DPD30063

ISLAMIC INVESTMENT

CHAPTER 2:
RISK AND RETURN
TOPIC WILL BE COVERED

2.1 Explain concept of return and risk in Islamic perspective

2.1.1 Describe concept of risk and return in Islamic
perspective
2.1.2 Determine components of return
a. Capital gain
b. Yield

2.2 Calculate return management

2.2.1 Total return
2.2.2 Holding period return
2.2.3 Holding period yield
2.2.4 Expected return
2.2.5 Arithmetic mean
2.2.6 Geometric mean
Cont. TOPIC WILL BE COVERED

2.3 Calculate risk measurement

2.3.1 Variance
2.3.2 Standard deviation
2.3.3 Coefficient of variation

2.4 Apply Capital Asset Pricing Model (CAPM)

2.4.1 Describe concept of return and risk in CAPM
2.4.2 Calculate required rate of return using CAPM
formula
2.4.3 Explain concept of trade-off between return
and risk on security market line (SML)
2.4.4 Plot CAPM graph and security market line (SML)

2.5 Distinguish relationship between return and risk in

investment
2.5.1 Explain relationship between return and risk in
investment
2.5.2 Plot graph of return and risk in investment
 CONCEPT OF RISK AND RETURN FROM
ISLAMIC PERSPECTIVE
Risk
• the variability of returns, the extend to which investment results
may differ or vary from expected return

Return
• the level of profit derived from an investment. Can be derived
from two sources, i.e. income and capital gains
CONCEPT OF RISK AND RETURN FROM
ISLAMIC PERSPECTIVE

Return

Risk
CONCEPT OF RISK AND RETURN FROM
ISLAMIC PERSPECTIVE
• Risk-Return Tradeoff is the relationship between risk and return,
in which investments with more risk should provide higher return,
and vice versa.
• Risk is the chance that the actual return from an
investment may differ from what is expected.
• Risk refers to the variation between the actual occurrence and the
expected occurrence.
• In the case of investments, risk can be regarded as the deviation of
the actual rate of return from the expected.
• Risk arises because of the element of uncertainty associated with
the future.
• Investment refers to postponing current consumption and putting
one’s money in an asset or assets with the hope of getting higher
returns in the future.
• Since we will only get the rewards in the future, there is an element
of uncertainty involved.
 CONCEPT OF RISK AND RETURN
FROM ISLAMIC PERSPECTIVE
• “O my children, do not enter the capital of Egypt by
one gate but go into it by different gates. However,
know it well that I cannot ward off you Allah’s will for
none other than He has nay authority whatsoever. In
Him I have put my trust and all who want to rely upon
anyone should put their trust in Him alone.” (Surah
Yusuf, 12: 67)
• “Yusuf said, You will plant for seven years
consecutively; and what you harvest leave in its spikes,
except a little from which you will eat. Then will come
after that seven difficult (years), which will consume
what you saved for them, except a little from which
you will store. Then will come after that a year in
which the people will be given rain and in which they
will press (olives and grapes)” (Surah Yusuf, 12: 47 – 49)
 CONCEPT OF RISK AND RETURN
FROM ISLAMIC PERSPECTIVE

• Prophet Yusuf (a.s) interpreted the dream of the king of

Egypt that Egyptian would face seven years of drought
after seven years of prosperity.
• Hence, he advised the king to develop an economic
strategy in order to overcome the upcoming
catastrophe.
• Egyptians had to implement the proposition by actively
planting crops during the first seven years of drought, as
interpreted by Prophet Yusuf.
• As recommendations implemented it resulted in the
country surviving the seven years of drought (Ibn Kathir,
1988).
 CONCEPT OF RISK AND RETURN
FROM ISLAMIC PERSPECTIVE

• The well known hadith about tying a camel, narrated by

Anas bin Malik that an Arab Bedouin asked the Prophet
in Medina:
“O the Messenger of Allah, should I leave my camel
untie and trust in Allah, or should I tie it? The Holy P
rophet s.a.w. replied: Tie your camel and then trust in
Allah”.
• The broad perspective on risk and its management are
embodied in the overall goals of Islamic law or maqasid
shariah.
• Chapra (2008) quotes al-Ghazali in defining maqasid as:
“The well being of people, which lies in safeguarding
their faith (deen), self (nafs), intellect (‘aqal),
posterity (nasl) and wealth (mal)”
 CONCEPT OF RISK AND RETURN
FROM ISLAMIC PERSPECTIVE

• As risk in Islamic economics represent the probable loss

of wealth, it is not desirable in itself from Islamic
perspective.
• From Islamic perspective, economic activities are not
judge by inherent of risk but whether they add value
and /or create wealth.
• Islamic legal maxim relating to risk is al-ghurm bil
ghunm or the detriment is a return for the benefit.
• The legal maxim means (entitlement to) profit is
accompanied by responsibility (for associated expenses
and possible loss).
• Usually the maxim used to propose the preference for
profit and loss sharing (PLS) financing instrument.
 CONCEPT OF RISK AND RETURN
FROM ISLAMIC PERSPECTIVE

• The legal maxim is based from the hadith of Prophet

s.a.w.,) “(entitlement to) profit is dependent on
responsibility (for attendant expenses and possible loss
and defects”
• The benefit of a thing is a return for the liability for loss
from that thing.
• The maxim asserts that party enjoying the full benefit
of an asset or object should bear the risk of ownership.
• The principle points out to the risk related to
ownership associated with sale and leasing transaction.
E.g. seller bear risk of the object of the sale / lessor
bear risk for the asset leased out.
 CONCEPT OF RISK AND RETURN
FROM ISLAMIC PERSPECTIVE

• Al-ghunm bil ghurm is similar to the notion of

risk-return trade-off in conventional finance.
• This maxim provides the rationale and the principle of
profit and loss sharing in sharikah contracts.
• A shariah maxim which bases the legitimization of
earning profit on the condition of risk-sharing and
engaging in an economic endeavour or enterprise which
contributes to the broader economy.
 COMPONENTS OF RETURN
1. CAPITAL GAIN
• Concerned with change in the market value of an investment
• The amount by which the proceeds from the sale of an investment exceed its
original purchase price is a capital gain.
• Investment is sold for less than its original purchase price is capital loss

Example:
Azam purchased 4 lots of Jaya Stock at RM 4.60 per share. He held the shares for
one year. At the end of one year, he sold the shares when they were RM 4.80 per
share.

P1 – P0
4.80 – 4.60
0.20 (capital gain) 13
2. YIELD
► Income received from the investment during the period in which the
investment is held
► Known as current income
► Consists of dividends form stocks or mutual funds, interest received
on bonds
► Usually cash or near-cash that is periodically received as a result of
owning an investment

EXAMPLE:
We can calculate the current income from investments PMB Shariah Aggressive
Fund and PMB Shariah Small Cap. Fund both purchased for RM 1000,over one-year
period of ownership. Investment PMB Shariah Aggressive Fund provide dividend of
RM80, investment PMB Shariah Small Cap Fund RM50. Which investment more
preferable?

14
►  

Year Closing price (RM) Dividend per share (RM)

2016 8.00 0.05

2017 8.50 0.35

2018 8.40 -

2019 8.80 0.25

15
 CALCULATION EXAMPLE
►  
►  

17
►  

Example:
What is annual holding period yield
if you invest RM 2500 at the
beginning of the year and after four
years the investment worth RM
3500.

18
 CALCULATION EXAMPLE
►  
D. REALISED RETURN
• The actual amount of the return earned on a security investment over
a period of time. This period of time is typically the holding period
which may differ from the expected yield of maturity.
• The actual return that has been earned or obtained.
• Return that have occurred on previous investment and the returns
received by investors and will not change for the future.
• Example ; dividend, bonus that has been declared or earned.

20
►  
Example:
Aisyah is planning to invest in a security that has several possible rates of
return. Given the following probability distributions return, what is the
expected rate of return on the investment?
►  

YEAR PRICE(RM) DIVIDEND(RM)

2014 3.14 0.15
2015 2.81 0.16
2016 2.86 0.18
2017 3.42 0.20
2018 4.95 0.21
►  
YEAR PRICE(RM) DIVIDEND(RM) TOTAL RETURN
2014 3.14 0.15
2015 2.81 0.16
2016 2.86 0.18
2017 3.42 0.20
2018 4.95 0.21
►  
►  

Year Price (RM) Dividend (RM) Total return

2016 28.40 0.02

2017 32.20 0.04
2018 30.12 0.01
2019 32.00 0.05
 Year Price (RM) Dividend (RM) Total return

2016 16.00 0.05

2017 20.00 0.10
2018 24.52 0.03
2019 17.50 0.05

Initial buying price = RM15.00

ATTITUDES TOWARD RISK

Risk-indifferent
• obtain the same
Risk-taker satisfaction from
• prefer to take a risk-free
situation and a
Risk- risk.
Averse risky situation.
• Willing to accept
a decrease in
• dislike risk. return for an
• increase
Require an in increase in risk
return to
compensate for
the increase in
risk.
MEASURING RISK
 PLOT GRAPH OF RETURN AND RISK IN
INVESTMENT

Return Shares (also

known as
equity)
Property

Fixed interest
(debt securities)
Cash

Risk
The risk – return comparison is a graph that in the vertical axis you have return,
and in the horizontal, risk or standard deviation. We observe the different risks,
and for holding only cash, our risk is small compared to the return, whereas , up
to the right, stocks have a higher risk and a higher return.
 CAPITAL ASSET PRICING
• MODEL
Capital Asset Pricing Model is a model that establishes the link between
risk and expected return.
• Help investors define the required return on an investment.
• It is used to price a risky asset or portfolio for a holding period.
• CAPM was developed based on a number of assumptions. These are:
a. All investors have the same expectations on expected returns and
risks (standard deviations) of assets;
b. There are no transaction costs and taxes. Transaction costs refer to
broker’s commissions, stamp duties, clearing fees, etc;
c. Assets or securities are perfectly divisible and are very liquid.
This means that there are many buyers and sellers in the market;
d. Borrowing rates and lending rates are equal to the risk free rate and
all investors can borrow or lend unlimited amounts at this rate; and
e. All investors have the same holding period. The holding period can
be one month, three month, one year or some other period.

Total risk = systematic risk + unsystematic risk

 CAPITAL ASSET PRICING
MODEL
• Investor concern with expected return and risk
(beta)
• Relationship between expected return of any
two asset (portfolio) can be related to their
differences in beta
• The higher the beta : the higher the return
• Equilibrium model for measuring risk-return
trade-off for all assets
Risk-free rate
• Is the theoretical rate of return of an investment with
no risk of financial loss. The risk-free rate represents
the interest that an investors would expect from an
absolutely risk-free investment over a given period of
time.
• It is also required rate of return for riskless
investments such as investments in government
securities.

Risk premium
• The slope of the SML – the difference between the
expected return on a market portfolio and the risk
free rate.
Beta
• The amount of systematic risk present in a
particular risky asset relative to that in an average
risky asset.
• Investors concern with expected return and
risk(beta). Relationship between expected return of
any two asset(portfolio)can be related to their
differences in beta. The higher beta: the higher the
return. Equilibrium model for measuring risk –
return trade off for all assets
• The higher the beta: the higher the return.
►  
CONCEPT OF TRADE – OFF BETWEEN RETURN
AND RISK ON SECURITY MARKET LINE (SML)

i. Risk return trade-off

• The tradeoff which an investor faces between risk
and return while considering investment decisions is
called the risk return trade off.
• Definition: Higher risk is associated with greater
probability of higher return and lower risk with a
greater probability of smaller return.
►  
 CAPM GRAPH AND SECURITY MARKET LINE(SML)

Expected rate of return SML

A
Rm B

C Risk Premium
Rf
Asset LESS RISKY Asset MORE RISKY
than the market index than the market index

1.0 Risk(beta)
 Point A- This security is
undervalued because it offers
more expected return than
investors require.- They are
earning more than a fair return
- Investor should buy a stock
Point B - This security is
overvalued/overpriced because
it does not offer enough
expected return than when
investors require. - Investor
should sell this stock

Point C - Equilibrium level-

They are earning a fair return-
Expected return would be
needed to compensate investors
for the systematic risk - This
security is correctly price
because it lies exactly on the
Security Market Line.
 RETURN AND RISK RELATIONSHIP IN INVESTMENT

1. Relationship between return and risk in investment

• The relationship between risk and return is a fundamental
financial relationship that affects expected rates of return on
every existing asset investment
• The risk-return relationship is characterized as being a
“positive” or “direct” relationship meaning that if there are
expectations of higher levels of risk associated with a particular
investment then greater returns are required as compensation
for that higher expected risk.
• Alternatively, if an investment has relatively lower levels of
expected risk then investors are satisfied with relatively lower
returns.
 GRAPH OF RETURN AND RISK IN INVESTMENT

a. Expected returns are directly associated with risk

Return

Risk
The relationship between return and risk commonly associated positively.
The higher the risk, the higher the returns.
b. Long term directly connected

Return

A
A
Risk (Beta)

The relationship between risk and return can be seen between the motion
graph, it can be either above or below the relationship between risk and
return.
c. Short term- positive or negative relationship

Return

Risk(beta)

In the short term, investors will not able to predict the real thing.
 THE END
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