Fundamentals of Islamic money and markets pdf

FUNDAMENTALS OF ISLAMIC MONEY AND MARKETS – Book Sample

Contents – FUNDAMENTALS OF ISLAMIC MONEY AND MARKETS

• 1 An Introduction to Conventional and Islamic Financial Systems 1
• Learning Outcomes 1
• Introduction 2
• The Roles and Functions of Financial Markets 4
• Structures of Financial Markets 6
• Based on the Instrument 6
• Based on the Issuance of Securities 8
• Methods Used in Secondary Markets 8
• Based on the Maturity 9
• Classification of Financial Markets 9
• The Money Market 10
• The Capital Market 12
• Types of Financial Intermediaries 13
• Depository Institutions 14
• Contractual Institutions 15
• Investments and Finance Institutions 17
• A Brief Overview of the Islamic Financial System 17
• Evolution of Islamic Finance 18
• Chapter Summary 20
• Chapter Questions 21
• Notes 22
• References 22
• 2 Development of Islamic Capital and Money Markets in Malaysia 23
• Learning Outcomes 23
• Introduction 24
• Development of Islamic Financial Institutions in Malaysia 24
• 1960 to 1990: Establishment of Islamic Financial Institutions 24
• 1990 to 2000: Conventional Banks Allowed to Offer Islamic
• Financial Products and Services 26
• 2000 to 2010: Islamic Subsidiaries and the International
• Integration of the Islamic Banking System 27
• Islamic Capital Markets in Malaysia 29
• Sukuk 30
• Islamic Collective Investments 31
• Islamic Stock Broking 32
• Malaysia International Islamic Financial Centre (MIFC) 33
• Chapter Summary 34
• Chapter Questions 36
• Notes 36
• References 36
• 3 Regulators and Transactions Platform for Capital and Money
• Markets 37
• Learning Outcomes 37
• Introduction 38
• Bank Negara Malaysia (BNM) 38
• Role and Functions 39
• BNM Administered Legislation 40
• Role of BNM on ICM Development 42
• The Securities Commission (SC) 42
• Role of SC on ICM Development 42
• Bursa Malaysia (BM) 45
• Role of BM on ICM Development 45
• Shariah-Compliant Stocks and ETF 46
• Islamic Equity Indices 46
• Islamic REITs and Sukuk Market 47
• Chapter Summary 47
• Chapter Questions 48
• Notes 48
• References 48
• Websites 48
• 4 Islamic Money Market 49
• Learning Outcomes 49
• Introduction 50
• Money Market Participants 50
• viii / Contents
• Functions of the Islamic Money Market 51
• Differences between Islamic and Conventional Money Markets 52
• Components of the Malaysian Islamic Money Market 53
• Islamic Interbank Market 53
• Mudarabah Interbank Investment 54
• Profit Calculation for Mudarabah Interbank Investment 55
• Example: Mudarabah Interbank Investment (MII) 56
• Commodity Murabahah 56
• Example: Commodity Murabahah Interbank Investment 58
• Wakalah Investment 58
• Trading of Islamic Money Market Instruments 59
• Government Investment Issue (GII) 60
• Example: Calculation of GII price 61
• Malaysian Islamic Treasury Bills (MITB) 61
• Example: Calculation of Proceeds on MITB 62
• Bank Negara Monetary Notes (BNMN) 62
• Sukuk Bank Negara Malaysia Ijarah (SBNMI) 63
• Islamic Negotiable Instruments (INI) 63
• Negotiable Islamic Debt Certificate (NIDC) 63
• Example: Calculation of Price of NIDC of Less Than One Year 64
• Example: Calculation of Price NIDC with Maturity of More
• Than One Year 65
• Islamic Negotiable Instruments of Deposit (INID) 66
• Example: Calculation of Proceeds for an INID 66
• Islamic Accepted Bill (IAB) 67
• Import and Local Purchases 67
• Export/ Local Trade 67
• Example: Price Calculation of IAB under Bai al-Dayn 68
• Sell and Buy Back Agreement (SBBA) 68
• Example: Sell and Buy Back Agreement 69
• Cagamas Sukuk 70
• Sanadat Mudarabah Cagamas (SMC) 70
• Example: Sanadat Mudarabah Cagamas (SMC) Calculation 71
• Sanadat Cagamas 71
• Islamic Corporate Sukuk 72
• Chapter Summary 72
• Chapter Questions 73
• Notes 73
• References 74
• 5 An Overview of Sukuk 77
• Learning Outcomes 77
• Introduction 78
• Comparing Sukuk, Bonds, and Shares 79
• Sukuk Types 81
• Sukuk Structures 81
• Sukuk al-Ijarah 82
• Sukuk al-Musharakah 88
• Contents / ix
• Sukuk al-Mudarabah 94
• Sukuk al-Salam 99
• Sukuk al-Istisna 102
• Sukuk al-Murabahah 106
• Sukuk al-Istithmar 110
• Sukuk al-Wakala 114
• Chapter Summary 117
• Chapter Questions 118
• Notes 118
• References 119
• 6 Shariah-Compliant Equity 121
• Learning Outcomes 121
• Introduction 122
• The Structure of Equity Markets 124
• Shariah-Compliant Equity Securities 125
• Differences between Shariah and Non–Shariah-Compliant
• Equity Markets 128
• Shariah-Compliant Stocks Screening 130
• Malaysia Securities Commission 130
• S&P Shariah Indices 131
• Pakistan Meezan Islamic Fund 133
• Global GCC Islamic Fund Screening 134
• Jakarta Islamic Index 135
• Chapter Summary 136
• Chapter Questions 136
• Note 136
• References 136
• 7 Islamic Mutual Funds 139
• Learning Outcomes 139
• Introduction 140
• Closed and Open-Ended Funds 140
• Conventional Mutual Funds 141
• Active and Passive Management 143
• Advantages of Mutual Funds 143
• Disadvantages of Mutual Funds 144
• Fees and Expenses 145
• Islamic Mutual Funds 146
• Basic Concept of Islamic Mutual Funds 147
• Shariah Stock Screening 147
• Purification of Income 148
• Types of Islamic Mutual Funds 149
• The Role of the Shariah Advisory Board in Islamic
• Mutual Funds 151
• Calculating NAV in the Islamic Mutual Funds 151
• Organisation of Islamic Mutual Funds 153
• x / Contents
• The Process of Investing in Islamic Mutual Funds 154
• Islamic Ethical Investment and Ethical Investment 156
• Chapter Questions 158
• Notes 158
• References 158
• 8 Islamic Real Estate Investment Trusts (I-REITs) 161
• Learning Outcomes 161
• Introduction 162
• Islamic Real Estate Investment Trusts (I-REITs) 165
• Shariah-Permissible Investments for I-REITs 166
• I-REITs Structure 169
• Case Study: Al-’Aqar KPJ REIT 171
• Case Study: Al-Hadharah Bousted REIT 174
• Difference between Conventional and Islamic REITs 176
• Chapter Summary 177
• Chapter Questions 178
• Notes 178
• References 178
• 9 Islamic Exchange-Traded Funds 179
• Learning Outcomes 179
• Introduction 180
• Open- and Closed-End Funds, and Unit Trust Funds 180
• Open-End Funds 180
• Closed-End Funds 181
• Unit Trust 181
• Exchange-Traded Funds (ETFs) 181
• Islamic Exchange Trade Funds (I-ETFs) 185
• Security Borrowing and Lending in Malaysia 190
• Islamic ETFs in Other Countries 195
• Challenges in Promoting I-ETFs 195
• Chapter Summary 196
• Chapter Questions 197
• Notes 197
• References 197
• 10 Islamic Derivatives Market 199
• Learning Outcomes 199
• Introduction 200
• Derivative Securities in the Conventional Market 200
• Risk Profile 202
• Main Players in the Derivative Markets 203
• Hedging with a Forward Contract 204
• Hedging with Future Contracts 205
• Hedging with Swap Contracts 206
• Contents / xi
• Derivative Securities in the Islamic Perspective 211
• Islamic Forward and Future Contract 213
• Islamic Option Contract 216
• Islamic Cross-Currency Swap 218
• Islamic Profit Rate Swap 220
• Islamic Structured Product 222
• Chapter Summary 225
• Chapter Questions 226
• Notes 226
• References 227
• Bibliography 229
• About the Authors 233
• Index 235

Islamic Money Market

The money market is an essential and integral component of the financial system. The money

market, capital market, derivative market, commodity market, and foreign exchange market together constitute the country’s financial market. They share a common function by providing an avenue for transactions of financial assets between buyers and sellers and between lenders and borrowers.

The money market can be described as the financial market for transactions in wholesale short-term funds. The tenor in money market transactions is from overnight to 12 months, although the most common tenor is three months or less. In many countries, transactions in the primary and secondary money market are over-the-counter (OTC) via electronic telecommunication, but some are done in an exchange such as the Bursa Suq Al-Sila’ in Malaysia. The capital market caters to long-term financial transactions with maturities longer than

12 months. The financial instruments in the capital market are more varied than the money market and they include sukuk, bonds, and equities. Transactions in capital market instruments are either exchange-traded or OTC. Derivative markets are markets for financial instruments whose values are derived from underlying instruments, such as from those in money and capital markets.

The instruments traded include futures, options, swaps, and forward rate agreements. The derivative market caters to future delivery in contrast to other markets where settlement is done on a spot basis. The commodity market offers trading in commodities and precious metals and is used by hedgers and traders. They are traded either in an exchange or in OTC. The foreign exchange market is a market for transactions in foreign currencies, both on a spot and forward-delivery basis. All transactions in this market are OTC and in currencies such as the U.S. dollar, British pound sterling, euro, Singapore dollar, and Japanese yen.

Money Market Participants

The main participants (shown in Figure 4.1) in the money markets are banks, nonbank financial institutions such as takaful and insurance companies, business corporations, the government treasury, and the Central Bank. Banks use the money market for liquidity pur- poses, especially to adjust the mismatch of assets and liability in their balance sheet. They will use the money market to obtain liquidity or to place their surplus funds for a limited period. They could also buy money market instruments such as Malaysian Islamic Treasury bills and NIDCs to invest surplus funds, or sell their holdings of these instruments to raise funds.

Business corporations as well as government agencies also use the money market for short-term investments. Likewise, large business corporations, by virtue of their high credit ratings, source short-term funds by issuing commercial papers. The central bank, being the regulator, and whose role it is to promote market stability, uses the money market to transmit its monetary policy. One such example is the use of open-market operations¹ as a means of influencing the liquidity level and short-term interest rates in the domestic financial system. Changes to the liquidity and short-term interest rates will affect long-term rates in the financial…

Functions of the Islamic Money Market

The functions of an Islamic money market can be divided into three main categories. The first function is liquidity management. The money market serves as an avenue for IFIs to source daily funding or to invest short-term. Access to the money market enables IFIs to maintain optimal liquidity, thereby allowing them to meet the demands of their customers at any time. This therefore allows the IFIs to cope with short-term pressures that may arise.

 It gives flexibility to the IFIs to face every liquidity situation that might arise due to different timing of cash inflows and outflows. Nonfinancial institutions use the money market to manage the fluctuations in their working capital needs, by obtaining either short-term funding or placement. Consequently, they will be able to enjoy low-cost funding or investment returns with low risk.

The money market also serves as the avenue for secondary trading of money market instruments. Money market participants, depending on their view of rates of return, will either buy or sell money market instruments in anticipation of obtaining investment returns. The instruments available in the money market provide investors with different levels of risks, returns, and maturity.

Finally, the money market is used as a channel for the central bank to conduct its monetary policies. As mentioned in the previous section, the central bank will use open market operations by undertaking repos and reverse repos,² purchasing and selling eligible securities, and providing short-term financing directly to banks that are in a deficit situation. In this way, the central bank is able to manage liquidity and influence benchmark rates in the money market.

 Changes in the liquidity and benchmark rates in the money market will thereby influence liquidity and rates of return in other markets. As such, the effect of a monetary policy change is first reflected in the money market, and that will ultimately lead to adjustments in other markets such as sukuk and bond, equity, and banking systems.

Differences between Islamic and Conventional Money Markets

The Islamic money market enables market players to perform similar functions as in con- ventional markets, but with the exception that the instruments used to perform these functions must be based on Shariah laws and principles. Islamic money market provides an avenue for money market players to invest surplus funds or to obtain short-term funding in a Shariah- compliant way. Similarly, it allows the players to trade Shariah-compliant money market instruments as well as to carry out Shariah-compliant swaps.

Table 4.1 shows that the Islamic money market uses a host of Shariah contracts, especially for the issuance and trading of Islamic money market instruments, whereas the conventional money market uses only one type of contract based on debt. Returns in the Mudarabah Interbank Investment as well as wakalah investment are also not predetermined upon placement, but rather fixed only upon maturity of investment. On the other hand, returns from Commodity Murabahah are fixed and the investor is informed of the return at the onset of placement of funds.

An interesting feature of the Islamic money market is that it is not only accessible to Islamic financial institutions but also to conventional banks, insurance companies, and other conventional nonbank financial institutions. This is the case especially for the Islamic money….

Components of the Malaysian Islamic Money Market

The Islamic Money Market, known in Malaysia as the Islamic Interbank Money Market, came into existence 10 years after the establishment of Malaysia’s first Islamic bank, Bank Islam Malaysia Berhad, in 1983. Prior to the establishment of IIMM in January 1994, the Government Invest- ment Certificate (GIC)³ was the only available Shariah-compliant short-term instrument available to Islamic banks for liquidity management

. The problem experienced using this instrument was that the secondary market for the instrument was not available, as the instrument was issued under the principle of qard al-hasan (benevolent loan), which made it nontradable. Thus, BNM remains the sole option for Islamic banks to deal with regarding liquidity management. They invest in GICs when they have excess liquidity and sell them back when they are in need of liquidity. Considering the growth rate of the Islamic banking sector, a single instrument for managing liquidity is inadequate.

 This development coupled with the dual banking system practice in Malaysia and other similar Muslims countries called for an urgent need for a full-fledged and developed IIMM. However, there is no example of how to design the Islamic money market. Therefore, what has been done is basically to structure the Islamic money market using the conventional money markets’ template by removing all aspects that contradict Shariah principles.

Today the Malaysian Islamic money market comprises two components:

1. Islamic interbank market.
2. Trading of Islamic money market instruments.

Islamic Interbank Market

Generally, the Islamic interbank market is considered the largest component of any Islamic money market and in particular the overnight subcomponent. An active interbank market is essential in providing signals to central banks to determine the volume of open market operations.

The overnight market is where IFIs trade among themselves their reserve balances to meet their day-to-day liquidity requirements. For instance, banks with surplus liquidity can place their excess funds at other banks overnight.

The overnight rate adjusts to balance the supply of and demand for bank reserves. A short-term market rate, in particular the interbank overnight rate may be used to serve as an operational guide for monetary operations of central banks Table 4.2 shows that the overnight market comprises 83 percent of the total interbank market while the other tenor remains an insignificant percentage. The Shariah contracts currently used in the Malaysian Islamic interbank market are mudarabah, murabahah, and wakalah.