Interest-free participating mortgage as a new housing finance method: stochastic modelling and comparison with conventional mortgage

Abstract

This paper mainly aims to develop a participating mortgage model complied with Islamic finance principles and to compare it with the conventional mortgage model. The point that distinguishes our work from the literature is that the model of participating mortgage we set up in this paper is completely out of interest and modeled on partnership bases. In our interest-free participating mortgage model, which can be adapted to all kinds of participating mortgages, all the prices and ratios are created in a stochastic manner and serve as a basis in this field with this feature. Interest rate such as risk-adjusted yield is altered in order to have a fully shariah compliant structure. Therefore, instead of risk adjusted yield, shariah compliant market rate of return which is determined in the Sukuk market is preferred in this study and modelled stochastically as well. In addition, it is the first study that includes early termination options (default, prepayment with penalty and defeasance) and their pricing simultaneously, which are the most important risks of interest-free participating mortgages as such in all types of mortgages. Finally, the interest-free participating mortgage and the conventional mortgage are compared over the pricing of early termination options.