Abstract

Benchmarks serve a critical role financial markets as a point of reference for pricing the riskiness of a financial security, to indicate the relative value or opportunity cost of capital while it also serves as a yardstick for the relative performance of a portfolio. The existence of a transparent, observable, liquid, easy-to-compute and non-manipulative benchmark is vital for efficient financial markets. Islamic finance has yet to develop appropriate benchmarks and currently use LIBOR as the reference benchmark in determining expected rate of return in shariah-compliant securities. This practice has been allowed by scholars as an exception under the law of necessity. Unfortunately, despite being in practice for decades, this exception has become a general rule and the practice is so prevalent that most practitioners in the Islamic finance Industry. The key difficulty lies in obtaining a rate of return in an economy based on profit-and-loss sharing. This chapter discuss in detail the development of a benchmark for shariah-compliant investments taking into consideration the conceptual and practical issues.