Five Main Contracts in Islamic Finance
For Islamic banks to a make profit and to satisfy the borrowers’ needs of cash, they have to conduct transactions that do not violate Islamic rules by looking for allowed contracts that can achieve the required goal. Mostly, they are based on sale and purchase transactions, accompanied by a degree of risk.
There are five main contracts in Islamic finance: Mudarabah, Musharakah, Murabahah, Ijarah and Salam:
i. Profit and loss sharing (Mudarabah): is a contract between two parties; one provides the capital and the other provides the labor to form a partnership to share the profits by certain agreed proportions.
ii. Joint venture (Musharakah): is a financial contract between two or many parties to establish a commercial enterprise based on capital and labor. The profit and loss are shared at an agreed proportion according to the amount of contribution.
iii. Cost plus (Murabahah): refers to a sale of a good or property with an agreed profit against a deferred or a lump sum payment. There are two contracts in Murabahah: the first contract is between the client and the bank, whereas the second contract is between the bank and supplier. The client (purchaser) orders a certain commodity through the bank, the bank then buys the commodity from the supplier and sells it to the client with specified profit whereby the client can make a lump sum or a deferred payment to the bank.
iv. Leasing (Ijarah): in which two parties are involved therein: the lessee and leaser. The leaser (bank) is the real owner of the asset or property and it is rented out to the lessee until full payment is received. The lessee has the option to keep the asset at contract maturity or give it back to the bank. If all payments are received, the lessee can keep the asset but at a higher price than the usual asset price.
v. Salam: is another contract where full payment for a good is paid in advance but the delivery of the good is made at an agreed future date.
Source: Characteristics of GCC Islamic Banks Investment in Malaysia, Ali Abusalah Elmabrok Mohammed
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