Question

a. What are the arguments used by scholars to argue that preference shares are not Shari'ah (6 marks) compliant? b. The following questions relate to the short selling of stocks. i. Briefly describe how short selling works. ii. Explain one economic advantage and one economic disadvantage of short selling. iii. Provide one argument used to argue the Shari 'ah permissibility of short selling and provide one argument used by those who contend that short selling should not be allowed from a Shari 'ah perspective (5 + 4 + 4 marks 13 marks) c. Differentiate between investment in stocks and speculative trading of stocks. (6 marks)

Answer 1

Solution

c.Investment in stocks involves purchasing the stocks with a view that they would generate stable and secure return in the future whereas the trading of stocks is buying / selling and selling / buying of stocks only with a motive to get immediate profits

So,investment is a long-term approach whereas the trading is a very short-term approach(less than 1 year)

While making an investment,the fundamentals of the stocks (i.e., financial statements,valuation,business model,management decision & analysis etc., ) are considered, whereas in trading mainly the present demand of supply of the stock in the market,sentiment of the stock .etc., are considered(fundamentals are given the least importance.

a.Scholars argue that the preference shares are not shariah compliant because of the following some of the reasons:

- Interest - Shariah law has strict prohibition regarding interest (both giving and taking interest on loan)

- Fixed Dividend rate - Preference shares based on their category some of them guarantee that the profit would be distributed to the shareholders on a certain fixed dividend rate.Even the company isn't able to pay the amount they will be obligated to pay the preference shareholders all the pending dues before they declare dividends to the common shareholders (This is on the case of cumulative class of preference shares)

This is against the Sharia law as it is treated like obtaining some kind of interest on loan (in Sharia's view).

-Waiver of right prior to realization of profit - The preference shareholders are entitled the returns even before the company narrows does on the final net /final profit as the preference shareholders have higher right when compared to the common shareholders.

- Loss sharing disproportionate to capital contribution - On this point also the Shariah scholars argue that the preference shares are not Shariah compliant as they have right to claim their capital even before the common shareholders when the company goes to liquidation.

(b) Short-Selling working

Is when we can sell the share even though we are not holding any.

Ex: I do not own even a single share of TATA MOTORS but I have a info that the share price will fall by a margin of 10% during today's trading session.

Then I would opt for short-selling 20 shares of TATA MOTORS.

When I opt for this option,It is like I virtually have 20 shares in my account (In actual I do not).Say the market price of the share is ₹160/-

Then I sell the shares at the existing market price (or) the specific price chosen by me (say) ₹150/-

Then at the end of that day's trading session,I need to buy the share so 20 shares are bought at the existing rate of 120/- to nulnify my negative balance in shares.So,the differential ₹160 - ₹120 (after deducting the trader's commission ) is my profit.

b.(ii) Disadvantage - A person opting for short-selling can only benefit when the price of the stock is going down.If in case the stock price rises up,the person suffers losses.

Advantage - It allows the option to gain huge profits even without actually requiring almost NO investment.It is gaining by the usage of trading broker's money and taking mere advantage / leverage on the market.

- It is making money in the bear market.

b.(iii) Shariah permissibility of short-selling - It can be permissible as it involves selling and buying the stock but does not involve "INTEREST" gain .

Short-selling is not according to Shariah law because we will be compulsarly buy back the stock at the end of the day which will bring us some fixed profit/gain (which is a form of benefiting like receiving the interest rate).

Also we will opt for short-selling only if we believe that the stock declines by at least some specified margin because only then we can generate profit as there are transaction charges and brokerage charges.We need to at least break-even those costs.

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