ISLAMIC CAPITAL MARKETS COMPARATIVE APPROACH
  • Book Title:
 Islamic Capital Markets Comparative Approach
  • Book Author:
Abbas Mirakhor
  • Total Pages
443
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ISLAMIC CAPITAL MARKETS COMPARATIVE APPROACH – Book Sample

Contents – ISLAMIC CAPITAL MARKETS COMPARATIVE APPROACH

  • Founding Thoughts—Adam Smith, Capitalism,
  • and Islamic Finance 1
  • Introduction and Overview 1
  • Chapter Topics 1
  • Chapter Objective 2
  • Key Terms 2
    • The Roots: The Economy, Real and Financial
  • Sectors, Risk and Islamic Finance 2
    • Uncertainty and Risk 3
    • Why Is There Uncertainty and Risk? 4
    • Types of Risk 5
    • Risk in the Real Sector and in the Financial
  • Sector 5
    • Financial System of Capitalism: The Foundations 6
    • Smith and Arrow 7
    • Smith and Ethical Rules 8
    • An Arrow-Debreu Economy 9
    • What Happened to the Smith-Arrow
  • Risk-Sharing Ideal? 10
    • Can Economics Explain a Positive Predetermined
  • Rate of Interest? 11
    • Islamic Finance: The Foundations 13
    • Islamic Rules Governing Exchange 15
    • Islamic Financial Markets and Instruments 20
    • Islamic Finance Industry at Present 22
    • What Does the “Paper Economy” Look Like Today,
  • Some Five Years After the Crisis? 23
  • Summary 24
  • Questions and Problems 25
  • References and Further Reading 26
  • CHAPTER 2 The Capital Markets 37
  • Introduction and Overview 37
  • Chapter Topics 37
  • Chapter Objective 37
  • Key Terms 38
  • 2.1 Introduction 38
  • 2.2 Key Trends in Capital Market Development 41
  • 2.3 Stock Exchanges of the Islamic World 45
  • 2.4 The Debt Markets 50
  • 2.5 The Money Markets 53
  • 2.6 The Derivatives Market 53
  • 2.7 Risks in Capital Markets 57
  • Summary 61
  • Questions and Problems 61
  • References and Further Reading 62
  • Websites 62
  • CHAPTER 3 Islamic Finance: Underlying Philosophy, Contracts, Instrument
  • Design, and Requisites 63
  • Introduction and Overview 63
  • Chapter Topics 63
  • Chapter Objective 63
  • Key Terms 64
  • 3.1 Introduction 64
  • 3.2 Underlying Themes and Fundamentals of Fiqh Mu’amalah 66
  • 3.3 Requirements for Islamic Capital Market Instruments/
  • Transactions 66
  • 3.4 Shariah-Based Contracts for Financial Transactions 68
  • 3.5 International Regulatory Institutions for Islamic Finance 77
  • Summary 79
  • Questions and Problems 80
  • References and Further Reading 80
  • Websites 81
  • viii / CONTENTS
  • CHAPTER 4 The Interbank Money Markets 83
  • Introduction and Overview 83
  • Chapter Topics 83
  • Chapter Objective 84
  • Key Terms 84
  • 4.1 Introduction 84
  • 4.2 Money Market—Components 87
  • 4.3 Money Market Instruments 90
  • 4.4 The Pricing of Money Market Instruments 93
  • 4.5 Determining the Yield of a Money Market Instrument 95
  • 4.6 Interest Rates, Yields, and Price of Money Market
  • Instruments 95
  • 4.7 Malaysia Money Market—Trading Performance 97
  • 4.8 The Central Bank, Money Market, and Monetary Policy
  • Operations 100
  • 4.9 Commercial Banks and the Money Market 102
  • Summary 105
  • Questions and Problems 106
  • References and Further Reading 106
  • Websites 107
  • CHAPTER 5 The Islamic Interbank Money Market (IIMM) 109
  • Introduction and Overview 109
  • Chapter Topics 109
  • Chapter Objective 110
  • Key Terms 110
  • 5.1 Introduction 110
  • 5.2 The Islamic Interbank Money Market 112
  • 5.3 Pricing the Mudarabah Interbank Investment Funds 113
  • 5.4 The Islamic Interbank Cheque Clearing
  • System (IICCS) 115
  • 5.5 Islamic Money Market Instruments 115
  • 5.6 Key Islamic Money Market Instruments 115
  • 5.7 Pricing of Islamic Money Market Instruments 122
  • 5.8 The Islamic Interbank Money Market and
  • Issues of Risk 122
  • 5.9 Trading Performance on IIMM 124
  • 5.10 The Kuala Lumpur Islamic Reference Rate (KLIRR) 125
  • 5.11 The Bursa Suq al Sila (BSaS) 128
  • 5.12 The Commodity Murabahah 129
  • 5.13 The Liquidity Management Centre (LMC) 131
  • CONTENTS / ix
  • Summary 133
  • Questions and Problems 134
  • References and Further Reading 135
  • Websites 135
  • CHAPTER 6 Bonds and Bond Markets 137
  • Introduction and Overview 137
  • Chapter Topics 137
  • Chapter Objective 138
  • Key Terms 138
  • 6.1 Introduction 138
  • 6.2 Bank Borrowing versus Bond Issuance 139
  • 6.3 Debt versus Equity and Bond Features 141
  • 6.4 Face Value and Par Value 142
  • 6.5 The Pricing of Bonds 145
  • 6.6 Bond Yields and Yield Curves 147
  • 6.7 Yield Curve and Credit Spreads 148
  • 6.8 What Constitutes a Yield? 149
  • 6.9 Interest Rate Change, Bond Yields, and Duration 151
  • 6.10 Risks Associated with Bonds 158
  • 6.11 Types of Bonds 159
  • 6.12 Bond Ratings 166
  • 6.13 Ratings and Yield/Credit Spreads 167
  • Summary 168
  • Questions and Problems 168
  • References and Further Reading 169
  • CHAPTER 7 Sukuk and Sukuk Markets 171
  • Introduction and Overview 171
  • Chapter Topics 171
  • Chapter Objective 172
  • Key Terms 172
  • 7.1 What Are Sukuk? 172
  • 7.2 Sukuk Fundamentals 174
  • 7.3 Underlying Islamic Contracts for Sukuk 176
  • 7.4 Sukuk Structures 178
  • 7.5 Sukuk Players 186
  • 7.6 Risks Associated with Investing in Sukuk 187
  • 7.7 Sukuk in Malaysia 191
  • 7.8 Sukuk in Malaysia: Growth and Evolution 194
  • x / CONTENTS
  • 7.9 Underlying Asset and the Structuring of Sukuk 195
  • 7.10 The Pricing of Sukuk 201
  • Summary 207
  • Questions and Problems 208
  • References and Further Reading 209
  • CHAPTER 8 Common Stocks and Equity Markets 211
  • Introduction and Overview 211
  • Chapter Topics 211
  • Chapter Objective 212
  • Key Terms 212
  • 8.1 Introduction 213
  • 8.2 The Evolution of Stocks 214
  • 8.3 Why Companies Choose to List 217
  • 8.4 Rights of Share Ownership 218
  • 8.5 Equity Ownership and Shariah Compliance 219
  • 8.6 The Valuation of Common Stocks 221
  • 8.7 The Market Required Rate of Return 229
  • 8.8 The Required Return and the Stock Price Dynamics 230
  • 8.9 Dividend Growth and the Trade-off with Capital
  • Gains 231
  • 8.10 Stock Market Indices 235
  • 8.11 Schools of Thought on Stock Price Behavior 236
  • Summary 243
  • Questions and Problems 244
  • References and Further Reading 245
  • CHAPTER 9 The Islamic Equities Market 247
  • Introduction and Overview 247
  • Chapter Topics 247
  • Chapter Objective 247
  • Key Terms 248
  • 9.1 Introduction 248
  • 9.2 Components of an Islamic Equities Market 249
  • 9.3 The Screening of Stocks for Shariah Compliance 249
  • 9.4 Components/Products of an Islamic Equities
  • Market 254
  • 9.5 Islamic Equity Indices 267
  • 9.6 The Stock Exchanges of the Islamic World 269
  • CONTENTS / xi
  • Summary 272
  • Questions and Problems 273
  • References and Further Reading 274
  • Websites 274
  • CHAPTER 10 Derivative Instruments: Products and Applications 275
  • Introduction and Overview 275
  • Chapter Topics 275
  • Chapter Objective 276
  • Key Terms 276
  • 10.1 Introduction 277
  • 10.2 What Are Derivative Instruments? 277
  • 10.3 Common Derivative Instruments 278
  • 10.4 The Evolution of Derivative Instruments 279
  • 10.5 Forward Contracts 280
  • 10.6 The Need for Futures Contracts 280
  • 10.7 The Need for Options 282
  • 10.8 Options: Key Features and Trade-offs 283
  • 10.9 Payoffs and Risk Profiles of Option Positions 284
  • 10.10 Interest Rate Swaps (IRSs) 291
  • 10.11 The Main Players in Derivative Markets 294
  • 10.12 Commodities versus Financial Derivatives 295
  • 10.13 Derivative Markets and the Role of the
  • Clearinghouse 296
  • 10.14 Applications: Using Derivatives to Manage Risk 297
  • 10.15 What Derivative to Use? 303
  • 10.16 Overview of Global Derivatives Trading 303
  • Summary 308
  • Questions and Problems 309
  • References and Further Reading 310
  • Websites 311
  • CHAPTER 11 Shariah-Compliant Derivative Instruments 313
  • Introduction and Overview 313
  • Chapter Topics 313
  • Chapter Objective 314
  • Key Terms 314
  • xii / CONTENTS
  • 11.1 Introduction 314
  • 11.2 Necessary Features for Islamic Financial Instruments 315
  • 11.3 Islamic Finance Instruments with Features of Derivative
  • Instruments 315
  • 11.4 The Islamic Profit Rate Swap (IPRS) 321
  • 11.5 How Is the IFI Hedged? 323
  • 11.6 Sukuk with Embedded Options 323
  • 11.7 Contemporary Derivative Instruments—How Shariah
  • Compliant Are They? 324
  • 11.8 Shariah-Compliant Instruments for Managing Exchange
  • Rate Risk 328
  • Summary 329
  • Questions and Problems 330
  • References and Further Reading 331
  • Website 331
  • CHAPTER 12 Exchange Rates and the Foreign Exchange Market 333
  • Introduction and Overview 333
  • Chapter Topics 333
  • Chapter Objective 334
  • Key Terms 334
  • 12.1 Introduction 334
  • 12.2 What Is an Exchange Rate? 335
  • 12.3 Exchange Rate Risk 337
  • 12.4 The Foreign Exchange Market 341
  • 12.5 Foreign Exchange Market Players 345
  • 12.6 Spot and Forward Markets 347
  • 12.7 Bid-Ask Spreads 348
  • 12.8 Cross Rates 349
  • 12.9 The Forward Market for Exchange Rates 350
  • 12.10 Forward versus Spot Rates 350
  • 12.11 Forward Market Players 351
  • 12.12 Nominal versus Real Exchange Rates 355
  • 12.13 Shariah-Compliant Techniques for Managing Currency
  • Exposure 356
  • Summary 360
  • Questions and Problems 361
  • References and Further Reading 363
  • Websites 363
  • CONTENTS / xiii
  • CHAPTER 13 Capital Markets and Government Policy 365
  • Introduction and Overview 365
  • Chapter Topics 365
  • Chapter Objective 365
  • Key Terms 366
  • 13.1 Risk Sharing 366
  • 13.2 Islamic Finance and Risk Sharing: Role of Public Policy 377
  • Questions and Problems 391
  • References and Further Reading 392
  • Index 403

Introduction – Islamic Finance: Underlying Philosophy, Contracts, Instrument Design, and Requisites

In this chapter we examine the underlying principles of Islamic finance, some of the key contracts, and Shariah requirements for capital market instruments. We also examine the source of rulings, Islamic ideology, and we discuss current trends.

The Shariah, which has taught how to manage Islamic finance, translates into “the way” or “path,” and is a set of rules designed to transform the faith of believers into the daily life of Muslims. The Shariah emanates from aqidah, which is the core set of rules between man and his Creator and is the basis of Islamic ideology. At a basic level, there are three key components of Islamic ideology: tauhid, nubuuwa, and maad. Tauhid refers to the oneness of God, while nubuuwa refers to the concept of prophethood. The concept of maad refers to one’s inevitable return to Allah (SWT) for the final judgment, the implication that one is answerable for all one’s actions.

The primary sources of the Shariah are the Quran and Sunnah. Sunnah refers to practices of the Prophet (SAW). Both the Quran and Sunnah form the main body or thrust of the Shariah. Secondary sources of the Shariah are also allowed.

 The two common secondary sources are ijma and qiyas. Ijma refers to consensus among Shariah scholars. Qiyas, on the other hand, refers to analogical reasoning or drawing similarities/ inferences from earlier situations—usually prophetic times. A third possible source is maslahah or public benefit—in other words, situations where a ruling is needed for the general interest of the community.

While the secondary sources give the Shariah the dynamism and the adapt- ability needed to always remain relevant, they have also been the source for differences among Shariah scholars. Differences in opinion among fuqaha (jurists) about  the acceptability of a practice, contract, or transaction emanate largely from differences in interpretation, in particular on qiyas-based rulings. Furthermore, interpretation of the Shariah has evolved along the lines of madhahib—(1) Hanafi (2), Maliki, (3) Shafii, and

(4) Hanbali. Since each madhab had taken root in different geographic regions, cultural settings, and social systems, interpretations and inferences may be colored by local values.

The Shariah is comprehensive and all-encompassing, so it relates to both the spiritual (ibadah) and socioeconomic aspects of Muslim life. Accordingly, Shariah is often categorized into two broad categories: matters relating to ibadah and matters relating to muamalah, or transactions. Although the former is sourced exclusively from the Qu’ran and has no room for differences arising from scholastic interpretation, the latter, fiqh muamalah, is open for interpretation and therefore to differences in opinion. Much of Islamic finance, economics, and Islamic banking/capital markets are governed by the rules of fiqh muamalah. Figure 3.1 shows how the Shariah’s two main components emanate from aqidah….

The Interbank Money Markets

The money market is a key component of the financial system. If the banking system and the capital markets are the two wheels of a country’s financial system, the money market can be thought of as the gear that moves both these wheels. The money market is connected to the capital market, in particular the bond market, in that it trades short- term debt papers. The money market was the main credit market in the eighteenth and nineteenth centuries; most banking activities were concentrated in short-term com- mercial loans to finance trade operations.

Money market operations used to be carried out through discounting commercial bills, issuance of banknotes, and short-term credit. Thus, the short end of the yield curve is derived from money market trading. It is not uncommon therefore to hear of the money market being characterized as the market for short-end debt. If tenor links the money market to the capital markets, the money market is linked to the banking system in another critical way.

Banks depend on the money market to manage their liquidity. While liquidity management is not the only use of money markets for banks, it is by far the most important. In fact, banks depend so much on the money market that often they are known as the interbank money market.

 The interbank money market is no different from the money market, only that it is bank dominated. With the exception of the United States, where the money market is securities dominated, with funds channeled through use of short-term securities such as treasury bills and commercial papers, most money markets are bank-dominated. In bank-dominated money markets, funds are moved through use of bank deposit instruments such as banker’s acceptances (BAs) and certificates of deposit (CDs).

Given the links that the money market has with both the capital market and the banking system, it has become the ideal avenue for central banks to conduct monetary operations. As such, the first impact of a monetary policy change is always felt first in the money market. It is the short interest rate/yield, derived from money market trading, that first responds to central bank policy implementation.

Adjustment in the bond market, equity market, and banking system follow the money market reaction. Thus, a well-functioning money market properly transmits policy initiatives to the rest of the financial system. Occasionally, central banks may also use the money market for credit allocation purposes. Today, given the many functions that the money market plays, there is a wide range of players who use and depend on the money market for their activities. Figure 4.1 shows the key players of a money market.

Though money markets play many critical functions today, they had humble beginnings. Money markets began as a needed extension of the correspondent banking system. In the early days, with banking largely a localized business, the need for economies of scale required banks to go into relationships with banks in other cities/ regions in order to extend their reach. This gave rise to correspondent banking. Deposits that country banks placed with their correspondent banks in the money centers and regional imbalances in deposit creation and credit demand supported the development of national money markets. The need to minimize counterparty risk and have trans- actions on an arm’s-length basis led to the creation of tradable debt papers, or com- mercial bills as they were then known. A market to discount and trade these papers was the next logical extension. Figure 4.2 portrays these early beginnings.

Although the above description was the typical evolution of money markets in the United Kingdom and the United States, Malaysia’s money market, as with its Islamic counterpart, the Islamic Interbank Money Market (IIMM) were established by

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