Islamic Capital Markets: Theory and PracticeISBN: 9781118247136
888 pages
January 2013

Bringing together theoretical and practical aspects of capital markets, Islamic Capital Markets offers readers a comprehensive insight into the institutions, instruments, and regulatory framework that comprise Islamic capital markets. Also exploring ideas about money, central banking, and economic growth theory and their role in Islamic capital markets, the book provides students and practitioners with essential information about the analytical tools of Islamic capital markets, serves as a guide to investing in Islamic assets, and examines risk management and the structure of Islamic financial products.
Author and Islamic finance expert Noureddine Krichene examines the development of leading Islamic capital markets, including Malaysia, looking at sukuks and stocks in detail and emphasizing valuation, duration, convexity, immunization, yield curves, forward rates, swaps, and risks. Analyzing stock markets, stock valuation, priceearnings ratio, market efficiency hypothesis, and equity premiums, the book addresses uncertainty in capital markets, portfolio diversification theory, riskreturn tradeoff, pricing of assets, cost of capital, derivatives and their role in hedging and speculation, the principle of arbitrage and replication, Islamic structured products, the financing of large projects, and more.
 Emphasizes both theoretical and practical aspects of capital markets, covering analytical concepts such as the theory of arbitrage, pricing of assets, capital market pricing model, ArrowDebreu state prices, riskneutral pricing, derivatives markets, hedging and risk management, and structured products
 Provides students and practitioners of finance with musthave information about the analytical tools employed in Islamic capital markets
 Examines all the most recent developments in major Islamic capital markets, including Malaysia
Discussing the advantages of Islamic capital markets and the prospects for their development, Islamic Capital Markets gives readers a fundamental grounding in the subject, with an emphasis on financial theory and real world practice.
Preface xv
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
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
RiskAdjusted versus CertaintyEquivalent Discount Rates 172
Applying the CAPM to Calculate CertaintyEquivalent 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 ArbitrageFree Pricing 199
Basic Principles of Derivatives Pricing 205
Summary 220
References 220
Questions 220
CHAPTER 7 The ConsumptionBased Pricing Model 225
Intertemporal Optimization and Implication to Asset Pricing 225
AssetSpecific Pricing and Correction for Risk 229
Relationship between Expected Return and Beta 231
The Mean Variance (mv) Frontier 232
RiskNeutral Pricing Implied by the General Pricing Formula 234
ConsumptionBased 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
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 InterestRate Futures Markets and Applications to Sukuks 317
Types of InterestRate Futures Contracts 318
The Pricing of Sukuk Forward Contracts 328
Hedging with InterestRate Futures 332
InterestRate Futures in Sukuk Portfolio Management 334
Immunization of Sukuk Portfolio with InterestRate 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
RiskNeutral Pricing 377
The Black–Scholes (BS) Model 378
Currency Options 383
Caps and Floors 384
Summary 385
References 386
Questions 386
CHAPTER 12 Swaps 389
Structure and Payoff of a Swap 390
Motivations for the Swap 391
The Valuation of PlainVanilla 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
InterestRate 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 ValueatRisk 453
Nature and Purpose of the Performance Evaluation 453
Measuring Performance 455
Methodologies for Evaluating Performance 456
The Fama–French ThreeFactor Model 466
Performance Attribution Models 467
ValueatRisk (VaR) 468
Methods for Calculating VaR 472
Stress Testing and Back Testing 478
Summary 479
References 480
Questions 480
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 IncomeExpenditure 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
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
ExchangeTraded 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
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
DR. NOUREDDINE KRICHENE, PHD, earned a doctorate in economics from the University of California, Los Angeles. He has taught Islamic finance at the Global University, INCEIF, in Malaysia, and was an economist with the International Monetary Fund Economist Program from 1986 to 2009. From 2005 to 2007, he was advisor at the Islamic Development Bank of Saudi Arabia. His areas of expertise are the international payments system, macroeconomic policies, finance, and energy and water economics.
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