Mathematical modelling of ashariah-compliant capital asset pricing model

Purpose - The capital asset pricing model (CAPM) is the most widely used asset pricing model that measures risk–return relationship. The CAPM is based on Markowitz’s mean variance analysis. The advancement of Islamic finance leads to the question whether or not the practice of modern investment theories and analyses such as the Markowitz’s mean variance analysis and CAPM are in accordance toshariahand could be used in pricing Islamic financial assets. Therefore, this paper aims to present a review of the CAPM and to discourse the set of assumptions underlying the model in terms ofshariahcompliance. Design/methodology/approach - Although most of the assumptions are not contradictory toshariahprinciples, there are Islamic variables such as prohibition of short selling, purification and zakat that should be taken into consideration when pricing Islamic financial assets. We then develop a mathematical model which is a modification of the traditional CAPM that incorporates principles of Islamic finance and integrating zakat, purification of return and exclusion of short sales. Findings - As a proof-of-concept, this paper presents the results of an empirical study on the proposedshariah-compliant CAPM in comparison to the traditional CAPM. The results show that the proposed Islamic CAPM is appropriate and applicable in examining the relationship between risk and return in the Islamic stock market. Originality/value - This study contributes to existing body of knowledge by presenting an algorithm and mathematical derivation of theshariah-compliant CAPM which has been lacking in the literature of Islamic finance. The paper offers a novel approach in pricing Islamic financial assets in accordance toshariah, advocated by modern investment theories of Markowitz’s mean variance analysis and CAPM.