Risk and Return in Islamic Finance: 2 Important Shariah Principles

Risk and Return in Islamic Finance: 2 Important Shariah Principles

The relationship between risk and return in Islamic finance involves these two important shariah principles. They are al ghunm bil ghurm and al kharraj bid daman. Both principles are Islamic legal maxims that build the fundamental Islamic law of contracts.

1. Al ghunm bil ghurm

Al ghunm bil ghurm refers to the principle in which someone who expects profit must accept responsibility in the case of loss. Ghurm (damage or loss) technically means the burden borne by a person in his wealth in compensation for the harm that is neither a crime nor treachery. Meanwhile, ghunm (gain, profit, or advantage) technically means obtaining something we do not owned before.

The principle explains that in Islam, earning profits or gaining returns (ghunm) should come with bearing the risks involved. Let’s say Fulan is a party who enjoys (or will enjoy) the outcome of any business activity. Likewise, Fulan shall also be the party who is ready to cover any costs or loss that may arise from that (ghurm). In other words, al ghurm refers to the act of risk-taking or liability for damage or loss.

Al ghunm bil ghurm becomes the fundamental basis of legitimate profit in Islam. Earning profits or returns should come with risk-taking. This legal maxim can help us understand why Islam forbids the practice of riba. Riba bears no risk, hence, rejecting the idea of risk-taking and risk sharing. Instead, Islam permits trade that can’t be free from risks. As we know, a seller will always bear risks while selling his goods, such as natural calamities or dropped market prices. Simply put, taking such risks becomes a legitimate way for the seller to make a profit.

2. Al kharraj bid daman

Kharraj (yield, return, or revenue) in this legal maxim refers to the yield or separable benefit resulting from an owned asset. Meanwhile, daman (responsibility, liability, or guarantee) technically refers to the liability or an asset in case it is damaged or destroyed. Al kharraj bid daman emphasizes that in Islam, a benefit of an asset is the right of someone who compensates if the asset is damaged (typically the owner). Meaning, an individual liable in case an asset is impaired deserves to take its yield as compensation.

This Islamic legal maxim becomes a justification of the entitlement to revenue or return on corresponding liability for bearing risks or losses. Islam forbids that someone or a company gain returns without assuming liability for losses that may arise.

In summary, both legal maxims are the basis of the relationship between risk and return in Islamic finance.

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