Interest Rates and Investment in Islamic Products - Dissertation Example

? The relation between interest rates and investment and investment in Islamic products Table of Contents: Table of contents: CHAPTER INTRODUCTION1.1 Background…………………………………………………..………………3 1.2 Theoretical Overview…………………………………………………………4 1.3 Problems Statement………………………………………………………….6 1.4 Aims and Objectives…………………………………………………………6 1.5 Research Questions……………………………………………………………………………………………….6 1.6 Dissertation layout……………………………………………………………………………………………….7 CHAPTER 2: LITERATURE REVIEW 1.1 Investment and Risks of investments in Islamic financial products……..….7 1.2 Previous studies in investment in Islamic financial products………………………………..9 1.3 Gaps in Literature………………………………………………………………………………………………..11 CHAPTER 3: RESEARCH Methodology 3.1 Research Methods and Data Collection……………………………………………12 3.2 Econometric Model………………………………………………………………...13 4. EXPECTED OUTCOMES…………………………………………………………14 5. CONCLUSION………………………………………………………………………15 Bibliography CHAPTER 1: INTRODUCTION 1.1 Background Islamic products are acquiring revenues from large number of sources, including mainly the financial assets, investing assets as well as investing in different business organisations across the country as well as across the globe1. The essential characteristic of the Islamic banking has been that it is “free of rate of interest”2. Islamic banking generally refers to the “Shariah Compliant mechanisms” in order to replace the interest-based financial system of intermediation with the interest-free one. Unlike the conventional banks and other financial intermediaries, Islamic banks have not been allowed to present a fixed as well as predetermined rate of interest on the deposits and also have not been allowed to alter interest rates on loans3. The underlying principle is that the conservative credit system incorporating interest rate policy leads to an unfair distribution of national income in the society and is regarded as a type of exploitation4. In effect, the insight of any of the “pre-determined fixed rate of return” totally disconnected from the real performance of the fundamental asset is not allowable. In Islamic theory of banking, the association between the investors and the financial intermediaries is rooted in “Profit and Loss Sharing” principle as the terms of different financial transactions require reflecting a symmetrical system of risk-return distribution between the counterparties5. 1.2 Theoretical Overview Theoretically, greater level of investments on the production structure of different goods and services in the country are creating significant level of pressure on the level of prices of those goods and services. Also as the financial and capital markets of the country are more flexible to provide the necessary amounts of investable loans to these business organisations, these companies are creating further pressure on the level of inflation in the country6. Hence, the interest rates are creating the most important effects in the process of development of the country7. This is because greater investments due to lower interest rates are creating inflationary pressures which are reducing the purchasing power of the people and thus reducing demand and hence production for goods and services or income in the country8. In case of Islamic banks, interest rates are prohibited. Hence the solution is devised through employment of a profit sharing ratio based on the profit of the Islamic bank. This is also known as the hibah rate. While interest rates are burden to the normal banks that have to bear losses themselves, here the loss is distributed between the depositor and the banks. The profit rate for the Islamic banks is constant irrespective of the market. The selling price and flat profit rate are fixed. The customer here pays a fixed monthly installment right from the start of the period till the time it is finally settled9. As far as investment funds are concerned, the most common categories of Shariah compliant products are ‘equity funds, real estate funds and commodity funds’. The socio economic component makes the Islamic investment products more striking since such investments do not consider interest rates. The financial institutions dominated by Shariah laws provide greater social justice. in fact investments is not allowed in businesses dealing with “alcohol, pork, gambling, weapons, tobacco, media, pornography and anything else which it deems Haraam or unlawful”. In fact after receipt of company dividends which are result of normal operations, there is a purification process where the earning generated form non complaint operations are contributed to Charity10. 1.3 Statement of problem Based on the above theoretical presentation, it should be interesting to study the relation between interest rates, inflation rates and investment in Shariah compliant company shares since ethical investments are becoming more lucrative. Studying the susuk prices of NASDAQ index of Dubai would be an interesting consideration. 1.4. Research aim and objective: There are various Islamic products which creating significant level of associations between the market rate of interest, level of inflation for these products and also the amounts of investments made on these products. The purpose of this paper is to conduct research on the basis of an expected analytical outcome of these close associations between the rate of interest and inflation and the level of investment and rate of interest of the investments on Shariah compliant shares. Susuk prices data of NASDAQ index has been taken since 2005. 1.5 Research Questions Is there any positive significant association between interest rates and investment in Shariah complaint company shares? Is there any positive significant association between inflation rates and investment Shariah complaint company shares? 1.6 Dissertation Layout: The dissertation layout of the paper is explained as the combination of an introductory description of the research paper, following with a detailed description of various related literatures and issues. Then the dissertation layout considers the methodology which is used in the research proposal paper. This research methodology is followed by an analytical aspect of the sample data and hence a detailed description of the expected outcome of the analysis of those data. Hence, the paper draws a conclusion on the research proposal and makes expected future aspects of the research paper. The methodology of the paper considers the statistical analysis of the data which comprising of rate of inflation, volumes of investments and the inflation rate of prices of shares of different Shariah compliant companies. The paper expects an outcome in terms of significant association between the rate of inflation, rate of interest and the investment amounts of the share. 2. LITERATURE REVIEW 2.1. Investment and Risks of investments in Islamic financial products Islamic banks vary significantly in the way that they typically organise endowments in respect to the “Profit Sharing Investments Accounts” which are compensated on the source of sharing the real returns on different assets funded by different investment funds, along with the “Investment Account Holders”11. In theory, these profits are importantly shared in the pre-agreed ratio as well as all losses on the assets funded by the investment finances are to be accepted by the “Investment Account Holders”, except in the situation related to misconduct, negligence or the breach of the contracted terms by ant of the Islamic banks12. According to Toumi and Viviani (2010), “in practice, the concept of sharing the actual profits with Investment Account Holders is far from being the common practice of Islamic banks. Under commercial pressure or regulatory pressure, the majority of Islamic banks absorb a proportion of losses normally borne by Investment Account Holders in order to mitigate potential massive withdrawal of funds. This practice exposes Islamic banks to a specific risk, called displaced commercial risk which requires allocating adequate capital to cover losses” (Toumi and Viviani, 2010, p.1). Greater level of investments on the production structure of different goods and services in the country are creating significant level of pressure on the level of prices of those goods and services. Also as the financial and capital markets of the country are more flexible to provide the necessary amounts of investable loans to these business organisations, these companies are creating further pressure on the level of inflation in the country13. Hence, the interest rates are creating the most important effects in the process of development of the country14. This is because greater investments due to lower interest rates are creating inflationary pressures which are reducing the purchasing power of the people and thus reducing demand and hence production for goods and services or income in the country15. According to Schoon (2010), Toumi and Viviani (2010), there exists close associations between the rate of interest, level of investments and the level of inflation rate for the Islamic products. These products are also becoming the mostly demanded products in these countries which are capturing the greatest market for various products. 2.2 Previous studies in investment in Islamic financial products In the Islamic countries, the relationship between the rate of interest and the level of overall investments and also with the level of investments in Islamic products has been highly significant. Also as show by researchers, Hassan and Mahlknecht (2001) the level of inflation is significantly getting affected with the rate of interest on loans and advances across the globe in respect to the Islamic products16. According to researchers, the rates of interest affect the level of prices of different goods and services by affecting the amount of production of these goods and services. The effects of the rate of interest on the production level of goods and services arise from the effects on the amounts of outstanding loans taken by business organizations for the purpose of producing those goods and services17. The later effects are closely associated with the impacts on the level of investments in the sector of production of various goods and services in the economy. Hence, it is quite arguable that the level of rate of interest is an important factor of the level of both the level of investments and also the level of inflation rate in the economy under consideration18. The rate of interest is affecting the level of investment in the production processes of many goods and services which comprise of the most important nature of the market of various Islamic products and services in a country. Islamic Bazaar is regarded as one of the most important markets for various goods and services are present and also large and significant level of global investments is made. Islamic Bazaar is held by two tough supports – religion and economy (Siddiqi and Hrubi, 2008, p.39). For the Islamic products greater level of investment is increasing the amounts of profit earnings which are further increasing the amount of investments in these products and thus the rate of interest is also increasing at a rapid rate. These aspects are also creating significant upward pressure on the prices of these Islamic products and the consumers are facing the problem of reduced real income from the purchase of Islamic products19. This paper is aimed at providing an analytical description of these relationships between the rate of interest and inflation and investments in Islamic products. 2.3. Gaps in the Literature: It has also revealed by a large number of books and articles that the increasing level of investments in the production sector of the country is creating the great level of barrier in the level of purchasing power of the people of a country. This fact is getting realised in a nation as the rate of interest is kept less variable. Hence, inflationary pressures are getting accelerated to dominate the financial and capital goods as well as the Islamic goods and services sector of the country. These related literatures have also correctly revealed the fact that during the last few years these associations have been significantly magnified and hence, the growth of the Islamic countries are also getting affected. However, these books, articles and other related sources have not considerably provided a detailed analysis of the trend in the process of increasing degree of these associations between those variables as explained especially when the investment is Shariah complaint. This has been the most important gap in the literature described in the paper. The idea here is to empirically justify all the theoretical aspects related to the relationships between the rate of interest and volume of investments in Shariah complaint products (company shares) and also between the level of rate of growth of prices of Islamic products and the market rate of interest rate. Hence, in this way, the gap in the literatures, which have been reviewed, has been overruled. 3. Research Methodology: 3.1. Survey Development and Data Collection: The report has been generated with the help of collection of data and information on the variables which are considered in the research as the most important ones. A mix of qualitative and quantitative approach has been undertaken. The research involves both secondary sources. Data have been collected for the three major variables which are associated with the topic of discussion. These variables are interest rate, inflation rate and investment in Shariah complaint company shares. Also the level of investments in shares of 36 major financial and government business organisations are collected from the Dubai NASDAQ Islamic Index (DATA is from 2005 because Islamic index is anticipated from 2005). Data on rate of interest and on inflation rate are collected for the time period of 2005 to 2011, for each of the 12 months. There will be no missing values and outliers in the data and hence, the data processing and the data collection approaches are accurate. During the data collection process expedient samples are collected. The research methodology of the paper will be based on a social science research structure where statistical analyses of data have been used (Kumar, 2002, p.5). 3.2. Econometric model Different quantitative variable have been used in the process of conducting the statistical analysis of the findings from the survey. However, as all of the variables have been quantitative hence these quantitative variables have been used in the Classical Linear Regression Model20 for effective calculations of all these variables. These relationships between the variables are presented and described in the following: Regression model 1: Inflation = f (rate of interest) Regression model 2: Investment = f (rate of interest) Hypothesis Testing: The model and hypotheses are tested simultaneously by the ‘linear regression analysis’ using MS Excel 2007. The variables are considered in measurement model and in structural model. The measurement model uses the latent variables in terms of observed variables and describes properties of measurement processes of these observed variables. The structural model describes the causal relationships among observed variables and also specifies quantities of unexplained variances. The hypotheses have been set explaining that there are relationships between the independent variable and each of the dependent variables. The null hypothesis of the statistical analysis of the paper is that the rate of interest does not affect the amounts of investment as well as the rate of growth of prices of different Islamic products. However, the alternative hypothesis of the paper is that the level of investment and also the level of inflation are getting affected by the rate of interest rate. The research methodology of this paper is expected to consider a statistical analysis of the data which are collected on the level of investment of investments on shares of different Shariah complaint companies and the market rate of interest and the level of inflation for these shares. 4. Expected Outcomes: Since the value for the ?2 is expected to be very close to unity (1), therefore the measurement model is expected to show a good estimation of the values of the variables21. The value for the AGFI for both measurement and structural models are expected to be close to unity (1), which indicates that both models are predicted to be well fitted models, i.e. the values of the variables obtained in both models largely explain the variances of the variables (which are measured in both models) from their mean (central) values22. The value of ?2 ratio is predicted to represent a better explanation of goodness of fits of these variables in both models. The two expected regression models are thus explained as: Inflation rate = 1.85 + 0.59 * (Interest Rate) Investment = 947747944 + (-) 47564166 * (Interest Rate) (See Appendix for regression results) The expected outcome of the research paper is related to the fact that significant level of association between the rate of interest and the level of investments in Islamic products is likely to be observed in the UAE. Also significant level of association between the levels of rate of change in prices of these products is also observed in the country for the selected Islamic products. The expected outcome of the paper is associated with the fact that significant level of positive association between the rate of interest and the level of inflation for the investment in Shariah compliant company shares are expected to be seen. Also significant level of negative correlation between the level of investment on shares of different companies and the market rate of interest are also expected to be seen. 5. Conclusion: Interest rates and the levels of investments are closely associated in respect to any form of economic structure. This investment is creating the most important impacts upon the process of development and growth of the production sector of the economy and also related to the overall economic progress of the production of different goods and services in that country. Also the rate of interest creates significant level of association between the rate of change in the prices of different goods and services in the country. In case of the large varieties of Islamic products (goods and services) these associations have been highly significant. In respect to the Islamic products overtime changes in the rate of interest have created significant level of effects on the inflation rate and also on the level of investments in the Islamic countries, such as Dubai. In this country, the changes in the rate of interest on bank loans and other financial asset transactions have greatly affected the level of inflation rate over the passage of time. Significant level of effects has been viewed in the country during the time period of 2001 and 2011. During this period also significant level of effects investments in Shariah complaint shares due to the changes in the rate of interests on loans and advances has also been observed. Even though significant changes in the rate of interest itself has not been viewed in the country during this time period, these associations between the rate of interest and inflation rate and the rate of interest and the volume of investments have been significant in the country. Hence, it is most likely to opine that the there exists a close association between the rate of interest and inflation and investment in Shariah compliant shares in UAE or economies dominated by the Shariah law. References: 1. Adnan Siddiqi, and Peter Hrubi, Islamic Investments Funds Versus Hedge Funds, UK: GRIN Verlag, 2008 2. Anis Chowdhury, The Newly Industrialising Economies of East Asia, London: Routledge, 1998 3. Humayun A. Dar, and Umar Moghul, The Chancellor Guide to the Legal and Shari'a Aspects of Islamic Finance, UK: Chancellor Publications, 2010 4. David Freedman, Statistical models: theory and practice, UK: Cambridge University Press, 2005 5. Hanudin Amin, and Rosita Chong, SUBSTITUTION EFFECTS: DO INFLATION AND DEFLATION AFFECT ISLAMIC HOME FINANCING?, Labuan e-Journal of Muamalat and Society, (2007), Vol. 1, pp. 41-51 6. Hung Gay Fung et al., Socially Responsible Investment in a Global Environment, UK: Edward Elgar Publishing, 2010 7. Hennie V. Greuning, and Zamir Iqbal, Risk Analysis for Islamic Banks, UK: The World Bank, 2008 8. HSBC, Introduction to Islamic Investing, HSBC Amanah, 2011, http://www.assetmanagement.hsbc.com/gam/attachments/mena/amanah/islamic_invest.pdf (accessed on June 27, 2012) 9. James Harrington, et al., Statistical Analysis Simplified: The Easy-To-Understand Guide to Spc and Data Analysis, USA: McGraw-Hill Professional, 1998 10. Kabir Hassan and Mervyn Lewis, Handbook of Islamic Banking, UK: Edward Elgar Publishing, 2007 11. Kabir Hassan, and Michael Mahlknecht, Islamic Capital Markets: Products and Strategies, UK: John Wiley and Sons, 2011 12. Muhammad Ayub, Understanding Islamic Finance, UK: John Wiley & Sons, 2009 13. Natalie Schoon, Islamic Banking and Finance, UK: Spiramus Press, 2010 14. Kauther Toumi, and Jean L. Viviani, ISLAMIC BANKS EXPOSURE TO DISPLACED COMMERCIAL RISK: IDENTIFICATION AND MEASURE, CR2M - CC028 - Universite Montpellier, 2010, available at: http://www.cr2m.net/meetings/TOUMI-VIVIANI.pdf (accessed on June 19, 2012) 15. Salman Syed Ali, Introduction: Islamic Capital Markets: Current State and Development Challenges, in Islamic Capital Markets: Products, Regulations and Development, Islamic Research & Training Institute (2008), available at: http://www.irtipms.org/OpenSave.asp?pub=232.pdf (accessed on June 19, 2012) 16. Sohail Jaffer, Islamic Insurance: Trends, Opportunities and the Future of Takaful, UK: Euromoney Books, 2007 17. Iraj Toutounchian, Islamic Money and Banking: Integrating Money in Capital Theory, UK: John Wiley & Sons, 2011 18. Yi Hua Erin Yuan and Chihkang Kenny Wu, RELATIONSHIPS AMONG EXPERIENTIAL MARKETING, EXPERIENTIAL VALUE, AND CUSTOMER SATISFACTION, Journal of Hospitality & Tourism Research, 2008, available at: http://www.udec.edu.mx/BibliotecaInvestigacion/Documentos/2009/Agosto/Merka%20experiental%20marketing%20exp%20value%20customer%20satisfaction.pdf (accessed on June 19, 2012) Appendix: Regression Model 1: Association between rate of interest, inflation rate and investments on shares SUMMARY OUTPUT Regression Statistics Multiple R 0.17 R Square 0.03 Adjusted R Square 0.02 Standard Error 3.40 Observations 143.00 ANOVA   df SS MS F Significance F Regression 1.00 49.71 49.71 4.31 0.04 Residual 141.00 1627.97 11.55 Total 142.00 1677.68         Coefficients S. E. t Stat P-value Lower 95% Upper 95% Intercept 1.85 1.40 1.32 0.19 -0.92 4.61 Slope 0.59 0.28 2.07 0.04 0.03 1.15 RESIDUAL OUTPUT Observation Predicted Residuals 1.00 5.43 -4.08 2.00 5.43 -4.08 3.00 5.72 -4.31 4.00 5.72 -4.13 5.00 5.72 -4.04 6.00 5.67 -3.88 7.00 5.67 -3.68 8.00 5.67 -3.54 9.00 5.67 -3.31 10.00 5.67 -3.10 11.00 5.67 -2.87 12.00 5.90 -3.10 13.00 5.90 -3.09 14.00 5.90 -3.01 15.00 5.79 -2.90 16.00 5.77 -2.88 17.00 5.75 -2.86 18.00 5.69 -2.79 19.00 5.67 -2.77 20.00 5.32 -2.42 21.00 5.31 -2.41 22.00 5.31 -2.41 23.00 5.28 -2.38 24.00 5.26 -2.34 25.00 5.26 -2.34 26.00 5.26 -2.34 27.00 5.23 -2.31 28.00 5.19 -2.28 29.00 5.14 -2.23 30.00 5.10 -2.19 31.00 5.06 -2.15 32.00 5.02 -2.11 33.00 4.97 -2.02 34.00 4.93 -1.95 35.00 4.90 -1.91 36.00 4.89 -1.77 37.00 4.87 -1.75 38.00 4.84 -1.53 39.00 4.84 -1.30 40.00 4.84 -0.89 41.00 4.77 -0.65 42.00 4.71 -0.36 43.00 4.67 0.01 44.00 4.61 0.11 45.00 4.57 0.30 46.00 4.54 0.37 47.00 4.47 0.52 48.00 4.44 0.60 49.00 4.43 0.61 50.00 4.43 0.62 51.00 4.40 0.84 52.00 4.38 0.97 53.00 4.37 1.04 54.00 4.44 1.05 55.00 4.46 1.32 56.00 4.50 1.32 57.00 4.51 1.40 58.00 4.56 1.42 59.00 4.58 1.46 60.00 4.60 1.59 61.00 4.60 1.59 62.00 4.60 1.59 63.00 4.60 1.60 64.00 4.60 1.60 65.00 4.60 1.60 66.00 4.60 1.60 67.00 4.60 1.60 68.00 4.61 1.60 69.00 4.61 1.62 70.00 4.62 1.63 71.00 4.62 1.65 72.00 4.63 4.66 73.00 4.63 4.73 74.00 4.63 4.84 75.00 4.64 4.88 76.00 4.64 5.01 77.00 4.64 5.14 78.00 4.66 5.30 79.00 4.68 5.74 80.00 4.73 5.43 81.00 4.77 5.88 82.00 4.85 5.97 83.00 4.37 6.63 84.00 4.98 6.15 85.00 4.98 6.24 86.00 4.98 6.35 87.00 4.98 6.39 88.00 4.97 6.55 89.00 4.97 6.73 90.00 4.95 6.98 91.00 4.94 7.01 92.00 4.94 7.05 93.00 4.94 7.09 94.00 4.93 7.19 95.00 4.93 7.28 96.00 4.93 7.33 97.00 4.92 5.33 98.00 4.92 4.59 99.00 4.89 3.42 100.00 4.88 2.78 101.00 4.84 1.81 102.00 4.77 0.48 103.00 4.70 -0.44 104.00 4.66 -1.30 105.00 4.56 -2.31 106.00 4.50 -2.40 107.00 4.44 -2.46 108.00 4.34 -2.78 109.00 4.37 -2.81 110.00 4.37 -2.81 111.00 4.38 -2.82 112.00 4.39 -2.91 113.00 4.40 -3.08 114.00 4.41 -3.13 115.00 4.43 -3.24 116.00 4.41 -3.39 117.00 3.87 -2.92 118.00 3.87 -3.05 119.00 3.87 -3.00 120.00 3.87 -2.99 121.00 3.85 -2.96 122.00 3.85 -2.95 123.00 3.83 -2.91 124.00 3.83 -2.84 125.00 3.81 -2.82 126.00 3.81 -2.80 127.00 3.81 -2.60 128.00 3.82 -2.58 129.00 3.82 -2.46 130.00 3.82 -2.36 131.00 3.82 -2.31 132.00 3.82 -1.32 133.00 3.79 -1.54 134.00 3.76 -1.41 135.00 3.73 -1.52 136.00 3.70 -1.46 137.00 3.68 -1.36 138.00 3.66 -1.61 139.00 3.65 -1.59 140.00 3.65 -1.67 141.00 3.64 -1.69 142.00 3.64 -1.66 143.00 3.63 -1.42 Regression 2: Association between investment, rate of interest and investments on shares SUMMARY OUTPUT Regression Statistics Multiple R 0 R Square 0 Adjusted R Square 0 Standard Error 345505679 Observations 35 ANOVA   df SS MS F Significance F Regression 1 124509398027839000 124509398027839000 1 0 Residual 33 3939347744829300000 119374174085737000 Total 34 4063857142857140000         Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Intercept 947747944 244079734 4 0 451163994 1444331894 Slope -47564166 46572979 -1 0 -142317603 47189270 RESIDUAL OUTPUT Observation Predicted Residuals 1 657606529 -207606529 2 657606529 592393471 3 633824446 116175554 4 633824446 -133824446 5 638580862 111419138 6 638580862 -238580862 7 619555196 -119555196 8 633824446 116175554 9 624311612 -124311612 10 629068029 -229068029 11 633824446 166175554 12 619555196 580444804 13 667119362 -17119362 14 671875779 -321875779 15 700414279 49585721 16 709927112 -209927112 17 719439945 -219439945 18 724196362 275803638 19 733709195 -233709195 20 719439945 -419439945 21 709927112 -209927112 22 724196362 -224196362 23 733709195 516290805 24 743222028 -343222028 25 747978445 -147978445 26 752734862 -102734862 27 762247695 737752305 28 767004112 -117004112 29 762247695 -12247695 30 771760528 -371760528 31 776516945 723483055 32 781273362 68726638 33 795542612 454457388 34 800299028 199700972 35 805055445 -705055445 Read More