MPRA Paper 46818 2 PDF

M PRA
Munich Personal RePEc Archive
Time Value of Money in Islamic

Perspective and the Practice in Islamic
Banking Implications
Rininta Nurrachmi and Mia Fathia and Ashanee Mad-ahdin

and Ninasrin Radenarmad and Rulia Akhtar
International Islamic University Malaysia
March 2012
Online at http://mpra.ub.uni-muenchen.de/46818/
MPRA Paper No. 46818, posted 8. May 2013 05:01 UTC
ECON6810 - Financial Economics
KULLIYYAH OF ECONOMICS AND MANAGEMENT SCIENCES
DEPARTMENT OF ECONOMICS
FINANCIAL ECONOMICS
(ECON 6810)
TERM PAPER
TIME VALUE OF MONEY IN ISLAMIC PERSPECTIVE AND
THE PRACTICE IN ISLAMIC BANKING IMPLICATIONS
SUBMIT TO
ASSOC. PROF. DR. SALINA HJ KASSIM
PREPARED BY
1. MIA FATHIA MATRICS NO. G0827756
2. ASHANEE MAD-AHDIN MATRICS NO. G0915660
3. NINASRIN RADENARMAD MATRICS NO. G0923508
4. RULIA AKHTAR MATRICS NO.G0923876
5. RININTA NURRACHMI MATRICS NO.G1015702
SEMESTER 2 2011/2012
Time Value of Money in Islamic Perspective and the Practice in Islamic Banking Implications
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TIME VALUE OF MONEY IN ISLAMIC PERSPECTIVE AND
THE PRACTICE IN ISLAMIC BANKING IMPLICATIONS
ABSTRACT
Time Value of money is a fundamental financial theory and a basic element in the monetary
system. This concept serves as the foundation for all other notions in finance. It impacts
consumer finance, business finance, and government finance. Basically the Conventional
Time value of money results from the concept of interest that prohibited in Islamic principle.
Moreover, there are several basic principles that caused the Conventional theory views
“Money” and “commodity” differs and compares with the principle as defined by Islam. This
leads the time valuation of money in Islamic Perspective is totally different from the
conventional. The objective of this study is to discuss the concept of Time Value of Money in
Islamic Perspective and its advantages. The paper attempts to analyze the difference between
the concept of Time in Islamic and Conventional Perspective. Furthermore, we are going to
highlight how Islamic Banks applied the concept of Time Value of Money in Islamic View to
their implications in the practice. In addition, this study observed the practical issues and
challenges in applying the concept of Time Value of Money in some financial products which
are Murabahah, Istisna and Salam.
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CHAPTER ONE
INTRODUCTION
1.1 BACKGROUND
The time value of money serves as the foundation for all other notions in finance. It impacts
consumer finance, business finance, and government finance. However, the Conventional
Time value of money results from the concept of interest that prohibited in Islamic principle.
There are several basic principles that caused the Conventional theory views “Money” and
“commodity” differs and compares with the principle as defined by Islam. Since the Islamic
banking and finance practice emerged in the 1960s and 1970s. It came out with a new system
which differed from conventional finance interest-based system. In the earlier time of its
emergence, Islamic banking and financial system was deemed to be a weird system, since the
system offers new view and thought. Actually, the illegitimate of interest-based system in
Shari‟ah perspective have been ascertained since fifteenth centuries ago. The interest-based
system should not arise. The existence of the interest-based system was caused by the west
hegemony. But today, after years past by, the Islamic banking and finance system has grown
rapidly. It has already been accepted by the public and become a part of the international
financial system.
As mentioned before, the interest-based system (riba) was practiced on conventional
system. This system has been declared as haram from Shariah point of view (Al Quran: 3:
130). As a replacement, Islamic banking and finance institution introduced several interest-
free systems that accommodate the banking and financing needs of the Muslim population.
Some of these systems are Murabahah, Mudarabah, Musharakah, Ijarah, Bai‟ Al Inah, Al
Ijarah Muntahiah Bi Tamlik, Bai‟ Bi Thaman Ajil. But, the doubts regarding their Shari‟ah
compliance are still extant. One of the reasons that bring about these doubts is the practice of
Time Value of Money in several interest-free systems on the Islamic banking and finance
institution. The Conventional Time value of Money is similar with riba, in term of all
deferred exchange transactions. While, the time value of money is not rule out in Islamic
legal financial theory and practice, as long as it is not part of lending relationship in which it
is claimed as a predetermined value (Ahmad and Hassan, 2004). Therefore, the interest-free
systems that applied in Islamic banking and finance institutions have to be reviewed,
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especially in the part of system having time value of money application on the underlying
contracts.
1.2 OBJECTIVE OF THE STUDY
The primary objective of this study is to discuss the concept of Time Value of Money in
Islamic Perspective and attempt to highlight how Islamic Banks applied this concept to the
practice in their implications. As the secondary aim of this paper, we attempt to achieve this
formulated objective:
1. To distinguish the Concept of Time Value of Money between Islamic and Conventional
Perspectives
2. To enlighten the advantages of Time Value of Money in Islamic perspective.
3. To observe the issuance of Time Value of Money in Islamic banks and their implication.
1.3 RESEARCH QUESTIONS
This study will specifically attempt to answer the following research question:
1. What is the concept of Time Value of Money in Islamic Perspective?
2. What is the difference between Islamic and Conventional in the concept of Time Value of
Money?
3. What are the advantages of Time Value of Money in Islamic Perspective?
4. How do the Islamic Banks apply the concept of Time Value of Money in their implication?
1.4 ORGANIZATION OF STUDY
This study will be divided into four chapters. The structure of the study is as follow:
Chapter 1 provides a brief introduction of the study which states about the background of the
study, objective of the study, research question and organization of study. Chapter 2 consists
of an explanation of Fundamental analysis of Time Value of Money which Comparison
between Conventional and Islamic Perspective. Also discuss the Islamic view for Time Value
of Money and The Advantages of Time Value of Money in Islamic Perspective. Chapter 3
describes the sample of product in Islamic Banks and investigates the \issues and challenges
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in choosing products. Chapter 5 represents the conclusion, limitation of study and provides
suggestions for future research.
CHAPTER 2
TIME VALUE OF MONEY:

CONVENTIONAL VERSUS ISLAMIC PERSPECTIVES
2.1 INTRODUCTION
Riba in deferred exchanges of two similar commodities is dealt within the Qur‟an. Qur‟an
says, “if you repent (from riba) then your capital sums are for you, deal not unjustly, and you
shall not be dealt with unjustly” (al-Baqarah, 2:279). Deferred exchanges normally result in
credits and loans. The verse indicates that there would be no riba if the creditors retrieve only
the principal amount from their debtors. That means, whatever commodity is the subject of
deferred exchange that commodity shall be returned in the original amount irrespective of the
period of indebtedness and any amount charged above the principal would be riba. Money is
treated as a commodity in exchange transactions because gold and silver were money during
the advent of Islam.
Therefore, if the debt is in the form of money then the lenders are entitled to receive
only the amount lent. Otherwise, riba will take place. It is obvious therefore, that riba in
deferred transactions is nothing but a charge for the period of indebtedness. In the economics
literature, this charge is also called a time value of money that represents a rental for the use
of money for a certain period. That is why interest representing time value of money stands
prohibited. This position is confirmed from the verse “if the debtor is in a difficulty then
grant him time till it is easy for him to pay” (al-Baqarah, 2:280). Therefore, one must
conclude that, according to the Qur‟an, time value of money is riba. An analysis of the
contemporary Islamic banking practices shows that time value of money is a part of all
financing transactions.
2.2 THE DEFNITION OF MONEY FROM CONVENTIONAL AND ISLAMIC

PERSPECTIVES
2.2.1 CONVENTIONAL PERSPECTIVE

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In order to understand more on Time value of money relationship with riba, it is crucial to
develop a basic understanding on money. According to Ikass (2009), the conventional
perspective, money can be seen as:
1. Money is a commodity and is used to obtain other goods.
2. Widely Marketable as it is highly in demand and valued good. Thus, it is sure that it can be
used anytime and anywhere
3. It can be transport easily. Money is made to make human life easier therefore to make sure
that it is convenience is important.
4. Relatively scarce as it is high in demand and high in value, which means it holds a high
value in small quantities.
5. Money is relatively imperishable. It is durable and can be use for future purchases.
6. Easy to store
7. Easily divisible
8. Money lasts forever.
9. All units of money are similar, meaning to say that it is easy to distinguish and estimate the
value of the money.
2.2.2 ISLAMIC PERSPECTIVE
As for the Islamic perspective, Mohsin (2009) and Meera (2002) found that:
1. Money has no intrinsic value, meaning to say that it cannot be utilized in direct fulfillment
of human needs. Money to Islam can only be used to acquire goods or services. It is not a
commodity which can e utilized directly without exchanging it for some other things.
2. All units of money of the same denomination are 100 percent equal to each other.
3. In commodity, the transactions of sale and purchase are affected on an identified and
specific commodity.
4. Money is a medium of exchange. It is a way to define a value of a thing, but not to itself.
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5. Money has standard of value which measures the relative different goods and services
2.3 ISLAMIC VIEW FOR TIME VALUE OF MONEY
2.3.1 THE CONCEPT OF TIME VALUE OF MONEY IN ISLAMIC PERSPECTIVE
Time Value of money is a fundamental financial theory and a basic element in the monetary
system. The time valuation of money in Islamic Perspective is totally different from the
conventional since Islam defined money that differs from conventional system. Concept of
money basically in Islamic perspective is not similar to Conventional. Islam defines money as
the medium of exchange and unit of account and not store of value (Ahmad and Hassan,
2004). No function at all that Money performs by itself unless when it is exchanged with
asset or to buy services that makes money become useful. Moreover, during the Prophet‟s
time, the main purpose of using money is as a substitution of barter trade system (the
exchange between goods) to maintain the economic stability. Furthermore, money has
worthless in itself due to money unable to produce by itself and it will be productive only
when it is jointed with other resources. From the Shari‟ah scholars‟ view, money is
considered as a capital when it combines with other resources to carry out the productive
activity like Mudarabah and Musharakah that lenders do not share only profit but also loss.
In addition, Islam banned to increase more money by lending out due to it leads to element of
interest that prohibited in Islam (Khan, 1991).
According to Imam al-Ghazali in Ihya Ulumiddin, he said that creation of Dirhams

and Dinars or money is one of the God‟s Blessings. The important function of Money is to
serve and facilitate the exchange transactions and it is not an objective in itself. Treating
money as a commodity like trading money contradicts the Shari‟ah principle and brings more
harm than benefit to the commodity, i.e. promotes inflation and creates the injustice to the
society. Moreover, the consequence of financial transactions as treating money as commodity
unable to not linked to real economy. This means that it prevents people from undertaking
real economic activities. In addition, when person can create more money via lending by the
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concept of interest, it easily receives money without taking skills and knowledge. This leads
the society is full of greed, speculation and immorality (Saadallah, 1994).
For the concept of time value of money is Islamic perspective, Islam recognized the
concept of positive time preference. All consumption and production activities take time and
to calculate the time value of money based on the real time that used for the activities as we
known as ex post in modern economics. Time is considered as a valuable economic resource
that can be explain into two main position (Batcha, 2009)
1. Opportunity cost of postponing current consumption current consumption brings

more satisfaction than future consumption. Thus, compensation should be made for utility
forgone today
2. Opportunity cost of not being able to invest funds in productive activity. Owner of
funds gives up possibility of earning a positive return on funds
Moreover, the concept of positive time preferences is supported by majority of jurists.

They agreed that prices for cash sale and credit sale can be varied, for example the view of
Grand Mufti of Saudi Arabia has permitted the installment sale wherein the credit price could
be higher than the cash price. In Islam view, both time and place have impact on time value
of money as we can see from the contract of Salam that support positive time preference:
price paid in advance for future delivery of goods is less than cash and carry price.
Furthermore, for the borrowing transaction in Islam encourages people to pay their debts well
which are Incremental amount purely voluntary as a token of gratitude and Incremental
amount denotes Islam‟s acknowledgement of positive time preference (Ayub, 2004).
Therefore, the idea of Islamic Time Value of Money is providing of funds should be
compensated for foregoing current consumption or opportunity to earn a positive return on
investments. However, this compensation cannot be contractually predetermined because
there is no certainty in any outcome. Nowadays the Application that offered by Islamic Bank
has applied this concept, for example, Profit loss sharing concept or Mudarabah transaction
that capital provider (Rabb-mal) has to a share of venture‟s profits because he has given up
current consumption or ability to invest funds elsewhere. In short, although the Shari‟ah
principles do not provide clearly of consideration and ruling of the ideal of time value of
money, its concept is positive time preference that based on real sector that is business and
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trade of goods not in exchange of monetary values and loans or debts and Shari‟ah scholars
allow any incremental in a loan give to cover the price of a commodity in any sale contract to
be paid at the future date (Ahmad and Hassan, 2004).
2.3.2 TIME VALUE OF MONEY AND ITS PERSPECTIVE IN ISLAMIC FINANCE
Study had shown that time has an economic value. This happens when all consumption and
production activities take place within a given time. As such, time is known to be a valuable
economic resource and a point of reference. For example, a lecturer may earn a minimum of
RM300, while other lecturers with the same qualification would earn as much as RM 6, 000.
By doing so, the lecturer had chosen to improve his self-worth and wealth. And if he had
chosen not to lecture, then he had lost the opportunity to increase his earning (Mohsin, 2009).
Time value of money is an important cornerstone of modern finance as earlier

mentioned. In basic terms, it means that money has its own time value. RM 2,000 today is not
the same as RM 2,000 after a year (Mohsin, 2009). A rational individual would prefer the
former than the latter. The basic fundamental reason behind this are that, first, a cash flow of
RM 2,000 now to an individual implies that he can purchase and consumer goods and
services worth the amount now, while RM2,000 in a years time would mean that he has to
wait until then before he could consume. The sacrifice involved in the postponement
of consuming the money requires the individual to be ³compensated´ for ³waiting´(Mohsin,
2009). Arguably, concern on consumption in the ³future´ always hit individuals just as hard
as their concern towards current consumption.
Moreover, if an individual consciously saves either for the rainy day or to finance
specific needs in the future, such future consumption if often more important than the present
consumption. And of course, one must realize that saving for the rainy day occurs only when
one has started out on one‟s current needs (Mohsin, 2009).Another argument put forward
which favors the time value of money concept is that it holds greater merit. Furthermore, it
asserts that an individual would prefer RM 2,000 now over tomorrow since he would have
the alternative to invest this amount now and earn are turn immediately. As for this rate of
return, it is known in conventional finance as rate of interest (Rosly, 2005).An Islamic
perspective, Time value of money does exist. The return available to the individual saver
does not always have to be related to riba-based transaction. As example, the return available
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on the next best permissible´ investment which is from trade or others would constitutes time
value of money in Islamic finance (Mohsin, 2009).
The concept of time value of money in the context of Shari‟ah is also established from
the fact that Shariah prohibits mutual exchanges of gold, silver or monetary values except
when it is done simultaneously. This is because a person can take benefit from the use of a
currency which has been received and has not been given counter value from which the other
party would benefit from (Ayub, 2007).The fact that Islam forbids riba does not mean that it
is against the concept of positive-time preference (PTP). Indeed, Islam does recognize PTP as
evident in the statements of the Prophet (pbuh), ³Virtuous are they who pay back their debt as
well´ (Rosly, 2005).Within the context of Islamic finance, the Shari‟ah prohibits the mutual
exchange of gold, silver, or monetary values except when it is done simultaneously and
equally (Hassan,2004). The reasoning behind this is that Islam does not allow people to profit
from using a currency that they have received before being given its counter-value, whereby
a situation of which the other party could take advantage of the other. Furthermore, time
valuation is possible only when goods are traded, not when exchanging monetary values and
loans or debts (Hassan, 2004).
Thus, in Islam, recognizing PTP does not imply awarding a contractual increase on
the principal loan. Any increase from an Islamic financing (qard) can only be stated on
maturity and not up front as normally practiced in interest-bearing financing contracts. The
increment, which is voluntary, is set by the debtor. In contract, the increment from riba
financing is contractual and set by the creditor (Rosly, 2005). On the basis of the above
rationale, an overwhelming majority of Islamic economics believe that economic agents in an
Islamic economy will have a positive time preference and there will be indicators available in
the economy to approximate the rates of their time preferences, generally determined by the
preference in an Islamic economy, as made in a number of studies on investment behavior in
the Islamic perspective (Ayub, 2007). Having deliberated previously on the TVM, the next
section considers what the scholars have said on the concept regarding their agreement or
differences.
2.4 FUNDAMENTAL ANALYSIS OF TIME VALUE OF MONEY: COMPARISON

BETWEEN CONVENTIONAL AND ISLAMIC PERSPECTIVE
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Unlike conventional banking based on interest-bearing loans, funds invested in an Islamic

bank are used essentially for trade. There is no room for ambiguity in Islam “every loan that
draws a gain is riba.”
Many people question whether Islamic finance differs meaningfully from

conventional finance. Outwardly, in form, many structures do bear a similarity in various
respects. The present day operating environment is a conventional one--, from market
structuring and dynamics, to rate benchmarks and circulation of money, to regulatory controls
as well. However, the way these two types of finances function with respect to core defining
parameters is very different. Many things look the same but are in essence differ in
fundamental perspectives.
We begin with basic principles. One is interest-based money lending while the other
operates like a trading house. What allows this difference? Two core principles lie at the
centre, elimination of Riba and Gharar. Any Islamic transaction needs to assess these two
things first. Keeping in mind the definition given in Hadith, one can discuss time value of
money and the workings of present day Islamic banks. For this, we would have to look at the
differences in ways in which modern capitalist theory views „money‟ and „commodity‟ from
the principles defined by Islam. Different views have been expressed about the conventional
time value of money from the point of view Islamic in the following figure
CONVENTIONAL PERSPECTIVES ISLAMIC PERSPECTIVES
Money is a commodity besides medium of Money is not a commodity though it is used as

exchange and store of value. Therefore, it can a medium of exchange and store of value.
be sold at a price higher than its face value and Therefore, it cannot be sold at a price higher
it can also be rented out. than its face value or rented out
Time value is the basis for charging interest on Profit on trade of goods or charging on
capital. providing service is the basis for earning profit
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Interest is charged even in case the Islamic bank operates based on profit and loss
organization suffers losses by using bank‟s sharing. In case, the businessperson has
funds. Therefore, it is not based on profit and suffered losses, the bank will share these
loss sharing. losses based on the mode of finance used
(Mudharaba, Musharakah).
While disbursing cash finance, running finance The execution of agreements for the exchange
or working capital finance, no agreement for of goods & services is necessary, while
exchange of goods & services is made. disbursing funds under Murabaha, Salam
&Istisnaa contracts.
Conventional banks use money as a Islamic banking tends to create link with the
commodity, which leads to inflation. real sectors of the economic system by using
trade related activities. Since, the money is
linked with the real assets therefore it
contributes directly in the economic
development.
2.5 THE ADVANTAGE OF TIME VALUE OF MONEY IN ISLAMIC PERSPECTIVE
As the concept of time valuation is possible only in business and trade of goods not in
exchange of monetary values and loans or debts. Therefore, no time value can be added to the
principal of a loan, or a debt after it is created or the liability of the purchaser stipulated. The
important conclusion view in Islam is time value of money is acceptable in respect of the
pricing of assets and their usufruct, it is not acceptable with regard to any addition to the
principal of loans or debts. Valuation of credit period based on value of the goods value of
the goods or their usufruct is different from the conventional concepts of „opportunity cost‟ or
the „time value‟ (Ayub, 2004). Thus, the time value of money in Islamic view represents the
advantages to the economy and society which are
 Fulfill the human need directly
The time valuation of money in Islamic principle differs from the conventional
theory as money and commodities have different characteristics, i.e. money has no intrinsic
value but it is only a unit of value or medium of exchange so it is unable to fulfill the human
needs by itself unless convert to the commodity. Thus, commodity can fulfill human needs
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directly and can be different quality while money has no differential quality in the sense of
the new note of RM 100 is exactly equal in value and quality to an old note of RM 100. Also
commodities are transacted or sold by pinpointing the commodity in questions or at least by
giving certain specifications. Since a commodity is known to possess an intrinsic value and
quality, the owner of such a commodity is allowed to sell it at whatever price the buyer and
himself mutually agree on, provided the seller does not commit a fraud but is subjected to the
forces of demand and supply. This would hold true even if the price is mutually agreed upon
is higher than the prevailing market price (Hassan, 2010). Therefore, the Islamic view that
based on the concept of real price of commodity and usufruct can fulfill the need of human
due to it is according to the real situation in the practice.
 Enhance the economic productivity
Since its concept based on the real sector of the economic activities, it encourages
people for working and trading. This leads the improvement and enhances the ability in
competition. Moreover, these economics activities increase the level of real productivity of
the system and develop the national economy for achieving the high level of economic
growth and the standard of living (Meera and Larbani, 2004).
 The stability of National Economy and society
Furthermore, it lead the stability to the country‟s economy because when all
economics activities mainly from real sector, it prevents the affect of fluctuation and
recession that originates from the greed and speculation. It also reduces the socio-economic
problems that happened when applying the conventional time value of money to the system
such as the collapse of the system, the default of loan payment, economic crisis and injustice
(Meera and Larbani, 2004).
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CHAPTER 3
THE SAMPLE OF PRODUCTS IN ISLALMIC BANKS

3.1 INTRODUCTION
This chapter represents the sample of products in Islamic Banks that applied the concept of
Time Value of money in Islamic Perspectives. The chapter is divided into two sections. The
first section discusses the sample of product in Islamic Banks, while the second section
provides the issues and challenges of these products.
3.2 THE SAMPLE OF PRODUCTS IN ISLALMIC BANKS
3.2.1 MURABAHAH FINANCING INSTRUMENT
It originally signified only the price determination method, called a cost-plus-profit or
markup sale, in which the seller or trader revealed his or her cost and the two parties
negotiated a profit margin to add to the cost as compensation for the trader‟s work. However,
given the recent growth of the modern Islamic finance industry and the desire to create
instruments that are parallel with conventional banks‟ products, Murabahah has evolved to
mean both a sale whose price is determined on a cost-plus basis and that is financed on credit,
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or bay‟ al-muajjil. Additionally, in modern times, the trader‟s role as financier has been taken
over by banks.
It occurred when a client wants to buy something and the seller also wants to sell it,
however he does not have the case sought by the seller. Under this arrangement, the bank also
discloses the information on its costs and profit margin to the buyer. But it does not
materially affect the actual exchange. Thus, one may as well not insist on these requirements.
The payment by the client may be in lump sum or in installments.
Figure: Murabahah Transaction

Murabahah transaction takes place between three parties: the seller of the product, the
client (customer or purchaser of the product), and the Islamic bank as depicted in the above
figure. Murabahah works in the following steps:
1. Bank buys the goods that the client want to buy from the supplier and pay cash to the supplier
2. Supplier then deliver the good to the bank
3. Bank may appoint supplier as agent to deliver the good to the client after the bank sell the
goods to the client on Murabahah basis which is cost plus profit on deferred basis.
4. The client will pay the bank the mark-up price that they have agreed before within the pre-
agreed period
Figure: Working of Transaction of Murabahah
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The figure shows the working transaction in Murabahan. The step will be explain as
follows :
1. The client make an application to the Islamic Bank
2. There is a purchase agreement between the supplier and the Islamic Bank.
3. There is a sale agreement between the client and the Islamic Bank
4. Islamic Bank make a payment to the supplier
5. Supplier make a delivery to the client
6. The client pay the installment to the Islamic Bank
Murabahah also has several conditions. First, a Murabahah contract has to be based
on the sale of an asset and cannot be used to finance other expenses such as the payment of
wages or accounts payable. Additionally, in the case of default by the consumer, the Islamic
bank only has a right to the product, and no additional mark-up or penalty may be charged.
The Islamic Bank may, however, ask for collateral in the case of default by the consumer.
Lastly, the markup rate that is charged by the Islamic bank is determined by the type of
product financed, type of collateral, creditworthiness of the consumer, and the length of time
for payment deferral.
Suppose Yusuf wants to buy a computer from Ruqayyah‟s Electronics. He chooses a
computer and asks for a price quote. Ruqayyah‟s Electronics quotes the price of the computer
at $1500. Yusuf then contacts Bank A and promises to buy the computer from the bank, with
an agreed-upon markup, if the bank first purchases the computer from Ruqayyah‟s
Electronics. Bank A agrees and purchases the computer from Ruqayyah‟s Electronics, paying
the full $1500. Bank A sends Yusuf as its agent to Ruqayyah‟s Electronics to pick up the
computer. Bank A and Yusuf then enter into Murabahah contract. Bank A indicates the cost
of the product to Yusuf as $1500. The two then negotiate a 5 percent mark-up for the services
provided, arriving at a total cost of $1575. Yusuf agrees to pay Bank A in installments,
paying $175 per month for 9 months.
3.2.2 SALAM FINANCING INSTRUMENT

Bai‟ Salam involves advance payment to a party for delivery of a thing in future. It
applies to the case in which things come into the possession of the seller due to his being their
producer or towards discharging his occupational functions, for instance a wholesaler
acquiring goods from a manufacturer and supplying them to the retailers. Other than helping
farmers who need money to grow their crops and to feed their family up to the time of
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harvest, the purpose of Salam is to aid the traders for import and export business.
Figure : Salam Transaction

In Salam transaction there are there parties involved, Output market, Islamic Bank
and Client / Producer. The above figure will be explained as follows:
1. Islamic Bank will give financing to producer to cover his expenses and enter Salam
contract with the promise to get the good later
2. Producer will deliver the goods to Islamic Bank
3. Islamic Bank will deliver and sell goods at output market
4. Islamic Bank will then get the sale proceed
Figure: The Working Transaction of Salam Financing

The figure depicts the working transaction in Salam. The process will be explain as
follows:
1. The client/producer make an application to the Islamic Bank
2. There is a Salam agreement between the client/producer and the Islamic Bank
3. There is a sale agreement between final buyer and the Islamic Bank
4. Islamic Bank make a financing to the client/producer
5. Client / Producer make a delivery to the Final buyer
6. The client pay the installment to the Islamic Bank
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Under Salam, it is lawful for traders to sell the goods in advance so that after
receiving their cash price, they can easily undertake the aforesaid business. Salam is
beneficial to the buyer because the price in Salam is lower than the price in spot sales.
Further, in Salam, the seller of the goods must be its producer or manufacturer.
The agreement should be explicitly mentioned on the following matters :
1. The quality and the quantity of the thing being sold
2. The price and the payment matters
3. Delivery matters such as time and place of delivery and how that might take effect.
For instance, Yusof is a farmer who has his own vineyard. He grows two varieties of
grapes which are Malacca and Cardinal in the area of two acres. This later period, he faces
financial problem which make him lack in spending. Hence, he needs money to undertake his
business and to feed his family up until the time of harvest. Therefore, he decides to apply
financing by the Islamic bank.
The Working of Salam Contract for Yusof :
1. Yusof executes a Salam contract to sell a specified amount of grapes in advance for RM
20.000 to bank A. The grapes are to be delivered on 1 July 2012.
2. Bank A pays RM 20.000 on a spot basis to Yusof and also stipulates from where to take
delivery on 1 July 2012
3. The grapes are delivered to bank A on 1 July 2012.
4. Bank A sells grapes in the output market at profit. (That is, Bank A make the contract
with merchant B in which merchant B will purchase grapes from bank A for RM30.000
on 1 July 2012. When Yusof supply the specified grapes to bank A on the agreed delivery
date, bank A informs merchant B to execute the sale and take delivery.)
3.2.3 ISTISNA FINANCING INSTRUMENT

An Istisna contract is a sale in which the customer asks the seller to manufacture a
specific product for purchase. Both parties agree on a price and specifications for the product
to be manufactured. If the product does not conform to those specifications when it is
delivered to the customer, he or she may retract the contract. The two parties have flexibility
when deciding payment timing and mode: the price can be paid in a lump sum at the time of
the contract, in a lump sum in the future, or over installments. This mode of financing is
usually used for aircraft manufacture, equipment installation at factories, construction, etc.
18
Istisna and bay‟ al-salam are both exceptions to the general rule for sale contracts that
the subject of the sale must exist at the time of the sale. However, four differences between
istisna and bay‟ al-salam contracts exist. First, the purchased good in an istisna contract must
be manufactured, while it does not have to be in a bay‟ al-salam contract. Also, buyers in
istisna contracts are not required to pay the full price immediately upon signing the contract,
as they are in bay‟ al-salam contracts. Additionally, an istisna contract can be canceled by
either side before the seller begins manufacturing, while a bay‟ al-salam contract can only be
canceled with the consent of both parties. Finally, the seller is given flexibility regarding time
of delivery in an istisna contract, while time of delivery must be specified exactly in a bay‟
al-salam contract.
Suppose Southwest Airlines wants to buy a new 737 aircraft from Boeing. Assuming
Boeing does not already have any premade 737 aircraft, Southwest and Boeing enter into an
istisna contract. The two parties agree to a price of $45 million with a deferred lump sum
payment and specifications regarding the airplane. Boeing delivers the airplane to Southwest
within a specified range of dates. Southwest is satisfied with the quality and specifications of
the aircraft and pays Boeing $45 million at an agreed-upon date in the future.
3.3 ISSUES AND CHALLENGES
Undeniable, Islamic banking system become more and more interested by many people
around the world after global financial crisis, not only Muslim but also Non-Muslim. No
doubt, it is the only system that can overcome and have no effect from such crisis. However,
there are still many problems which occur in operating and practicing under the system that
many Islamic scholars concerned. Therefore, in this particular point, this paper tries to
discuss issues that arise in those three modes of Islamic financing as mention earlier and
highlight how Islamic bank face such critical challenge.
3.3.1 MURABAHAH FINANCING INSTRUMENT

Murabahah in its classical form may not give rise to many Shari‟ah issues as legal rulings
related to its application have been laid down clearly and comprehensively by past jurist.
However, murabahah in its modern structure which is a form of combined contracts may
result in many issues.
19
In the issue of rebate in the event of a default, classical jurists argued that the
murabahah contract is one of the trust-based contracts in which everything should be
disclosed including the cost price and the mode of payment of the first sale. For example‟ if
someone bought a commodity through a murabahah contract which was concluded on a
deferred payment basis , he must disclose to his customer(second buyer) that he has
purchased the commodity on a deferred payment basis .If not, he is said to have committed a
betrayal because a murabahah contract involves the time value of money which must be taken
into account as it is recognized by the shariah, The time value of money in this regard entails
the deferment earns a portion in the price of a murabahah contract, Hence, jurists stipulated
that an increment in the price of a murabahah contract is due to assingnig monetary value to
deferment. As such, the question that arises from this is whether the bank must give a rebate
to the customer in the event of default, and whether to give for early settlement, or not. This
is because, in both cases, the deferment which constitutes the basis for increment in a
murabahah contract is no longer enjoyed by the customer since he has to settle the debt on a
spot basis.
The problems in murabahah indeed have several points but, in order to see clearly,
we will observe what scholar and practitioners give criticism about main issues in
murabahah. A number of scholars and practitioners have criticized murabahah for two main
reasons. First, they view the markup as a disguised form of interest, especially since the
markup rate currently used by most Islamic banks is tied to the prevailing interest rate in the
market, such as the London Interbank Offered Rate (LIBOR). Second, murabahah does not
fulfill the mission of Islamic banking, namely to justly share risk between the lender and the
borrower.
In response to the first criticism, scholars have declared that the profit margin is
acceptable according to Shariah due to several differences between murabahah and
conventional loans. First, in a murabahah sale, because the bank must own the product for
some period of time after purchasing it before reselling it to the customer, it exposes itself to
the risk that the product will be harmed or destroyed, the product‟s value will fluctuate, or
that the seller will change his or her mind before buying the product from the bank. However,
banks effectively avoid this risk by making the period of time between the purchase and the
resale minutes or even seconds. Therefore, banks do not truly take any ownership risks.
Second, scholars argue that a profit margin is acceptable because it compensates the lender
20
for the service it is providing. If the bank were to purchase and take possession of a good
before reselling it to the customer, no one would dispute that the bank is providing a service
to the customer. However, as this presents many operational challenges, banks most often
appoint the customer as its agent to take possession of the good. Though the bank provides a
smaller service in this case, it is arguably still a service that should be compensated. Third,
scholars argue markup is lawful because it compensates the bank for the opportunity cost of
not having those same funds available to it. That is the Shariah does allow for compensation
for the time value of money for sales contracts but not for loans. Since a murabahah is a sales
contract, scholars argue compensation for the time value of money is lawful.
In response to the second criticism, scholars stress that murabahah is not the primary
or preferred method for financing trade and sales, though it is allowed. Rather, profit and loss
sharing financing methods such as PLS musharakah and PLS mudarabah are preferred. This
preference, however, has not resulted in a proportionally higher number of PLS contracts. In
the early years of modern Islamic finance, murabahah was used as a temporary instrument
for ease and convenience while scholars tried to develop risk sharing instruments that could
serve the same purpose. However, rather than disappearing, the importance of murabahah
instruments has grown, and murabahah has become the dominant mode of financing. Islamic
banks use murabahah contracts for about 80 percent of their investments while PLS
mudarabah contracts account for less than 5 percent.(Iqbal,Z.& Mirakhor,A,2007)
As a result of this disproportionately high number of murabahah contracts, scholars

have suggested a number of ways for banks to reduce their reliance on these contracts. First,
some have suggested altering murabahah contracts in order to eliminate distortions or abuses
of the contract‟s original intention. Second, others have suggested that banks change their
markup methods to represent the amount of service the bank has actually provided rather than
a percentage of the total value of the product, which is often similar to prevailing interest
rates. Scholars should continue to alter the terms of murabahah contracts in the future in order
to return to instruments that truly share risk and reward, which is a basic principle of Islamic
finance.
3.3.2 SALAM FINANCING INSTRUMENT

It is evident from the foregoing discussion that Shariah allowed Salam to fulfill the needs of
farmers and traders, therefore, it is basically a mode of financing for small farmers and
21
traders. The mode of financing can be used by modern banks and financial institution,
especially to finance the agricultural sector. As pointed out earlier, the price in Salam may be
fixed at a lower rate than the price of those commodities delivered at the spot. In this way, the
difference between the two prices may be a valid profit for the banks or financial institutions.
In order to ensure that the seller shall deliver the commodity on the agreed date, they also can
ask him to furnish a security, which may be in the form of a guarantee or in the form of
mortgage or hypothecation. In case of default in delivery, the guarantor may be asked to
deliver the same commodity by purchasing it from the market, or to recover the price
advanced by him. The only problem in Salam that may agitate the modern banks and
financial institutions today is that they will receive certain commodities from their clients,
and will not receive money. Being conversant with dealing in money only, it seems to be
cumbersome for them to receive different commodities from different client and to sell them
in the market. They cannot sell those commodities before they are actually delivered to them,
because it is prohibited in Shari‟ah.
But whenever we talk about the Islamic modes of financing, one basic point should
never be ignored. The point is that the concept of the financial institutions dealing in money
only is foreign to Islamic Shari‟ah. If these institutions want to earn a halal profit, they shall
have to deal in commodities in one way or the other, because no profit is allowed in Shari‟ah
on advancing loans only. Therefore, the establishment of an Islamic economy requires a basic
change in the approach and in the outlook of the financial institutions. They shall have to
establish a special cell for dealing in commodities. If such a special cell is established, it
should not be difficult to purchase commodities through Salam and to sell in spot markets.
However, there are two other ways of benefiting from the contract of Salam.
First, after purchasing a commodity by way of Salam, the financial institutions may
sell them through a parallel contract of Salam for the same date of delivery. The period of
Salam in the second (parallel) transaction being shorter, the price may be a little higher than
the price of the first transaction, and the difference between the two prices shall be the profit
earned by the institution. The shorter the period of Salam, the higher the price, and the greater
the profit. In this way the institutions may manage their short term financing portfolios.
Second, if a parallel contract of Salam is not feasible for one reason or another, they
can enter into a promise to sell the commodity to a third party on the date of the delivery.
Being merely a promise, and not the actual sale, their buyers will not have to pay the price in
22
advance. Therefore, a higher price may be fixed and as soon as the commodity is received by
the institution, it will be sold to the third party on a pre-agreed price, according to the terms
of the promise.
A third option is sometimes proposed that at the date of the delivery, the commodity
be sold back to the seller on a higher price. But this suggestion is not in line with the dictates
of Shariah. It is never permitted by the Shariah that the purchased commodity be sold back to
the seller before taking its delivery, and if it is done on a higher price it will tantamount to
riba which is totally prohibited. Therefore, this proposal is not acceptable at all.
3.3.3 ISTISNA FINANCING INSTRUMENT

An Istisna‟ contract is applicable to various industrial productions which can be constructed
or manufactured and supervised by specification. For example, an istisna‟ contract can be
employed in housing construction and advanced technology industries, equipment such as
aircraft, automobile, ship and factory equipment. In Istisna, since it is not necessary that the
price is paid in advance, nor is it necessary that it is paid at the time of the delivery, rather, it
may be deferred to any time according to the agreement of the parties, therefore, the time of
payment may be fixed in whatever manner they wish. The payment may also be in
installments.
On the other hand, it is not necessary that the financier himself construct, for example,
the house. He can enter into a parallel contract of Istisna with a third party, or may hire the
services of a contractor (other than the client). In both cases, he can calculate his cost and fix
the price of Istisna with his client in a manner that may give him a reasonable profit over his
cost. The payment of installments by the client may start, in this case, right from the day
when the contract of Istisna is signed by the parties, and may continue during the construction
of the house and after it is handed over to the client. In order to secure the payments of
installments, the financier as a security may keep the title deeds of the house or land, or any
other property, until the client pays the last installment.
The financier, in this case, will be responsible for the construction of the house in full
conformity with the specifications detailed in the agreement. In case of discrepancy, the
financier will undertake such alternation on his own cost as may be necessary for bringing it
in harmony with the terms of the contract. In addition, in contemporary application, the
23
another shari‟ah issue in an istisna‟ contract arises in the event the manufacturer fails to
deliver the manufactured asset on the date agreed upon‟ one way that can be exercised to
overcome this issue is by allowing the stipulation of a punitive condition upon the
manufactured in the event of his failure to deliver the purchased asset at the agreed time. That
is as pointed out earlier, it is not necessary in istisna that the time of delivery is fixed.
However, the purchaser may fix a maximum time for delivery that means that if the
manufacturer delays the delivery after the appointed time, he will not be bound to accept the
goods and pay the price.
In order to ensure that the goods will be delivered within the specified period, some
modern agreements of this nature contain a penal clause to the effect that in case the
manufacturer delays the delivery after the appointed time, he shall be liable to a penalty
which shall be calculated on a daily basis. Can such a penal clause be inserted in a contract of
istisna according to Shariah? Although the classical jurists seem to be silent about this
question while they discuss the contract of istisna, yet they have allowed a similar condition
in the case of ijarah. They say, if a person hires the service of a tailor to tailor his clothes, the
fee may be variable according to the time of delivery. The hirer may say that he will pay Rs.
100/- in case the tailor prepares the clothes within one day and Rs. 80/- in case he prepares it
after two days.
The problems and challenges of Islamic banks cannot be effectively dealt with unless
the leadership of Islamic banking becomes truly committed and competent. In a nutshell, it is
yet to be substantially proved that Islamic banking offers more efficient and ethical solutions
in the contemporary financial world.
CHAPTER 4
CONCLUSION
4.1 CONCLUSION
The time value of money in Islamic perspective is totally different from the conventional one.
The return available to the individual saver does not always have to be related to riba-based
transaction. The concept of time value of money in the context of Shari‟ah is established from
the fact that Shari‟ah prohibits mutual exchanges of gold, silver or monetary values except
when it is done simultaneously. The fact that Islam forbids riba does not mean that it is
24
against the concept of positive-time preference (PTP). Furthermore, time valuation is possible
only when goods are traded, not when exchanging monetary values and loans or debts
(Hassan, 2004). As the concept of time valuation is possible only in business and trade of
goods not in exchange of monetary values and loans or debts. Therefore, no time value can be
added to the principal of a loan, or a debt after it is created or the liability of the purchaser
stipulated. The important conclusion view in Islam is time value of money is acceptable in
respect of the pricing of assets and their usufruct, it is not acceptable with regard to any
addition to the principal of loans or debts.
Undeniable, Islamic banking system become more and more interested by many
people around the world after global financial crisis, not only Muslim but also Non-Muslim.
No doubt, it is the only system that can overcome and have no effect from such crisis.
However, there are still many problems which occur in operating and practicing under the
system that many Islamic scholars concerned. For example, in the Murabahah, Salam and
Istisna financing instruments, there are several issues related to the time value of money on
Islamic perspective that still debatable. The problems and challenges of Islamic Banks cannot
be effectively dealt with unless the leadership of Islamic Banking becomes truly committed
and competent. In a nutshell, it is yet to be substantially proved that Islamic banking offers
more efficient and ethical solutions in the contemporary financial world.
4.2 LIMITATION OF THE STUDY
The study mainly focuses on the fundamental of Time Value of money in Islamic perspective
and how to apply this concept in the Islamic Banking implications, i.e. Murabahah, Istisna
and Salam and also discuss their issues and challenges that exist from the applying these
products. In fact, there are many products in the Islamic banks for example Mudarabah,
Musharakah, Ijarah and so on. In case, discussing in different products may give the different
results in discussing how to apply the concept of Time Value of Money in Islamic View. As a
result of that, the explanation of their issues and challenges of these products would be
different.
4.3 SUGGESTION FOR FUTURE STUDY
The study formulates some suggestion for further research that is as follows:
25
First, future study may investigate the correlation with the real sector that has not sharpened
illustrated. It may describe the government contribution on the Effect of Time Value of
Money in Islamic Perspective.
Second, further study may suggest the possible solutions of today‟s issues and challenges of
Murabahah, Istisna and Salam from applied the concept of Time Value of Money has not
elaborated on this present paper.
Finally, given this study was conducted on three samples Shari‟ah compliance financial
products only, the analysis can be further extended to other products and their issues and
challenges from applied the concept of Time Value of Money in Islamic view in the today
practice such as Mudarabah, Musharakah and Ijarah.
REFERENCES
Al-Qur‟an
Al- Hadith
Ahmad, A.U.F., Hassan, M.K. (2004). The Time Value of Money Concept in Islamic
Finance. The American Journal of Islamic Social Sciences 23:1. Retrieved April 30,
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2012.http://www.iefpedia.com/english/wp-content/uploads/2009/11/The-Time-Value-
of-Money-Concept-in-Islamic-Finance.pdf
Anwar Batcha, A. (2009).Time Value of Money and Riba’: Islamic Perspective. Kuala
Lumpur: INCEIF
Anwar, M. (2000). Islamicity of Banking and Modes of Islamic Banking. Professorial

Inaugural Lecture Series IIUM.
Ayub,M. (2007). Understanding Islamic Finance, England: Wiley Finance
Ikass. R. (2009). Characteristics of Money. Retrieved April 30, 2012, from Slideshare.
Kahf, M. (1994). „Time Value of Money and Discounting in Islamic Perspective: Re-
visited‟. Review of Islamic Economics, Vo1.3, No.2, (1994), pp. 31-38
Khan. M. F. (1991). „Time Value of Money and discounting in Islamic Perspective‟. Review
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Meera,A.K (2002). The Islamic Gold Dinar, Selangor: Pelanduk
Mohsin, D.M (2009). Islamic Economics. Kuala Lumpur: INCEIF
Muneeza, A., Nik Nurul, A., & Hasan, R. (2011).The possibility of application of salam in
Malaysian Islamic banking system. Humanomics, Vol. 27 Iss: 2 pp. 138 – 147.
Emerald Group Publishing Limited. Retrieved April 30, 2012
http://www.emeraldinsight.com/journals.htm?articleid=1926466
Nagaoka, Shinsuke. (2012). Islamic Finance for Sustainable Development: Its Historical
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Vol.2 No.1
Siddiqui, A. S. (1996). Time Value of Money, Bay Muajjal, and Bay Salam. Retrieved April
30, 2012. http://ravi.lums.edu.pk/aesm/papers/Time%20Value%20of%20Money
%20%20%20%20%20%20Shamim%20Ahmad%20Siddiqui.doc.
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http://www.accountancy.com.pk/docs/islam_salam_istisna.pdf
28

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M PRA

Munich Personal RePEc Archive

Time Value of Money in Islamic

Rininta Nurrachmi and Mia Fathia and Ashanee Mad-ahdin

International Islamic University Malaysia

KULLIYYAH OF ECONOMICS AND MANAGEMENT SCIENCES

TIME VALUE OF MONEY IN ISLAMIC PERSPECTIVE AND

THE PRACTICE IN ISLAMIC BANKING IMPLICATIONS

ASSOC. PROF. DR. SALINA HJ KASSIM

1. MIA FATHIA MATRICS NO. G0827756

2. ASHANEE MAD-AHDIN MATRICS NO. G0915660

3. NINASRIN RADENARMAD MATRICS NO. G0923508

4. RULIA AKHTAR MATRICS NO.G0923876

5. RININTA NURRACHMI MATRICS NO.G1015702

TIME VALUE OF MONEY IN ISLAMIC PERSPECTIVE AND

THE PRACTICE IN ISLAMIC BANKING IMPLICATIONS

1.2 OBJECTIVE OF THE STUDY

2. To enlighten the advantages of Time Value of Money in Islamic perspective.

1.3 RESEARCH QUESTIONS

1. What is the concept of Time Value of Money in Islamic Perspective?

3. What are the advantages of Time Value of Money in Islamic Perspective?

1.4 ORGANIZATION OF STUDY

TIME VALUE OF MONEY:

2.2 THE DEFNITION OF MONEY FROM CONVENTIONAL AND ISLAMIC

2.2.1 CONVENTIONAL PERSPECTIVE

1. Money is a commodity and is used to obtain other goods.

8. Money lasts forever.

2.2.2 ISLAMIC PERSPECTIVE

2.3 ISLAMIC VIEW FOR TIME VALUE OF MONEY

2.3.1 THE CONCEPT OF TIME VALUE OF MONEY IN ISLAMIC PERSPECTIVE

According to Imam al-Ghazali in Ihya Ulumiddin, he said that creation of Dirhams

1. Opportunity cost of postponing current consumption current consumption brings

Moreover, the concept of positive time preferences is supported by majority of jurists.

2.3.2 TIME VALUE OF MONEY AND ITS PERSPECTIVE IN ISLAMIC FINANCE

Time value of money is an important cornerstone of modern finance as earlier

2.4 FUNDAMENTAL ANALYSIS OF TIME VALUE OF MONEY: COMPARISON

Unlike conventional banking based on interest-bearing loans, funds invested in an Islamic

Many people question whether Islamic finance differs meaningfully from

CONVENTIONAL PERSPECTIVES ISLAMIC PERSPECTIVES

Money is a commodity besides medium of Money is not a commodity though it is used as

2.5 THE ADVANTAGE OF TIME VALUE OF MONEY IN ISLAMIC PERSPECTIVE

 Fulfill the human need directly

 Enhance the economic productivity

 The stability of National Economy and society

THE SAMPLE OF PRODUCTS IN ISLALMIC BANKS

Figure: Murabahah Transaction

Figure: Working of Transaction of Murabahah

3.2.2 SALAM FINANCING INSTRUMENT

Figure : Salam Transaction

Figure: The Working Transaction of Salam Financing

3.2.3 ISTISNA FINANCING INSTRUMENT

3.3 ISSUES AND CHALLENGES

3.3.1 MURABAHAH FINANCING INSTRUMENT

As a result of this disproportionately high number of murabahah contracts, scholars

3.3.2 SALAM FINANCING INSTRUMENT

3.3.3 ISTISNA FINANCING INSTRUMENT

4.2 LIMITATION OF THE STUDY

4.3 SUGGESTION FOR FUTURE STUDY