Class Lecture (Chapter-2)

Islamic Financial System (Fin-5402)

Program: MBA (Regular + Executive)
Course instructor: Basharat Hossain
Department of Business Administration (DBA)
International Islamic University Chittagong (IIUC)

Capital Market
Definition of Stock/ Equity Market:

 A stock market or equity market is a public entity for the trading of company stock (shares)
and derivatives at an agreed price.
 These are securities listed on a stock exchange as well as those only traded privately.
 The stocks are listed and traded on stock exchanges which are entities of a corporation
or mutual organization. The largest stock market in the USA, by market capitalization, is
the NYSE.

Definition of Stock Exchange:

 Stock exchange can be defined as “an association, organization, or an individual who is

established for the purpose of assisting, regulating, and controlling business in buying, selling
and dealing in securities.”
 A market in which securities are bought and sold: "the company was floated on the Stock
Exchange".
 The initial offering of stocks and bonds to investors is by definition done in the primary
market and subsequent trading is done in the secondary market.
 A stock exchange is often the most important component of a stock market.
 Supply and demand in stock markets are driven by various factors that, as in all free markets,
affect the price of stocks.

The Primary market is the market where investors purchase newly issued securities.

Initial public offering (IPO): An initial public offer occurs when a company offers stock for sale to
the public for the first time. An IPO involves several steps.

1. Company appoints investment banking firm to arrange financing.

2. Investment banker designs the stock issue and arranges for fixed commitment or
best effort underwriting.
3. Company prepares a prospectus (usually with outside help) and submits it to the
Securities and Exchange Commission (SEC) for approval. Investment banker
circulates preliminary prospectus (red herring).
4. Upon obtaining SEC approval, company finalizes prospectus.
5. Underwriters place announcements (tombstones) in newspapers and begin selling
shares.

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
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Underwriting:

Securities underwriting refers to the process by which investment banks raise investment capital from
investors on behalf of corporations and governments that are issuing securities (both equity and debt
capital). The services of an underwriter are typically used during a public offering.

This is a way of distributing a newly issued security, such as stocks or bonds, to investors.
A syndicate of banks (the lead managers) underwrites the transaction, which means they have taken
on the risk of distributing the securities. Should they not be able to find enough investors, they will
have to hold some securities themselves. Underwriters make their income from the price difference
(the "underwriting spread") between the price they pay the issuer and what they collect from investors
or from broker-dealers who buy portions of the offering.

The Secondary market is the market where investor trade previously issued securities. An investor
can trade:
 Directly with other investors.
 Indirectly through a broker who arranges transactions for others.
 Directly with a dealer who buys and sells securities from inventory.

A secondary market can be organized as an exchange where buyers and sellers meet in one central
location to conduct trades. An example of an exchange is the New York Stock Exchange. A
secondary market can also be organized as an over-the-counter market. In this type of market, dealers
in different locations buy and sell securities to anyone who comes to them and is willing to accept
their prices. An example of an over-the-counter market is the federal funds market.

Stock Exchange in Muslim Countries:

Many Muslim countries, or those with a majority Muslim population, have well established stock
markets, for example, Bangladesh, Egypt, Indonesia, Malaysia and Pakistan. These stock exchanges
are basically Western style markets tolerating practices that may not strictly adhere to Islamic
principles.

Importance/Roles/Functions of Stock Market:

The stock exchange helps achieve various benefits. It:

1. provides a market place where a large number of sellers and buyers can meet,
2. helps remove the apprehension of investors, the buyers, regarding future liquidity problems,
that may encourage the investors to accept a lower rate of return than they would have done in
the absence of the exchange and consequently lead to reducing the cost of equity capital,
hence reducing the average cost of capital of the firm,
3. helps provide more representative prices of securities than the case would be with separately
organized markets,
4. provides a means of testing the validity of securities by assigning a value to these securities,
that is influenced by the views of specialized experts in the market, and
5. Provides an effective way of absorbing new issues of securities which helps corporations to
raise funds.

Islamic Stock Exchange:

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
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Malaysia is making solid progress in establishing the necessary infrastructure to facilitate stock
trading in accordance with Islam. Islamic broking houses and Islamic managed funds operate and a
separate “Islamic Index” has been established comprising 179 permissible stocks on the Kuala
Lumpur Stock Exchange.

Listing on an Islamic stock exchange:

The listing requirements for an Islamic stock market will require scrutiny, not only of the financial
performance and soundness of firms, but also of the religious acceptability of their business activities.

Non-Muslim in Islamic Stock exchange:

Example, where the major stockholders are not Muslims, but conduct their affair in a way that does
not contravene any principles of Islam. Should these firms be allowed to list on an Islamic stock
exchange?

Bank Islam Malaysia, for example, conducts a substantial amount of its financing activities with firms
that are owned by non-Muslims. In Bangladesh, Islamic bank also provide services for non-muslim
clients.

Definition of stock:

A stock represents a share of ownership of a corporation, or a claim on a firmʹs earnings/assets. Stocks

are part of wealth, and changes in their value affect peopleʹs willingness to spend. Changes in stock
prices affect a firmʹs ability to raise funds, and thus their investment.

Definition of 'Common Stock'

A security that represents ownership in a corporation. Holders of common stock exercise control by
electing a board of directors and voting on corporate policy. Common stockholders are on the bottom
of the priority ladder for ownership structure. In the event of liquidation, common shareholders have
rights to a company's assets only after bondholders, preferred shareholders and other debtholders have
been paid in full.

In the U.K., these are called "ordinary shares."

If the company goes bankrupt, the common stockholders will not receive their money until the
creditors and preferred shareholders have received their respective share of the leftover assets. This
makes common stock riskier than debt or preferred shares. The upside to common shares is that they
usually outperform bonds and preferred shares in the long run.

Definition of 'Preferred Stock':

A class of ownership in a corporation that has a higher claim on the assets and earnings than common
stock. Preferred stock generally has a dividend that must be paid out before dividends to common
stockholders and the shares usually do not have voting rights.

The precise details as to the structure of preferred stock is specific to each corporation. However, the

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
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best way to think of preferred stock is as a financial instrument that has characteristics of both debt
(fixed dividends) and equity (potential appreciation). Also known as "preferred shares".

'Common Stock' and Preferred stock in Islam:

Ownership shares issued by corporations and traded by investors include both common stock and
preferred stock. While there are several ways in which the two types of stock differ, the most
significant way, from an Islamic legal point of view, is that preferred stocks guarantee the amount of
the dividend.

Such a predetermined and guaranteed rate of return is prohibited for the reason that it may be
classified as riba. Thus, while an investor may share the risks of ownership with other investors, the
preferred status of the preferred stock means that there is extra compensation for the owner for which
the owner has not had to pay. This, in simplified terms, amounts to riba al fadl. In Lesson Two of this
course, we will take a detailed look at riba and the forms it may take. For similar riba-based reasons,
fixed-income securities, convertible notes, and the like are also prohibited.

As a general rule, then, Muslim investors may trade only in common stock.

In some cases, however, preferred stock may be offered without a fixed dividend or without a
dividend at all. Even so, it is the right of the shareholders to change those terms through a vote at their
shareholders? meetings. Thus, while a Muslim investor may purchase such stock, s/he may hold it
only for as long as it carries no fixed dividend. If the status of the stock changes as a result of a vote,
the Muslim investor will have to liquidate his/her interest in the company immediately. And if a fixed-
amount dividend is received before the stock can be sold, the entire amount of the dividend will have
to be given away as charity.

Some concept and their application Islam:

'Insider Trading':

The buying or selling of a security by someone who has access to material, non-public information
about the security. Insider trading can be illegal or legal depending on when the insider makes the
trade: it is illegal when the material information is still nonpublic--trading while having special
knowledge is unfair to other investors who don't have access to such knowledge. Illegal insider
trading therefore includes tipping others when you have any sort of nonpublic information. Directors
are not the only ones who have the potential to be convicted of insider trading. People such as brokers
and even family members can be guilty.

Insider trading is legal once the material information has been made public, at which time the insider
has no direct advantage over other investors. The SEC, however, still requires all insiders to report all
their transactions. So, as insiders have an insight into the workings of their company, it may be wise
for an investor to look at these reports to see how insiders are legally trading their stock.

Buying on margin or Margin trading:

Margin buying refers to the buying of securities with cash borrowed from a broker, using other
securities as collateral. This has the effect of magnifying any profit or loss made on the securities. The
securities serve as collateral for the loan. The net value—the difference between the value of the
securities and the loan—is initially equal to the amount of one's own cash used. This difference has to
stay above a minimum margin requirement, the purpose of which is to protect the broker against a fall
in the value of the securities to the point that the investor can no longer cover the loan.

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
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Example:

Jane buys a share in a company for $100 using $20 of her own money and $80 borrowed from her
broker. The net value (the share price minus the amount borrowed) is $20. The broker wants a
minimum margin requirement of $10.
Suppose the share price drops to $85. The net value is now only $5 (the previous net value of $20
minus the share's $15 drop in price), so, to maintain the broker's minimum margin, Jane needs to
increase this net value to $10 or more, either by selling the share or repaying part of the loan.

Islamic perspective margin trading:

From an Islamic perspective margin trading is clearly unacceptable. This has been reinforced by the
Council of the Islamic Fiqh Academy (CIFA) which considered margin trading at its 1993 meeting.
The CIFA ruled that it is not permissible to borrow money with interest from a stockbroker, or other
party, to buy shares and to deposit them as security for the loan. However, this does not outlaw the
practice entirely, as it is possible to construct non-interest bearing financial contracts to achieve the
same thing. For example, in Malaysia, Bank Islam Malaysia Berhad offers share financing through
Mudarabah profit sharing contracts.

Short Selling'

The sale of a security that is not owned by the seller, or that the seller has borrowed. Short selling is
motivated by the belief that a security's price will decline, enabling it to be bought back at a lower
price to make a profit. Short selling may be prompted by speculation, or by the desire to hedge the
downside risk of a long position in the same security or a related one. Since the risk of loss on a short
sale is theoretically infinite, short selling should only be used by experienced traders who are familiar
with its risks.

Consider the following short-selling example. A trader believes that stock SS which is trading at $50
will decline in price, and therefore borrows 100 shares and sells them. The trader is now “short” 100
shares of SS since he has sold something that he did not own in the first place. The short sale was only
made possible by borrowing the shares, which the owner may demand back at some point.

A week later, SS reports dismal financial results for the quarter, and the stock falls to $45. The trader
decides to close the short position, and buys 100 shares of SS at $45 on the open market to replace the
borrowed shares. The trader’s profit on the short sale – excluding commissions and interest on the
margin account – is therefore $500.

Suppose the trader did not close out the short position at $45 but decided to leave it open to capitalize
on a further price decline. Now, assume that a rival company swoops in to acquire SS because of its
lower valuation, and announces a takeover offer for SS at $65 per share. If the trader decides to close
the short position at $65, the loss on the short sale would amount to $15 per share or $1,500, since the
shares were bought back at a significantly higher price.

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
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Islamic perspective of Short Selling'

Umer Chapra strongly advocates the abolition of short selling in an Islamic market, arguing that such
sales are speculative and fail to perform any useful economic function. The public interest,
masalahah, is better served by prohibiting short sales. The element of speculation involved in short
sales further suggests that short selling is unacceptable.

Speculations and arbitrage:

SPECULATION : It is the transaction of members to buy or sell securities on stock exchange with a
view to make profits to anticipated raise or fall in price of securities.

A speculator will buy stock in anticipation of prices rising usually with a short-term horizon. The
danger of this, as observed by Brailsford and Heaney (1998), is that what is initially planned as a
short-term position, with a sale to be completed before taking delivery of the stock, may well result in
a longer term position when the stock does not perform as expected. Such purchases are often
financed on margins or other forms of borrowing.

A speculator will sell in anticipation of prices falling. This strategy may involve a short sale whereby
the speculator borrows stock from a broker with a view to subsequently buying it at a lower price,
thereby completing the deal.

Arbitrage: The simultaneous purchase and sale of an asset in order to profit from a difference in the
price. It is a trade that profits by exploiting price differences of identical or similar financial
instruments, on different markets or in different forms. Related to speculation is the practice of
arbitrage. An arbitrageur is a particular type of speculator who seeks to obtain a risk free return with a
zero investment. An example of a potential arbitrage opportunity is the existence of identical assets at
different prices in different markets. Such practices are more difficult with modern communications
and computerised trading, as price discrepancies in different domestic markets are quickly eliminated
from the system. Arbitrage will be regarded as one aspect of speculation.

Islamic Perspective of Speculations and arbitrage:

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
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Islamic economists and scholars that speculation, as described above, is unacceptable because of its
association with gambling and excessive risk taking. In addition, speculation creates volatility. This
undermines the orderly functioning of the stock market while the profits of speculators are achieved at
the expense of other investors. Any potential benefit of speculation, for example by injecting liquidity
into the market is not considered by Islamic scholars to outweigh the negative aspects. If any activity
is deemed to be forbidden and Haram, that activity cannot be acceptable under any circumstance.

BROKER: He is one act as an intermediary on behalf of others. A broker in a stock exchange is a

commission agent who transacts business in securities on behalf of non-members.
 A broker deals with the jobber on behalf of his clients. in other words, a broker is a
middleman between a jobber and clients
 A broker is merely an agent, buying or selling securities on behalf of his clients
 A broker gets only commission for his dealings
 The broker deals in all types of securities

Definition of 'Hedge':
Making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge
consists of taking an offsetting position in a related security, such as a futures contract. An example of
a hedge would be if you owned a stock, then sold a futures contract stating that you will sell your
stock at a set price, therefore avoiding market fluctuations. Hedging naturally belongs to Islamic
economic objectives as long as it does not involve pure speculation and gambling-like activities

Regulatory body:

SEC-securities and exchanges commission

CRB-Company Regulatory body
SAC-sharia Advisory council

Financial derivative:

Definition:

John C. Hull, “A derivative can be defined as a financial instrument whose value depends on (or
derives from) the values of other, more basic underlying variables.”

Robert L. McDonald “A derivative is simply a financial instrument (or even more simply an agreement
between two people) which has a value determined by the price of something else.” A derivative
instrument, broadly, is a financial contract whose payoff structure is determined by the value of an
underlying commodity, security, interest rate, share price index, exchange rate, oil price, and the like.

E.F.Brigham & Jole F. Houston, “Derivatives are securities whose values are determined by the
market price or interest rate of some other assets.”

So it is said that derivative is a financial instrument or a contract/ agreement between two parties
whose value depend on or derive from values or prices of any other underlying assets. The underlying
basis of a derivative instrument may be any product including commodities, precious metals like gold
and silver, foreign exchange rate, bonds of different types, including medium to long-term negotiable
debt securities issued by governments, companies, etc., short-term debt securities such as T-bills; and
Over-the-counter (OTC) money market products such as loans or deposits.

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
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In the global financial markets most widely used derivative products are- Forward, Future, Option,
and Swap. In a narrow sense all derivative products are indeed zero-monetary-sum transactions. In a
broader sense, however, it is not the case that derivatives contracts are always zero-sum transactions
but they can often do create value.

Features of derivative:

 Derivative is agreement or contract between two counterparties.

 Value of the derivative depends on or derives from future value of some asset or set of assets.
 Derivative is executed in future.
 Derivative is often said to provide “zero-sum” payoff.
 Derivative agreement is aleatory.

Use of derivative:

Derivative is generally used as an instrument to hedge risk, but can also be used for speculative
purposes.

User of derivative: Hedger, Speculator and Arbitrager are the main user of derivative.

Derivative products are-

1. Forward,
2. Future,
3. Option,
4. Swap

1. Forward:

Forward is a derivative product which means an agreement between two parties for delivery some
underlying assets in future at the price of issuing date or today’s price. In forward contract both
parties must honor the contract, that is forward contract must execute in due date. Since forward
contracts are not standardized so they are traded in over the counter market. Forward rate agreement is
a special type of forward contract originally introduced by banks in 1983.

Features of forward:

 Forward contracts trade in over the counter dealer type market.

 Forward contract are negotiated between the contracting parties with all contract terms
subject to mutual agreement.
 In forward contract each party is directly responsible to the other and consequently the
identities of the counterparties are critically important.
 Forward contracts are much more difficult to terminate – in fact termination is often not
possible.
 Forward contracts are less liquid and characterized by larger bid- ask spreads.
 Forward contract must be executed in due future time.
 Forward contracts are much more tailor made.

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
Page 8
Uses of Forward:

Generally agricultural and manufacturing goods & commodities are actually delivered under forward
contract. Now in Bangladesh and most of countries of the world construction materials are also
delivered through forward contract.

2. Future:

Futures are highly standardized forward contracts that call for either deferred delivery of some
underlying assets or a final cash settlement based on some clearly define rule. These contracts trade
on organized futures exchanges with a clearing association that acts as a middleman between the
contracting parties. Here short means the contract seller and long means the contract purchaser.

Features of Future:

 Future contracts are highly standardized forward contract.

 Future contracts are traded on organized market or future exchange.
 A clearing association stands between the parties of a future contract. As a result
counterparties identities are irrelevant.
 In future contract there is a daily mark to market process for corresponding transfers of
margin where each parties to a contract is assured of the other parties performance.
 The institutional structure of future contracts makes them very easy to terminate via simple
offsetting transactions.
 Prices of the future contract are informationally efficient.

Uses of Future:

In the earlier time futures are used only for agricultural commodity but now it also used for financial
instruments. Mainly futures are widely used to hedge price risks. These include Commodity-price
risk, Equity price risk, interest rate risk and exchange rate risk.

3. OPTION:

An option is an agreement or a contract between two parties in which one party has the right but not
obligation to do something usually to buy or to sell some underlying assets. According to F. Brigham
“Option is a contract that gives its holder the right to buy ( or sell) an asset at a pre-determined price
within a specified period of time.” That is option is a contract that grant its purchaser the right but not
the obligation to do something. Most often this is the right to buy or sell some number of units of
some number of units of some underlying asset. An option can be in-the-money, at-the-money, or out-
of-the-money. Which of these terms apply basically rely on the relationship between the current price
of the underlying assets and the strike price of the option. Here strike price means the price at which
the option is exercised. Option has limited lives. If not exercised with in the period mention in the
option contract, an option is worthless. Generally option is two types such as call option and put
option. A call option grants its purchaser the right to buy some underlying asset while a put option
grants its purchaser the right to sell some underlying asset. Only the purchaser of the call or put
options has a right without an obligation. The contract seller has an absolute obligation. Again option
is two types- American option and European option. American option is an option that can be
exercised at any time before its maturity on the other hand European option is an option that can be
exercised only at the maturity.
Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,
International Islamic University Chittagong, Bangladesh
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Features of option:

 Option give its holder the right not obligate to buy or sell some underlying assets.
 It has limited time period with in which it must exercise.
 Option is exercised at strike price.
 Option prices are always quoted and reported per unit of underlying asset.
 Options are traded in both over the counter markets and organized markets.

Uses of Option:

Options are attractive as speculative instruments because they provide the speculator with
considerable leverage and strictly limiting downside risk. They are also attractive to hedgers because
they provide a way to protect from adverse price movements. The option is also used to hedge
exchange rate risk, equity price risk or commodity price risk.

4. SWAP:

SWAP is an agreement between two counterparties in which the first agrees to make fixed price
payment to the second while the second agrees to make floating price payments to the first. It is the
revolutionary example of financial engineering. By entering into swaps with a swap dealer, both
parties can obtain the form of financing them desire and simultaneously exploit their comparative
borrowing advantages. SWAP occurs because the parties involved prefer someone else payment
stream. According to F.Brigham “SWAP occurs when two parties agree to exchange obligations to
make specified payment streams.”

The three most common types of SWAPs are interest rate swap, currency swaps and commodity
swaps.

Interest Rate swap convert a fixed-rate obligation to a floating-rate obligation. Here exchangeable
notional amount called notional principals. In interest rate swap, the notional principals to be
exchanged are identical in the amount and involve the same currency as well as periodic usage
payments called interest are also in the same currency, only the value differential needs to be
exchange on the periodic settlement dates. Interest rate swaps are often motivated by a desire to
reduce the cost of financing.

Currency SWAP converts an obligation in one currency to an obligation in another currency. In a

currency swap, the currencies in which the principles’ are denominated are different and for this
reason (but not always) need to be exchanged. A currency swap is viable whenever one counterparty
has comparatively cheaper access to one currency than it does to another.

Commodity SWAP converts a floating price to a fixed price. In a commodity swap the first
counterparty makes periodic payments to the second at a per unit fixed price for a given quantity of
some commodity. The second counterparty pays the first a per unit floating price for a given quantity
of some commodity. The commodities may be the same or different. If they are the same then no
exchanges of notional are required as well as if they are different exchanges of notional could be
required.

Features of SWAP:

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
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  Both parties of swap are mutually benefited.
 Exchange obligation between two parties.
 SWAP is settled with presence of swap dealer.
 Flexible derivative instrument.
 Both parties exploit comparative borrowing advantages.

Uses of SWAP: SWAP can be used to hedge multiperiod price risks, to reduce the cost of financing,
Exploit economic of scale, Arbitrage the world’s capital markets, to enter new markets and to create
synthetic instrument. Swaps are also used by industrial corporations, financial corporations, thrifts,
banks insurance companies, world organizations and sovereign governments.

DERIVATIVES in ISLAM:

Requisites For A Shariah Compliant Derivative Instruments

1. Riba (usury)
2. Rishwah (corruption)
3. Maysir (gambling)
4. Gharar (unnecessary risk/Excessive uncertainty)
5. Jahl (ignorance)

FUTURE CONTRACT & ISLAMIC FINANCE:

The following three contracts in Islamic finance can be considered as future/forward contracts

1. The Salam Contract

2. The Istisna Contract and
3. The Joa’la Contract

1. Features of Ba’i Salam: “Two parties sale/purchase an underlying asset at a predetermined

future date but at a price determined and fully paid for today”

Beneficial to the seller: The predetermined price is normally lower than the prevailing spot price.
The lower Salam price compared to spot is the “compensation” by the seller to the buyer for the
privilege given to him’

One sided-Counter party risk: “To overcome the potential for default on the part of the seller, the
Shari'ah allows for the buyer to require security which may be in the form of a guarantee or
mortgage”

2. Features of Istisna:

A buyer contracts with a manufacturer to manufacture a needed product to his specifications”

Price is Agreed upon & Fixed.
Termination: Cancelled before production begins.
Payment: Time of Delivery

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
Page 11
 3. Joala Contracts:
The Joala Contract is essentially an Istisna but applicable for services as opposed to a
manufactured product.”

OPTIONS IN ISLAMIC FINANCE:

Overview of Istijrar
1. Istijrar involves two parties
2. Bank purchases on behalf of its customer
3. The difference in price is bank’s earning/return
P*=Po(1+r)
Istijrar could be P* or an average price of commodity between the period t0 an t90.

4. Which party chooses to “fix” the settlement price—embedded option

5. Both parties agree on following two items

a) Predetermined murabaha price P*

b) Upper and lower bound

PLB Po P* PUB

Po = the price that bank pays to purchase underlying commodity

P* = Murabaha price; P* = Po (1+r).

PLB = the lower bound price
PUB = the Upper bound price

At Maturity:
Ps =Avg price; if the underlying asset price remained within the bounds.
Ps = P*; if the underlying asset exceeds the bounds and one of the parties chooses to exercise its
option and use P* as the price at which to settle at maturity.
Basic Idea:
Not A Zero Sum Game
Contract avoids “Riba and Gharar”

Swap:

Islamic Cross Currency Swap

Two simultaneous Murabaha transactions:

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
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 1. Term Murabaha: “A murabaha is a sale arrangement whereby a financier purchases goods
from a supplier and then on-sells them to a counterparty at a deferred price that is marked-up
to include the financier's profit margin”

2. Reverse Murabaha (Tawarruq): “A method where the financial institution, either directly
or indirectly, will buy an asset and immediately sell it to a customer on a deferred payment
basis. The customer then sells the same asset to a third party for immediate delivery and
payment, the end result being that the customer receives a cash amount and has a deferred
payment obligation for the marked-up price to the financial institution ”

Sukuk

Sukuk commonly refers to the Islamic equivalent of bonds. However, as opposed to conventional
bonds, which merely confer ownership of a debt, Sukuk grants the investor a share of an asset, along
with the commensurate cash flows and risk. As such, Sukuk securities adhere to Islamic laws
sometimes referred to as Shari’ah principles, which prohibit the charging or payment of interest.

How Sukuk (Islamic Bonds) Differ from Conventional Bonds

Modern sukuk emerged to fill a gap in the global capital market. Islamic investors want to balance
their equity portfolios with bond-like products. Because sukuk are asset-based securities — not debt
instruments — they fit the bill. In other words, sukuk represent ownership in a tangible asset, usufruct
of an asset, service, project, business, or joint venture.
Each sukuk has a face value (based on the value of the underlying asset), and the investor may pay
that amount or (as with a conventional bond) buy it at a premium or discount.

Ensuring sharia compliance with sukuk

The key characteristic of sukuk — the fact that they grant partial ownership in the underlying asset —
is considered sharia-compliant. This ruling means that Islamic investors have the right to receive a
share of profits from the sukuk’s underlying asset.

Putting bonds and sukuk side-by-side

When you have the basics about how conventional bonds and sukuk work, it’s time to put them next
to each other. This table offers a quick look at the key ways in which these investment products
compare.
Distinguishing Sukuk from Conventional Bonds

Conventional Bonds Sukuk

Asset Bonds don’t give the investor a share of Sukuk give the investor partial
ownership ownership in the asset, project, business, or ownership in the asset on which
joint venture they support. They’re a debt the sukuk are based.
obligation from the issuer to the bond holder.

Investment Generally, bonds can be used to finance any The asset on which sukuk are

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
Page 13
criteria asset, project, business, or joint venture that based must be sharia-compliant.
complies with local legislation.

Issue unit Each bond represents a share of debt. Each sukuk represents a share of
the underlying asset.

Issue price The face value of a bond price is based on the The face value of sukuk is based
issuer’s credit worthiness (including its on the market value of the
rating). underlying asset.

Investment Bond holders receive regularly scheduled (and Sukuk holders receive a share of
rewards and often fixed rate) interest payments for the life profits from the underlying asset
risks of the bond, and their principal is guaranteed (and accept a share of any loss
to be returned at the bond’s maturity date. incurred).

Effects of Bond holders generally aren’t affected by
costs costs related to the asset, project, business, or
joint venture they support. The performance of
the underlying asset doesn’t affect investor
rewards.
Sukuk holders are affected by
costs related to the underlying
asset. Higher costs may translate
to lower investor profits and vice
versa.

Types of Sukuk: 6 types

Sukuk al mudaraba (sukuk based on equity partnership)

In simple mudaraba contracts, investors are considered to be silent partners (rab al mal), and the
party who utilizes the funds is the working partner (mudarib). The profit from the investment activity
is shared between both parties based on an initial agreement.
The same type of contract applies to sukuk. In a mudaraba sukuk, the sukuk holders are the silent
partners, who don’t participate in the management of the underlying asset, business, or project. The
working partner is the sukuk obligator.
The sukuk obligator, as the working partner, is generally entitled to a fee and/or share of the profit,
which is spelled out in the initial contract with investors.

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
Page 14
Sukuk al murabaha (cost plus or deferred payment sukuk)

A murabaha contract is an agreement between a buyer and seller for the delivery of an asset; the price
includes the cost of the asset plus an agreed-upon profit margin for the seller. The buyer can pay the
price on the spot or establish deferred payment terms (paying either in installments or in one future
lump sum payment).
With sukuk that are based on the murabaha contract, the SPV can use the investors’ capital to
purchase an asset and sell it to the obligator on a cost-plus-profit-margin basis. The obligator (the
buyer) makes deferred payments to the investors (the sellers). This setup is a fixed-income type of
sukuk, and the SPV facilitates the transaction between the sukuk holders and the obligator.
The murabaha contract process begins with the obligator (who needs an asset but can’t pay for it right
now) signing an agreement with the SPV to purchase the asset on a deferred-payment schedule. This
agreement describes the cost-plus margin and deferred payments.

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
Page 15
Special purpose vehicle (SPV)

Sukuk al-salam (deferred delivery purchase sukuk)

In a salam contract, an asset is delivered to a buyer on a future date in exchange for full advance spot
payment to the seller. Sharia allows only salam and istisna contracts to be used to support advanced
payment for a good to be delivered in the future. This same mechanism is used for structuring the
salam sukuk.
In salam sukuk, the sukuk holders’ (investors’) funds are used to purchase assets from an obligator in
the future. The SPV provides the money to the obligator. This contract requires an agent (which may
be a separate underwriter) who will sell the future assets because the investors want money in return
for their investment — not the assets themselves.
The proceeds from the sale (typically the cost of the assets plus a profit) are returned to the sukuk
holders. Salam sukuk are used to support a company’s short-term liquidity requirements.

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
Page 16
Sukuk al-ijara (lease-based sukuk)
The ijara contract is essentially a rental or lease contract: It establishes the right to use an asset for a
fee. The basic idea of ijara sukuk is that the sukuk holders (investors) are the owners of the asset and
are entitled to receive a return when that asset is leased.
In this scenario, the SPV receives the sukuk proceeds from the investors; in return, each investor gets
a portion of ownership in the asset to be leased. The SPV buys the title of the asset from the same
company that is going to lease the asset. In turn, the company pays a rental fee to the SPV.
The ijara contract process begins when a company that needs an asset but can’t afford to purchase it
outright contracts with an SPV, which agrees to purchase the asset and rent it to the company for a
fixed period of time.

Sukuk al musharaka (joint venture sukuk)

The musharaka contract supports a joint venture business activity in which all partners contribute
capital, labor, and expertise. The profit and losses are shared among all parties based on agreed-upon
ratios.
With musharaka sukuk, the sukuk holders (investors) are the owners of the joint venture, asset, or
business activity and therefore have the right to share its profits. In a musharaka sukuk, unlike sukuk
based on mudaraba, a committee of investor representatives participates in the decision-making
process. Musharaka sukuk can be traded in the secondary market.
The musharaka sukuk process begins when an obligator signs a musharaka contract with the SPV that
specifies a profit-sharing ratio and indicates that the obligator will transfer assets (such as cash and
property) to the joint venture.

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
Page 17
Sukuk al istisna (Islamic project bond)

Istisna is a contract between a buyer and a manufacturer in which the manufacturer agrees to
complete a construction project by a future date. The contract requires a fixed price and product
specifications that both parties agree to. If the end product doesn’t meet contract specifications, the
buyer can withdraw from the contract.
Istisna sukuk are based on this type of contract. The sukuk holders are the buyers of the project, and
the obligator is the manufacturer. The obligator agrees to manufacture the project in the future and
deliver it to the buyer, who (based on a separate ijara contract) will lease the asset to another party for
regular payments.
The process of issuing istisna sukuk begins when the obligator (manufacturer or contractor) and the
SPV sign an istisna contract.

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
Page 18
 Islamic capital market screening system:
(Collected from :islamic capital market product: development and challenges, published byIRTI,IDB)

Screening Criteria of SEC Malaysia

Screening for Shartah complaint stocks is done at central level by the Shart'ah' Advisory
Council (SAC) of the Securities and Exchange Conunission (SEC). A list of
permissible stocks is issued by the SAC twice a year. The screening criteria is mainly
activity or income based. No debt or liquidity screens are used. Thus screening will
require income statements but not the balance sheets of the companies. Individual
funds or investment companies do not make their own Shart'ah' screening criteria. Following
screening criteria are used:
1. Core Activities: The core activities of the companies should not be Shari'ah
incompatible. Therefore companies with following as their core business activities are
excluded: Financial services based on riba (interest); gambling; manufacture or
sale of non-l}aliil products or related products; conventional insurance;
entertainment activities that are non-permissible according to Shari'ah; manufacture
or sale of tobacco-based products or related products; stockbroking or share
trading in Shartah non-approved securities; and other activities deemed non-
permissible according to Shari'ah.

2. Mixed Activities: For companies with activities comprising both permissible and
non-permissible elements, the SAC considers two additional criteria:

a) The public perception or image of the company must be good; and

b) The core activities of the company are important and considered maslahah (public
interest) to the Muslim ummah (nation) and the country, and the non-permissible element is
very small and involves matters such as 'umam balwa (common plight and difficult to

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
Page 19
avoid), turf (custom) and the rights of the non- Muslim communitywhich are accepted
by Islam.
3. Bench Marks of Tolerance: Applicable in case of mixed activities. If the contributions
in turnover or profit before tax from non-permissible activities of a company exceed the
benchmark, the securities of the company are classified as Shartah non-approved. The
benchmarks are:

a) The five-percent benchmark: Applied to assess the level of mixed contributions from the
activities that are clearly prohibited such as riba (interest-based companies like conventional
banks), gambling, liquor and pork.

b) the ten-percent benchmark: Applied to assess the level of mixed contributions from
the activities that involve the element of 'umiim balwa which is a prohibited element
affecting most peopled and difficult to avoid. For example, interest income from fixed
deposits in conventional banks.

c) The 25-percent benchmark: This benchmark is used to assess the level of mixed
contributions from the activities that are generally permissible according to Shari'oh
and have an element of maslahah (public interest), but there are other elements that may
affect the Shart'ah status of these activities. For example, hotel and resort operations, share
trading ctc., as these activities may also involve other activities that are deemed non-
permissible according to the Shari'ah.

4. Debt and Liquidity: No restrictions on the proportion of debt or proportion of liquid assets
in total assets.

Metwally Model: Maximum Share Price:

Usually, share price is determined by the demand and supply of stock or share in the market.
A share price will reach to maximum level when it touches the maximum margin of circuit
breaker.

Determination of Equilibrium Share Price in Islamic stock market:

D-Demand of stock/share
S-Supply of stock/share
E-Equilibrium
P-Price
Ep- Equilibrium price
Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,
International Islamic University Chittagong, Bangladesh
Page 20
Eq- Equilibrium Quantity
MaxP-Maximum price
MinP-Minimum price

Metwally (1404/1984) developed a set of recommended operating rules for an Islamic stock
market aimed at preventing the practice of speculation. The thrust of his approach is that
share prices are not free to find their own level. The Management Committee of the stock
exchange would meet at three monthly intervals to set the maximum price for the shares in all
listed companies. This price would be based on the net worth of a company as reported in the
quarterly balance sheet presented to the Committee. Trading in stocks could only take place
for one week following the announcement of the maximum price.

Transactions would not be permitted at prices above the maximum set by the committee.

Investors would be free to trade shares at any price below the maximum. New issues of stock
would also only be permitted during the trading period, with the issue price being the already
determined maximum. The aim is to prevent excess returns to subscribers. While these strict
trading rules are likely to have a major deterrent effect on speculation, they do have many
flaws.

Criticism of Metwally Model:

Umer Chapra (1405/1985b) considered the rules unworkable.

First is the question of determining a maximum price based on accounting data. A balance
sheet prepared in accordance with traditional accounting principles is unlikely to provide a
good guide to the true market value of a company’s stock.

Second is the matter of equity. Being restricted to a short period in which they can trade their
stocks would disadvantage small investors. Those who need to liquidate their investment may
be forced to accept lower prices.

Attention!
All class lectures available at:
www.islamiceconomicsbd.blogspot.com

Prepared by - Basharat Hossain, Assistant Professor of Economics, Dept. of Business Administration,

International Islamic University Chittagong, Bangladesh
Page 21