariah financial system, and suggest

amendments if required. A speedy emerging area of finance is the

Shariah-compliant financial system. In the first decade of 21st-century

Islamic financing has shown a tremendous increase and global volume

has reached US $ 1,041 billion by the end of 2009. Being financial

intermediaries Islamic Financial Institutions (IFIs) have shown

commendable progress in deposit collection under profit and loss sharing

schemes however investment avenues are limited in comparison to

conventional banks. Although a large number of financing modes are

available to IFIs, yet maintenance of required liquidity is a serious issue

because the money market and capital market is dominated by interest-

based instruments and conventional practices (some are clearly prohibited

by Shariah). Recently Al-meezan Investment Management Ltd. (AIML)

has started screening of Shariah-compliant stocks on KSE and provided

an avenue for Shariah Compliant Investors/IFIs to invest inequities. This

study is conducted to understand conventional asset pricing models,

document any mismatching with Shariah financial system, and suggest

amendments if required. Findings suggest existing models of equity

pricing (CAPM, APT/MFM) are very much practicable under the Shariah

framework with a slight modification of risk-free return because under

Shariah framework risk-free returns do not exist. The results show that

the existing models of equity pricing (CAPM, APT/MFM) are very much

practicable under the Shariah framework with a slight modification of

risk-free return because under Shariah framework risk-free returns do not

exist.

Abbes (2012). "Risk and Return of Islamic and Conventional

Indices"

Examines the risk and the return characteristics of the Islamic market

indices versus their conventional counterpart indices. For this purpose, a

large international data of 35 indices combining developed, emerging and

GCC markets over the period of Jun 2002 to April 2012 is used. The t test

has been employed to investigate the mean returns difference between

both types of indices. The results show that there is no significant

difference in mean between Islamic and conventional indices except for

Italy and Australia. The EGARCH estimation results reveal the presence

of a leverage effect risk in all studied indices. The study of the risk

adjusted performances of Islamic stock market indices versus their

conventional counterpart indices using differences-in-Sharpe ratio test

and the CAPM model show that in the entire period as well as in the

crisis period there is no difference between performance the types of

indices in risk adjusted return basis. Consequently, Muslim investors can

pursue passive stock investments in conformity to their religious beliefs

without sacrificing financial performance.

Lean and Parsva (2012). "Performance of Islamic Indices in

Malaysia FTSE Market: Empirical Evidence from CAPM"

Investigate the relationship between return and market risk for the

Islamic stocks in Malaysia Financial Times Stock Exchange (FTSE)

market. The Capital Asset Pricing Model (CAPM) has been examined

extensively for common stock return and index return. However, the

examination with Islamic stocks is limited the sample use FTSE Bursa

Malaysia EMAS Shariah Index (FBMSHA) and FTSE Bursa Malaysia

Hijrah Shariah Index (FBMHS) are proxy for the Islamic portfolio, the

sample period is from 1 March 2008 to 28 February 2011. The results

show that some new insights on the performance of Islamic stocks in

Malaysia FTSE market through stating the hypothesis that the risk of the

Islamic indices is high in a downturn economic status in comparison with

a normal period.
 Sadaf and Andleeb (2014). "Islamic Capital Asset Pricing Model

(ICAPM)"

Attempt to empirically evaluate Shariah Compliant Asset Pricing

Model using data from Shariah complaint stocks of Karachi- Meezan

Index, The price data for these Shariah complained stocks are obtained

from ZHV Securities and KMI30 index price from Sc traders, with the

Sample period from March 2012 to March 2013. With the increase in

trend of moral investment, the conventional finance has observed an over

increasing significance of Islamic finance. This change is being observed

not only in Asian and Islam dominant countries, but also western

corporate world. The results show that the returns would approximately

the same when they use risk free rate (T-bills rate) or inflation rate.

However they show a constant trend when evaluated without using risk

free rate or inflation rate.

Pouryani (2015). "Providing Recommendations on Capital Asset

Pricing Model (CAPM) on the Basis of Islamic Assumptions"

Test the recommendations on Capital Asset Pricing Model (CAPM)

on the basis of Islamic assumptions. Using a sample from Islamic

financial system comprising Islamic banking, Islamic insurance and

Islamic capital market in Tehran Stock Exchange during the period 2013-

2014. The Islamic financial system has received significant attention as

an efficient and executable financial model substitute for the neoclassic

system. Islamic financing too is a renowned topic in financing which has

illustrated remarkable growth and performance since the first decade of

the 21st century. Although criticized for practicing the same pricing

criteria as the conventional financial system in product pricing and profit

charging, it is argued that Islamic finance falls within the frameworks of

the Sharia law (Islamic law). Therefore, capital asset pricing in the stocks

market is targeted in the present research. In this theoretically conducted

work, the author aims to suggest an alternative to the CAPM (Capital

Asset Pricing Model) as one of the most important financial models used

for pricing of assets. The results show that an offer a suggestion to the

CAPM using rules governing the Islamic financial system such as value-

based pricing (on the basis of total asset), mechanisms underlying

financial operations in the Islamic system and the system’s assumed

Islamic contracts. The proposed model hereby presented is an expansion

of the CAPM in the Islamic domain.

Febrianto and Rachman (2016). "Islamic Capital Asset Pricing

Model: A comparative analysis"

Aim of the current study is to compare the conventional model with

others which are developed by using zakat and inflation as a replacement

component for risk free rate in CAPM, called Islamic CAPM. Moslem

investors often find dilemma about asset pricing while having

investments in stock exchange. Conventional asset pricing model, such as

Capital Asset Pricing Model (CAPM), cannot accommodate the needs for

asset pricing which is free from riba and interest as one of the sharia

requirements. Using a sample from 25 companies (i.e. companies that

survived from February 2015 to February 2016) from Indonesian Shariah

Stock (ISS) The result shows that Islamic investors could use inflation as

a replacement component for risk free rate. The statistical evidence also

shows that the accuracy of this model is similar to the conventional asset

pricing model.

Hakim et al., (2016). "Capital Asset Pricing Model and Pricing of

Islamic Financial Instruments"

Test the proposed models together with conventional CAPM in Bursa

Malaysia using three- and ten-year data and the effect of Shariah-

compliant CAPM. The prohibitions of riba (interest) and trading in non-

ḥalal businesses in Islam redefines investment universe assumed by

Capital Asset Pricing Model (CAPM). The sample use FTSE Bursa

Malaysia EMAS Shariah Index as proxy for the Shariah-compliant

market portfolio and one-year yield of AAA-rated ṣukuk as proxy for the

zero-beta portfolio during 2015. In Islamic investment world, risk-free

asset and market portfolio with non-ḥalal constituents are irrelevant. They

propose two-versions of Shariah-compliant CAPM that use Shariah

complaint market portfolio and are free of risk-free asset. The results

show that the models with three-year data reveal remarkable similarity
between versions of Shariah-compliant models. Besides, Shariah-

compliant CAPM is as capable of explaining returns on Shariah-

complaint stocks as conventional CAPM is of explaining returns on all

stocks.

Hanif et al., (2016)." Risk and Returns of Shariah

Compliant Stocks on the Karachi Stock Exchange – A

CAPM and SCAPM Approach"

Examine the asset pricing mechanism of Shariah compliant securities

listed on the Karachi Stock Exchange. They select the CAPM market

model to test for the impact in variations of stock returns on a sample of

Shariah-compliant companies from Karachi Stock Exchange (KSE)

on ten years monthly data (2001-2010). They first test the basic CAPM

(Capital Asset Pricing Model) and its modified form known as the

Shariah-compliant asset pricing model (SCAPM). They also analyze

return differences due to size (market capitalization), book to market

(B/M) value, price-earnings ratio (PER), and cash-flow yield (CFY). The

results show that a strong impact of the market index on stock returns

(adj-R2 70%) and confirm the anomalies of size, B/M, CFY, and PER,

while SCAPM is slightly better in explaining variations in cross-sectional

stock returns.
 Derbali et al., (2017). "Shariah-compliant Capital Asset Pricing

Model: new mathematical modeling"

Propose a novel approach in pricing Islamic financial assets in

accordance to Shariah, advocated by contemporary investment theories of

Markowitz's Mean-Variance Analysis and CAPM. The Shariah-compliant

Capital Asset Pricing Model that they developed with a few changing's of

the traditional Capital Asset Pricing Model is integrating zakat,

purification of return and exclusion of short sales. Then, they utilize a

sample composed of 10 Shariah-compliant public listed companies in

Bursa Malaysia and Lumpur Composite Index (KLCI), the sample period

is from January 01, 2003, to December 31, 2015. The results show that

the Islamic CAPM is appropriate and applicable in investigating the

linkage amongst risk and return in the Islamic stock market. Their

investigation contributes to existing body of knowledge by presenting an

algorithm and mathematical modelling of the Shariah-compliant CAPM

which has been lacking in the literature of Islamic finance.

Hasanah and Maspupah (2017). "Shariah Compliant Asset

Pricing Model (SCAPM) the Formula of Risk and Return

Modification in Islamic Finance"

Test to contribute in terms of risk assessment and return on Islamic

investment, especially in Indonesia. The method in this study is

exploratory through a literature study approach on the Capital Asset

Pricing Model (CAPM) model and explores studies on investment sharia

compliance issues to obtain a risk and return assessment model in the

sharia framework, the Shariah Compliant Asset Pricing Model (SCAPM)

during 2016. As an Islamic financial institution to the capital market for

investment, guidance in the area of risk and returns and security under the

sharia framework is required. Traditional CAPM developed in an interest-

based environment (usury) is not compatible with the Islamic financial

system. Thus making estimates of risk and return models accepted by the

sharia model without changing the assumptions of the existing model

(CAPM). The results show that the Sharia Asset Price Model on Demand

(SCAPM) is a modification of the Capital Asset Pricing Model (CAPM)

model, which has been explained that one of the basic assumptions of the

CAPM is that there is no inflation. So in this study, the researcher did not

use inflation but replaced the inflation factor with the rate of return of

Bank Indonesia Sharia Certificate (SBIS). The results show that the

Islamic financial system is not limited to banking, but also includes

capital formation, capital markets, and all kinds of financial

intermediation. The system interprets as "interest-free" tend to create

confusion.
 Hazny et al., (2017). "Mathematical Modelling of a Shariah-

compliant Capital Asset Pricing Model"

Present a review of the CAPM and to discourse the set of assumptions

underlying the model in terms of Shariah compliance from ten shariah-

compliant public listed companies in Bursa Malaysia, during the period

from 1 January 2002 to 31 December 2015 The Capital Asset Pricing

Model (CAPM) is the most widely used asset pricing model that

measures risk-return relationship. The CAPM is based on Markowitz’s

Mean-Variance Analysis. The advancement of Islamic finance leads to

the question whether or not the practice of modern investment theories

and analyses like the Markowitz’s Mean Variance Analysis and CAPM

are in accordance to Shariah and could be used in pricing Islamic

financial assets. Although most of the assumptions are not contradictory

to Shariah principles, there are Islamic variables such as prohibition of

short selling, purification and zakat that should be taken into

consideration when pricing Islamic financial assets. The results show that

develop a mathematical model which is a modification of the traditional

CAPM that incorporates principles of Islamic finance and integrating

zakat, purification of return and exclusion of short sales. At the end, as a

proof-of-concept, the results show that the proposed Shariah-compliant

CAPM in comparison to the traditional CAPM.

 Husein and Hasanah (2017). "Determining the optimum portfolio

of Shariah stocks using an approach of Shariah Compliant Asset

Pricing Model (SCAPM)"

Investigate Shariah Compliant Asset Pricing Model (SCAPM) is a

modification of the model Capital Asset Pricing Model (CAPM). This

study is quantitative descriptive study of theories of optimal portfolio

analysis applied to trading stocks, especially in Stocks Jakarta Islamic

Index (SJIII). Sampling technique used was purposive sampling and

obtained 26 shares during the period from 2010-2016. The analysis tool

used is Mat Lab R2010a. The results of this study are not prove the

Markowitz portfolio theory. This is explained by the amount of Beta

market (β_m) a value beta below 1 indicates that the fluctuation of stocks

returns do not follow the movement of market fluctuations. Investors are

likely to want a high profit, the investors are advised to choose a second

portfolio groups, with rate of 0.176722% and investors are likely to enjoy

a substantial risk in the investment portfolio are advised to choose the

first group with a great risk of 0.8501%.

Hassan et al., (2018). "The effects of Shariah board composition

on Islamic equity indices' performance"

Test the effects of Shariah board composition on Islamic equity

indices' performance. Based on a sample of 54 Islamic indices over the

period 2007–2014 from Indonesian Shariah Stocks (ISS), they investigate

the effect of Shariah board members' educational background on Islamic

indices' risk and return characteristics via the screening criteria. Using a

capital asset pricing model benchmark analysis, they assess the sensitivity

of Islamic indices to their conventional peers in terms of beta and derive a

measure of return (Jensen's alpha). First, they observe that the higher the

number of members in common among the boards, the higher the risk–

return profile of Islamic indices. Second, commonalities among board

members lead to standardization of the screening criteria and to similar

Islamic indices' performance. The results show that the different betas

across providers depend on the screening criteria, while the economic

educational background of board members affects performance in terms

of Jensen's alpha. Their study aims at contributing to the governance

literature related to board composition and its importance as a possible

driver of performance. In addition, given the impressive growth that

Islamic finance has experienced during the last decade, this topic is of

great interest to the asset management industry.

 3.3 Summary of the Previous Studies

Table (3-1) Summary of Previous Studies

No. Author Objective Sample Period Results

Market
Previous Studies
1. Ferdian et Examine the firm ISS 2009 The results show that even
al., 2011 size, book to market though size and value
equity, and security premium exist in the
returns. Indonesian Shariah Stocks;
the market factor is still the
most important factor among
the Fama & French Three
Factors Model.
2. Hanif, 2011 Investigates to KSE 2008- The results show that the
understand 2011 existing models of equity
conventional asset pricing (CAPM, APT/MFM)
pricing models. are very much practicable
under the Shariah framework
with a slight modification of
risk-free return because
under Shariah framework
risk-free returns do not exist.
3. Abbes, Examines the risk International 2002 - The results show that there is
2012 and the return data 2012 no significant difference in
characteristics of the mean between Islamic and
Islamic market conventional indices except
indices versus their for Italy and Australia.
conventional
counterpart indices.
4. Lean and Investigate the FTSE 2008 - The results show that some
Parsva, relationship between 2011 new insights on the
2012 return and market performance of Islamic
risk for the Islamic stocks in Malaysia FTSE
stocks in Malaysia market through stating the
Financial Times hypothesis that the risk of the
Stock Exchange Islamic indices is high in a
downturn economic status in
comparison with a normal
period.
5. Sadaf and Attempt to ZHV and 2012 - The results show that the
Andleeb, empirically evaluate KMI 2013 returns would approximately
2014 Shariah Compliant the same when they use risk
Asset Pricing Model free rate (T-bills rate) or
using data from inflation rate.
Shariah complaint
stocks of Karachi-
Meezan Index.
6. Pouryani, Test the TSE 2013- The results show that an
2015 recommendations on 2014 offer a suggestion to the
Capital Asset Pricing CAPM using rules governing
Model (CAPM) on the Islamic financial system
the basis of Islamic such as value-based pricing
assumptions. (on the basis of total asset),
mechanisms underlying
financial operations in the
Islamic system and the
system’s assumed Islamic
contracts.
7. Febrianto Aim of the current ISS 2015 - The result shows that Islamic
and study is to compare 2016 investors could use inflation
Rachman,2 the conventional as a replacement component
016 model with others for risk free rate.
which are developed
by using zakat and
inflation as a
replacement
component for risk
free rate in CAPM.
8. Hakim et Test the proposed EMAS 2015 The results show that the
al., 2016 models together with models with three-year data
conventional CAPM reveal remarkable similarity
in Bursa Malaysia between versions of Shariah-
using three- and ten- compliant models.
year data and the
effect of Shariah-
compliant CAPM.
9. Hanif et Use firm life cycle as KSE 2001- The results show that a
al., 2016 a conditioning 2010 strong impact of the market
variable for index on stock returns (adj-
fundamental analysis, R2 70%) and confirm the
and investigate how anomalies of size, B/M,
the implications of CFY, and PER, while
 fundamental signals SCAPM is slightly better in
for evaluating firm explaining variations in
performance vary cross-sectional stock returns.
according to life
cycle stage.
10. Derbali et Propose a novel Bursa 2003- The results show that the
al., 2017 approach in pricing Malaysia 2015 Islamic CAPM is appropriate
Islamic financial and KLCI and applicable in
assets in accordance investigating the linkage
to Shariah, advocated amongst risk and return in
by contemporary the Islamic stock market.
investment theories
of Markowitz's
Mean-Variance
Analysis and CAPM.
11. Hasanah Test to contribute in ISS 2016 The results show that the
and terms of risk Islamic financial system is
Maspupah, assessment and return not limited to banking, but
2017 on Islamic also includes capital
investment, formation, capital markets,
especially in and all kinds of financial
Indonesia. intermediation.
12. Hazny et Present a review of Bursa 2002 – The results show that
al., 2017 the CAPM and to Malaysia 2015 develop a mathematical
discourse the set of model which is a
assumptions modification of the
underlying the model traditional CAPM that
in terms of Shariah incorporates principles of
compliance. Islamic finance and
integrating zakat, purification
of return and exclusion of
short sales.
13. Husein and Investigate Shariah SJIII 2010- The results of this study are
Hasanah, Compliant Asset 2016 not prove the Markowitz
2017 Pricing Model portfolio theory. This is
(SCAPM) is a explained by the amount of
modification of the Beta market (β_m) a value
model Capital Asset beta below 1 indicates that
Pricing Model the fluctuation of stocks
(CAPM). returns do not follow the
movement of market
fluctuations.
14. Hassan et Test the effects of ISS 2007– The results show that the
al., 2018 Shariah board 2014 different betas across
composition on providers depend on the
Islamic equity screening criteria, while the
indices' performance. economic educational
background of board
members affects performance
in terms of Jensen's alpha.

3.5 What Distinguishes this Study from Previous Ones?

In this chapter, the researcher discusses empirical studies that have

investigated the Islamic Capital Asset Pricing Model (ICAPM). Also, the

researcher presents the empirical studies conducted in markets that are

related to the subject of the study.

What distinguishes the current study is that to the best of author’s

knowledge, none of the studies that have been conducted in Jordan take

into consideration modernization of traditional CAPM to Islamic Capital

Asset Pricing Model (ICAPM). Therefore, the current study is the first of

this kind to test the importance of the difference between CAPM and

ICAPM in the Jordanian Market.

3.6 Summary

This chapter has reviewed the related literature of the study. The

following chapter will describe data and methodology of the study.