Adverse selection analysis for profit and loss sharing contracts

Purpose – The purpose of this paper is to determine the optimal profit-and-loss sharing (PLS)-based contract when market frictions occur. Design/methodology/approach – This paper opts for an adverse selection analysis and Monte Carlo simulation to assess the less risky contract for the principa...

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Main Authors:	Ajmi, Hechem, Abd Aziz, Hassanuddeen, Kassim, Salina, Mansour, Walid
Format:	Article
Language:	English English English
Published:	Emerald Publishing 2019
Subjects:	HG Finance
Online Access:	http://irep.iium.edu.my/77572/ http://irep.iium.edu.my/77572/ http://irep.iium.edu.my/77572/1/77572_Adverse%20selection%20analysis.pdf http://irep.iium.edu.my/77572/2/77572_Adverse%20selection%20analysis_WOS.pdf http://irep.iium.edu.my/77572/13/77572_Adverse%20selection%20analysis%20for%20profit%20and%20loss%20sharing%20contracts_Scopus.pdf

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recordtype	eprints
spelling	iium-775722020-02-28T03:33:05Z http://irep.iium.edu.my/77572/ Adverse selection analysis for profit and loss sharing contracts Ajmi, Hechem Abd Aziz, Hassanuddeen Kassim, Salina Mansour, Walid HG Finance Purpose – The purpose of this paper is to determine the optimal profit-and-loss sharing (PLS)-based contract when market frictions occur. Design/methodology/approach – This paper opts for an adverse selection analysis and Monte Carlo simulation to assess the less risky contract for the principal and the agent when musharakah, mudarabah and venture capital financings are used in imperfect markets. Furthermore, this framework enables us to capture the level of market frictions that the principal can bear and the level of audit that he/she may undertake to mitigate bankruptcy. Findings – The simulation results reveal that Musharakah is the less risky contract for the principal compared to Mudarabah and venture capital when the shock is low and high. Furthermore, our findings indicate that the increase of market frictions engender higher audit cost and profit-sharing ratios. The increase of the safety index in the case of high shock is most likely attributed to the increase of the audit parameter for all contracts to mitigate the selfish behavior of the agent. Accordingly, the principal tends to require a higher profit-sharing ratio to compensate for the severer information asymmetry. Research limitations/implications – This paper has two main limits. First, the results were not compared to real data because the latter are not available. Second, this paper is a general framework to determine the less risky contract for the principal and does not consider the firm and sectoral characteristics. However, it can be extended in various ways where stress can be put on conflicts of interest between the principal and the agent with the aim to determine the contract that aligns their interests. In addition, the examination of firm dynamics in the case of equity and debt financing can provide further arguments for economic agents regarding the value of the firm, the growth rate and the lifetime of the project when information is asymmetrically distributed. Practical implications – The findings shed some light on the necessity of the Islamic finance experts to rethink of the promotion of Musharakah because it dominates the two other contracts when market frictions occur. Social implications – Although Maghrabi and Mirakhor (2015), Alanzi and Lone (2015) and Lone and Ahmad (2017) among others showed that profit and loss sharing can ensure economic growth, findings may motivate economic players to consider Musharakah financing with the aim to reach financial inclusion and social, which is in line with Shari’ah requirements and Islamic values. Originality/value – Although several papers highlighted the financial contracting theory from Shari’ah perspective, they ignored the financial issues that are associated to adverse selection. This paper provides theoretical evidence regarding the selection of the less risky financing mode in case of equity financing using Monte Carlo simulation. Keywords Monte Carlo simulation, Adverse selection analysis, Market frictions, PLS contracts Emerald Publishing 2019-04-20 Article PeerReviewed application/pdf en http://irep.iium.edu.my/77572/1/77572_Adverse%20selection%20analysis.pdf application/pdf en http://irep.iium.edu.my/77572/2/77572_Adverse%20selection%20analysis_WOS.pdf application/pdf en http://irep.iium.edu.my/77572/13/77572_Adverse%20selection%20analysis%20for%20profit%20and%20loss%20sharing%20contracts_Scopus.pdf Ajmi, Hechem and Abd Aziz, Hassanuddeen and Kassim, Salina and Mansour, Walid (2019) Adverse selection analysis for profit and loss sharing contracts. International Journal of Islamic and Middle Eastern Finance and Management, 12 (4). pp. 532-552. ISSN 1753-8394 https://www.emerald.com/insight/content/doi/10.1108/IMEFM-03-2018-0079/full/html
repository_type	Digital Repository
institution_category	Local University
institution	International Islamic University Malaysia
building	IIUM Repository
collection	Online Access
language	English English English
topic	HG Finance
spellingShingle	HG Finance Ajmi, Hechem Abd Aziz, Hassanuddeen Kassim, Salina Mansour, Walid Adverse selection analysis for profit and loss sharing contracts
description	Purpose – The purpose of this paper is to determine the optimal profit-and-loss sharing (PLS)-based contract when market frictions occur. Design/methodology/approach – This paper opts for an adverse selection analysis and Monte Carlo simulation to assess the less risky contract for the principal and the agent when musharakah, mudarabah and venture capital financings are used in imperfect markets. Furthermore, this framework enables us to capture the level of market frictions that the principal can bear and the level of audit that he/she may undertake to mitigate bankruptcy. Findings – The simulation results reveal that Musharakah is the less risky contract for the principal compared to Mudarabah and venture capital when the shock is low and high. Furthermore, our findings indicate that the increase of market frictions engender higher audit cost and profit-sharing ratios. The increase of the safety index in the case of high shock is most likely attributed to the increase of the audit parameter for all contracts to mitigate the selfish behavior of the agent. Accordingly, the principal tends to require a higher profit-sharing ratio to compensate for the severer information asymmetry. Research limitations/implications – This paper has two main limits. First, the results were not compared to real data because the latter are not available. Second, this paper is a general framework to determine the less risky contract for the principal and does not consider the firm and sectoral characteristics. However, it can be extended in various ways where stress can be put on conflicts of interest between the principal and the agent with the aim to determine the contract that aligns their interests. In addition, the examination of firm dynamics in the case of equity and debt financing can provide further arguments for economic agents regarding the value of the firm, the growth rate and the lifetime of the project when information is asymmetrically distributed. Practical implications – The findings shed some light on the necessity of the Islamic finance experts to rethink of the promotion of Musharakah because it dominates the two other contracts when market frictions occur. Social implications – Although Maghrabi and Mirakhor (2015), Alanzi and Lone (2015) and Lone and Ahmad (2017) among others showed that profit and loss sharing can ensure economic growth, findings may motivate economic players to consider Musharakah financing with the aim to reach financial inclusion and social, which is in line with Shari’ah requirements and Islamic values. Originality/value – Although several papers highlighted the financial contracting theory from Shari’ah perspective, they ignored the financial issues that are associated to adverse selection. This paper provides theoretical evidence regarding the selection of the less risky financing mode in case of equity financing using Monte Carlo simulation. Keywords Monte Carlo simulation, Adverse selection analysis, Market frictions, PLS contracts
format	Article
author	Ajmi, Hechem Abd Aziz, Hassanuddeen Kassim, Salina Mansour, Walid
author_facet	Ajmi, Hechem Abd Aziz, Hassanuddeen Kassim, Salina Mansour, Walid
author_sort	Ajmi, Hechem
title	Adverse selection analysis for profit and loss sharing contracts
title_short	Adverse selection analysis for profit and loss sharing contracts
title_full	Adverse selection analysis for profit and loss sharing contracts
title_fullStr	Adverse selection analysis for profit and loss sharing contracts
title_full_unstemmed	Adverse selection analysis for profit and loss sharing contracts
title_sort	adverse selection analysis for profit and loss sharing contracts
publisher	Emerald Publishing
publishDate	2019
url	http://irep.iium.edu.my/77572/ http://irep.iium.edu.my/77572/ http://irep.iium.edu.my/77572/1/77572_Adverse%20selection%20analysis.pdf http://irep.iium.edu.my/77572/2/77572_Adverse%20selection%20analysis_WOS.pdf http://irep.iium.edu.my/77572/13/77572_Adverse%20selection%20analysis%20for%20profit%20and%20loss%20sharing%20contracts_Scopus.pdf
first_indexed	2023-09-18T21:49:24Z
last_indexed	2023-09-18T21:49:24Z
_version_	1777413667837444096

Adverse selection analysis for profit and loss sharing contracts

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