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Islamic Capital Markets: Theory and Practice

ISBN: 978-1-118-24713-6
888 pages
January 2013
Islamic Capital Markets: Theory and Practice (1118247132) cover image
A comprehensive look at the essentials of Islamic capital markets

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, price-earnings ratio, market efficiency hypothesis, and equity premiums, the book addresses uncertainty in capital markets, portfolio diversification theory, risk-return trade-off, 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, Arrow-Debreu state prices, risk-neutral pricing, derivatives markets, hedging and risk management, and structured products
  • Provides students and practitioners of finance with must-have 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.

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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 RiskReturn 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

Risk-Adjusted versus Certainty-Equivalent Discount Rates 172

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 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

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

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

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

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

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

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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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