International Journal of Theoretical and Applied Finance

Islamic banks are established with the mandate of conducting all their transactions in conformity with Islamic precepts which prohibit, among other things, the receipt and payment of interest. Unlike conventional (non-Islamic) commercial banks, Islamic banks mobilise funds primarily via investment accounts using profit sharing contracts. In this paper, we argue that the concept of financial risk, on which modern capital structure theories are based, is not relevant to Islamic banks. Given the contractual obligation binding the Islamic bank's shareholders and investment account holders to share profits from investments, we propose a theoretical model in which, under certain assumptions, an increase in investment accounts financing enables the Islamic bank to increase both its market value and its shareholders' rates of return at no extra financial risk to the bank. We theoretically demonstrate that such a process leads to an increase in the Islamic bank's market value but does not alter its weighted average cost of capital, i.e. the weighted average cost of capital of the Islamic bank remains constant. The evidence obtained from estimating and testing the model on annual accounts drawn from a sample of 12 Islamic banks lends support to our theoretical predictions, as do the results from counterfactual simulations and sensitivity experiments. Hence, in the context of Islamic banks both our theoretical and empirical results provide a new dimension to the theory of capital structure, which is based on a mixture of only debt and equity financing. In general, viewed against the main competing tenets of the traditional school and the MM standpoint, our results provide an encompassing paradigm on the theory of capital structure.

There has been constant debate about the predictability of the security markets. We examine the relationship between the prices of a stock and its convertible bond during the Hong Kong stock market bubble of 1997 and its subsequent crash. We find that the price behavior of the share and the convertible bond not only gave a clear signal of the market reversal, but also the minimum range of the stock price change. This example offers concrete evidence that the market becomes highly predictable at times and gives us a chance to understand the relationship of the underlying stock and its derivatives during market bubbles.

Information theory teaches that entropy is the fundamental limit for data compression, and electrical engineers routinely use entropy as a criterion for efficient storage and transmission of information. Since modern financial theory teaches that competitive market prices store and transmit information with some efficiency, should financial economists be concerned with entropy? This paper presents a market model in which entropy emerges endogenously as a condition for the operational efficiency of price discovery while entropy maximization emerges as a condition for the informational efficiency of market prices. The maximum-entropy formalism makes the efficient market hypothesis operational and testable. This formalism is used to establish that entropic markets admit no arbitrage and support both the Ross arbitrage pricing theory and the Black–Scholes stock option pricing model.

An informationally efficient price keeps investors as a group in the state of maximum uncertainty about the next price change. The Entropy Pricing Theory (EPT) captures this intuition and suggests that, in informationally efficient markets, perfectly uncertain market beliefs must prevail. When the entropy functional is used to index the market uncertainty, then the entropy-maximizing market beliefs must prevail. The EPT resolves the ambiguity of asset valuation in incomplete markets, notably, the valuation of derivative securities. We use the EPT to derive a new stock option pricing model that is similar to Black–Scholes' with the lognormal distribution replaced by a gamma distribution. Unlike the Black–Scholes model, the gamma model does not restrict the dynamics of the stock price or the short-term interest rate. Option replication based on the gamma model accounts for random changes in the stock price, price volatility and interest rates.