Debt and equity in a primary financial market: a theory with Islamic implications

A Riba-free primary financial market can achieve Pareto-optimality. The dominance of the mixed debt/equity system has some implications for deviation from informational efficiency. Risks normally associated with equity returns are definite indicators of risk-aversion on the part of investors. An investor may in fact prefer equity to a risk-free asset even though he is more risk-averse than the demand-side issuer of equity. Therefore, free- market forces establish the financial equilibrium balancing the risk-averse and the risk-less equity investment. Theoretical claims of efficiency losses in the financial supply process due to Islamization appear groundless.