Islamic capital markets theory and practice pdf

ISLAMIC CAPITAL MARKETS THEORY AND PRACTICE – Book Sample

Contents – ISLAMIC CAPITAL MARKETS THEORY AND PRACTICE

• Acknowledgments xxi
• Glossary of Arabic Terms xxiii

PART ONE

• Islamic Capital Markets: Tools of Securities Investment, Asset Pricing,
• Risk Management, and Portfolio Performance
• CHAPTER 1
• Capital Theory and Islamic Capital Markets 3
• On the Nature of Capital 5
• On the Nature of Interest and Profit 10
• Capital Theory in Islamic Finance 12
• Time Preference and Capital Markets 13
• Capital Productivity: The Intertemporal Production Opportunity Set 18
• General Equilibrium: Time Preference and Capital Productivity 22
• Model of Capital as a Subsistence Fund 26
• Capital as an Engine of Growth 29
• The Capital Market and the Economy 34
• The Intermediation Role of the Capital Market 43
• Summary 44
• References 45
• Questions 45
• CHAPTER 2
• Portfolio Theory and Risk–Return Tradeoff 47
• Market Uncertainty 48
• Portfolio Diversification Theory 52
• Portfolio Diversification in the Case of Two Risky Assets 56
• A Model of a Riskless Asset and a Risky Asset 59
• Asset Pricing Based on Risk–Return Tradeoff 62
• The Security Market Line 68
• Efficiency Frontier, Capital Market Line, Characteristic Line,
• and Security Market Line 70
• vii
• The Cost of Capital Based on the Capital Asset Pricing Model 71
• Summary 72
• References 73
• Questions 73
• CHAPTER 3
• The Analytics of Sukuks 75
• Valuation of an Asset 75
• Valuation of Sukuks 78
• Yield to Maturity 79
• Reinvestment of Sukuk Coupons 79
• The Par Yield 80
• Spot Rates and Forward Rates 81
• The Term Structure of Rates of Return 89
• Sukuk Duration 94
• Sukuk Convexity 100
• Immunization of Sukuk Portfolio 104
• Summary 110
• References 111
• Questions 111
• CHAPTER 4
• Islamic Stocks 117
• Sharia Screening 117
• Islamic Indexes 118
• Speculation and Gambling 119
• Stock Yield 122
• Common Stock Valuation 125
• Forecasting Stock Prices 128
• Fundamental and Technical Analysis 135
• The Efficiency Hypotheses of Stock Markets 138
• Evaluating Companies 142
• Mechanics of Trading 144
• Summary 150
• References 152
• Questions 152
• CHAPTER 5
• The Cost of Capital 155
• Objective of the Firm: Market Value Maximization and the Cost of Capital 156
• Project Selection: The Hurdle Rate 157
• Defining Capital Cost: The Discount Rate 158
• The Net Cash Flow 160
• The Present Value Formula 161
• Relationship between Risk and the Cost of Capital 163
• Estimating the Cost of Equity Capital and Overall Cost of Capital 166
• Capital Asset Pricing Model (CAPM) 168
• Risk-Adjusted versus Certainty-Equivalent Discount Rates 172
• viii CONTENTS
• Applying the CAPM to Calculate Certainty-Equivalent Cash Flow 174
• The Valuation of Securities, Leverage, and the Cost of Capital: The
• Modigliani and Miller Theory 176
• Weighted Average Cost of Capital 180
• Implications of the Capital Cost Analysis for the Theory of
• Investment: Capital Structure and Investment Policy 182
• The Agency Problem 183
• Summary 184
• References 184
• Questions 185
• CHAPTER 6
• Asset Pricing under Uncertainty 189
• Modeling Risk and Return 190
• Market Efficiency and Arbitrage-Free Pricing 199
• Basic Principles of Derivatives Pricing 205
• Summary 220
• References 220
• Questions 220
• CHAPTER 7
• The Consumption-Based Pricing Model 225
• Intertemporal Optimization and Implication to Asset Pricing 225
• Asset-Specific Pricing and Correction for Risk 229
• Relationship between Expected Return and Beta 231
• The Mean Variance (mv) Frontier 232
• Risk-Neutral Pricing Implied by the General Pricing Formula
• pt ¼ Etًmt‏1xt‏1ق 234
• Consumption-Based Contingent Discount Factors 235
• Equity Premium and Interest Rate Puzzles 236
• Summary 239
• References 240
• Questions 240
• CHAPTER 8
• Futures Markets 243
• Institutional Aspects of Forward and Futures Contracts 243
• Valuation of Forward and Futures Contracts 249
• Foreign Currencies Futures and the Yield Rate Parity 255
• Hedging 256
• Rolling the Hedge Forward 262
• The Hedge Ratio 263
• Cross Hedging 266
• Speculating in Futures Markets 268
• Summary 270
• References 271
• Questions 271
• Contents ix
• CHAPTER 9
• Stock Index Futures 275
• Specifications of the Stock Index Futures Contract 276
• The Pricing of a Stock Index Futures Contract 279
• Hedging with Stock Index Futures 282
• The Minimum Risk Hedge Ratio 286
• Cross Hedging 288
• Target Beta and Capture Alpha with Stock Index Futures 290
• Constructing an Indexed Portfolio 296
• Asset Allocation 297
• Portfolio Insurance 304
• Index Arbitrage 305
• Program Trading 309
• Summary 312
• References 313
• Questions 313
• CHAPTER 10
• Interest-Rate Futures Markets and Applications to Sukuks 317
• Types of Interest-Rate Futures Contracts 318
• The Pricing of Sukuk Forward Contracts 328
• Hedging with Interest-Rate Futures 332
• Interest-Rate Futures in Sukuk Portfolio Management 334
• Immunization of Sukuk Portfolio with Interest-Rate Futures 343
• Summary 347
• References 348
• Questions 349
• CHAPTER 11
• Basic Principles of Options 353
• Options: Basic Definitions 353
• Trading Strategies 357
• Option Pricing 365
• Pricing the Put Option 371
• Call–Put Parity 373
• The Binomial Model: Extension to Two Periods 374
• The Option Delta 376
• Risk-Neutral Pricing 377
• The Black–Scholes (BS) Model 378
• Currency Options 383
• Caps and Floors 384
• Summary 385
• References 386
• Questions 386
• x CONTENTS
• CHAPTER 12
• Swaps 389
• Structure and Payoff of a Swap 390
• Motivations for the Swap 391
• The Valuation of Plain-Vanilla Swaps: The Swap Rate 393
• Currency Swaps 401
• Pricing a Currency Swap 408
• Equity Swap 414
• Credit Default Swap 416
• Total Return Swap 417
• Structured Notes: Inverse Floater and Bear Floater 420
• Options on Interest Rate Swaps: Swaptions 423
• Interest-Rate Swaps as Hedging Instruments 427
• Summary 431
• References 432
• Questions 432
• CHAPTER 13
• Mutual Funds 437
• How Does a Mutual Fund Work? 438
• Index Funds and Hedge Funds 439
• Types of Mutual Funds 440
• Fees and Expenses 442
• Regulations 444
• Mutual Fund Performance 445
• Mutual Fund Advantages and Risks 449
• Summary 450
• References 451
• Questions 451
• CHAPTER 14
• Portfolio Performance and Value-at-Risk 453
• Nature and Purpose of the Performance Evaluation 453
• Measuring Performance 455
• Methodologies for Evaluating Performance 456
• The Fama–French Three-Factor Model 466
• Performance Attribution Models 467
• Value-at-Risk (VaR) 468
• Methods for Calculating VaR 472
• Stress Testing and Back Testing 478
• Summary 479
• References 480
• Questions 480
• Contents xi

PART TWO

• Money and Capital Markets
• CHAPTER 15
• The Banking System 487
• On the Nature of Central Banking 488
• On the Nature of Money 491
• Fractional Banking and the Money Multiplier 495
• The Central Bank 502
• The Reserves Market: Demand and Supply of Reserves 507
• The Regulatory and Supervisory Role of the Central Bank 512
• The Debate over the Role of the Central Bank 517
• The Theory of Two Interest Rates 521
• Central Banking and Financial Markets 522
• Central Bank in Islamic Finance 523
• Summary 524
• References 526
• Questions 527
• CHAPTER 16
• The Demand for Money 529
• Motives for Holding Money 531
• Demand for Money as Affected by the Rate of Interest 532
• The Baumol–Tobin Model of Money Demand 535
• Equilibrium in the Market for Money 536
• Demand for Money as Influenced by the Price Level 538
• Other Determinants of the Demand for Money 539
• Effects of Changes in the Money Market 541
• The Quantity Theory of Money and Money Demand 543
• The Cambridge Transaction Approach 549
• The Restatement of the Quantity Theory as a Demand for Money Function 550
• Summary 554
• References 555
• Questions 556
• CHAPTER 17
• Capital Markets and the Macroeconomy 559
• Financial Crises and Approaches for Recovery 559
• The Income-Expenditure Sector 563
• The Monetary Sector 566
• Macroeconomic Equilibrium 570
• Macroeconomic Equilibrium under Keynesian Assumptions 575
• Classicists’ Approaches to Recovery from Depression 579
• Islamic Approaches to Recovery from Depression 582
• Stagflation and Post–2008 Crisis Unemployment 583
• Summary 585
• References 587
• Questions 588
• xii CONTENTS
• PART THREE
• Regulations and Institutions of Capital Markets and Islamic Structured Finance
• CHAPTER 18
• Institutions and Regulations of Capital Markets 591
• Regulatory Legislation 592
• The Securities and Exchange Commission 594
• The U.S. Commodity Futures Trading Commission 596
• The Stock Market 596
• Brokerage Firm 598
• Online Trading: A Form of Discount Brokerage 600
• Investment Advisers 602
• Clearinghouses 603
• Central Securities Depository 604
• Investment Banks 607
• Investment Companies 607
• Investment Funds 609
• Mutual Funds 611
• Exchange-Traded Funds 615
• Hedge Funds 622
• Money Market Funds 626
• Structured Investment Vehicles 627
• Summary 627
• References 628
• Questions 629
• CHAPTER 19
• Institutions and Instruments of Islamic Capital Markets 631
• The Sharia Advisory Council 631
• Islamic Modes of Financing and Islamic Instruments 633
• Islamic Funds 638
• Islamic Derivatives Markets 644
• Guidelines on the Offering of Islamic Securities 645
• Summary 647
• References 648
• Questions 648
• CHAPTER 20
• Sukuks 649
• Asset Securitization 650
• Structure and Legal Documentation of Islamic Private Debt Securities 651
• Types of Sukuk Structures 653
• Sukuk Issuance in Practice 658
• Risks Underlying Sukuks’ Structures 663
• Managing the Financial Risks of Sukuk Structures 666
• Summary 669
• References 670
• Questions 671
• Contents xiii
• CHAPTER 21
• Islamic Structured Products 673
• Structured Finance 673
• Definition of Structured Products 675
• Features of Structured Products 676
• Risks and Benefits of Structured Products 678
• Types of Structured Products 680
• Financial Engineering of Structured Products 681
• Islamic Structured Products 682
• Challenges for Islamic Structurers 691
• Examples of Structured Products 693
• Summary 699
• References 700
• Questions 700
• About the Author 703
• Index 705

Islamic Capital Markets Tools of Securities Investment, Asset Pricing, Risk Management, and Portfolio Performance

This part of the book deals with topics in Islamic finance. It has 14 chapters. Chapter 1 develops elements of capital theory deemed essential for understanding Islamic capital markets. Chapter 2 presents selection theory for a portfolio of risky securities. Chapters 3 and 4 present the analytical tools needed for investors in sukuks and Islamic stocks. Chapter 5 addresses the cost of capital in corporations’ capital bud- geting. Chapters 6 and 7 present models of asset pricing in an uncertain environment, based on the principles of portfolio replication, arbitrage, and risk-neutral probability distributions. Chapters 8 through 12 address risk management based on the use of financial derivatives. Chapter 13 deals with mutual funds, a very popular and highly regulated form of managed investment. Chapter 14 presents models for analyzing the performance of managed funds and estimating their value-at-risk. This part of the book enables readers to develop a command of the tools used in securities trade and port- folio investment; become familiar with the hedging and speculative nature of financial derivatives; and develop skills for portfolio management.

The purpose of this chapter is to present elements of capital theory that are necessary for understanding Islamic capital markets. It lays out the objective of investment, which is economic growth. It defines the notions of capital, interest rate, and profit rate. It presents the classical intertemporal consumer and producer theory; it describes the determination of the equilibrium rate of return on investment, based on the supply of saving and demand for investment. The chapter presents a model of capital as a subsistence fund, the role of capital as an engine of growth, and describes the relationship of the capital market with the rest of the economy. In this connection, the chapter studies the relationship between real flows and financial flows in a flow-of-funds model. Finally, the chapter describes the intermediary role of capital markets.

The capital market deals with a commodity called capital. A transaction in the capital market consists of an act of saving met by an act of investment. It involves an exchange of money as a capital (saving) for a security (investment; e.g., bond, equity, or sukuk, an Islamic securitized asset). The commodity traded in the capital market is different from the commodity that is exchanged in the goods market. A consumer who buys an apple, a tangible good, takes ownership of the apple with no further obligation on the part of the seller of the apple.

In the case of a security, besides the buyer’s taking ownership of the security, an intangible asset, there are obligations of the seller of the security that extend over a future period. These obligations consist of paying a return to the buyer at different times in the future and redeeming the security at maturity.¹

 There is therefore a time dimension associated with a transaction in the capital market, which is not the case for a transaction in the goods market; the latter is timeless. The buyer of a security expects to receive a future income stream, and the seller of the security expects to pay this income stream. In addition, there is uncertainty about whether the expected future income stream from a security will be realized. Particularly, there are risks, such as market risk, counterparty risk, and many others. Time and uncertainty are inherent characteristics of capital market transactions.

Sellers of securities want to invest and need capital; buyers of securities have savings and want to generate income on their capital. Both buyers and sellers are planning over a time horizon, and their decisions necessarily involve intertemporal choices.

In the case of stocks, buyers expect to readily convert securities into cash via the stock market. A main feature of stock markets is that they provide liquidity to investors.

The characteristics of intertemporal choices are different from those of timeless choices.

Three considerations intervene:

1. A dollar in the future has a lower value than a dollar today: called the time value of money.
2. Capital, by its nature, is productive, contributes to an increase in output, and offers a future product.
3. Demand for securities is saving and supply of securities is investment. Both demand and supply of securities fall within the realm of capital theory. The latter provides the framework to analyze saving decisions and the motivation for consumers to save, in addition to investment decisions and motivation for producers to invest. This is called the time-preference and capital productivity framework. It is an exchange production model that determines the optimal time pattern of production and consumption and equilibrium yield rate.

Flows exchanged on the capital market are by definition capital flows. What is meant by capital? The concept of capital has been defined in different ways:

• As any tangible asset, such as a house, building, ship, machinery, corn seed, or wheat seed. A balance-sheet value.
• A subsistence fund, meaning a quantum of goods necessary to sustain life such as food, medicine, energy, clothing, shelter, and so on.
• Cash or an asset that can be easily converted to cash (often called money capital or liquid capital).

Understanding the nature of capital is essential for understanding capital market theory. The prices quoted for sukuks, bonds, stocks, and other securities are prices of expected future income streams. They are forward-looking capital values. They are functions of time and the expected yield of the asset—the higher the asset’s expected return, the lower its price.

The determination of asset prices rests on the notions of rate of interest, rate of profit, rental rate, and the marginal productivity of capital. It is important to define each of these concepts, how it is measured, and how it affects asset prices.

Capital is a key factor in economic growth. The latter is identified with investment and capital growth. Capital propels the economy on a growth path, whereby invest- ment in capital leads to higher output growth, higher consumption, higher saving, and higher investment. The process extends indefinitely into the future as long as investment is sustained and capital is growing. Constraint on growth is attributed to constraint on saving and capital. Capital markets increase saving and investment, considerably reduce the cost of financing, and increase the return on investment.

Corporations are no longer constrained by their net earnings to undertake large-scale projects; they tap savings in the capital market from local and foreign sources. Savers are able to earn income on their savings, further increasing those savings.

Capital markets were a historical necessity to relax financing constraint. Without capital markets, growth would be depressed. The development of capital markets enabled corporations to mobilize savings, invest them, and thus increase capital and growth. Capital markets are interlocked with money, goods, and labor markets. Changes of demand and supply in any of these markets have a direct bearing on capital markets; inversely, changes in the capital market strongly affect these markets.