Portfolio Theory and Asset Pricing

The portfolio and valuation analyses are the major aspects in Islamic capital markets. Asset pricing, in particular of stocks, is an important area of finance and offers analytical tools for investors in an Islamic stock market. This chapter reviews portfolio diversification theory and its relation to Islamic finance; the relationship between risk and expected return and asset pricing; the equity premium and interest rate puzzles which demonstrate inefficiency and price distortions in conventional finance; the efficiency hypotheses of stock markets; and the theoretical stability of an Islamic stock market, which does not face systemic risk. In Islamic capital markets, a benchmark rate of return reflecting the return to the real sector of the economy would replace the interest rate in the conventional financial system, as there is no debt financing in an Islamic economy.