FIN 431Islamic Finance Spring 2013

FIN 431Islamic Finance Spring 2013

This course will introduce students to important aspects of Islamic Banking and Finance, focusing on the relevance and importance of tradable securities, regulatory framework and shariah principles that guide innovations in Islamic BF. Students will critically investigate the nature and types of contracts in IBF and examine practical operations of IBF. They will develop a working knowledge of the principles on which the Islamic financial markets operate with application to the Islamic bond market, the Islamic equity market and Islamic financial instruments issued by corporations to raise capital.

Assessments

Class participation – (10%)

Midterm Exams (worth 20% each)

Term Assignment and presentation (worth 20%):

One 2 hours Final Exam (worth 50%)

List of Topics

• TENTATIVE list based on what was taught last year– We will proceed logically in a coherent manner– I need to know a bit more about you decide on

the “level” and “style” of delivery

Introduction

• Markets?

• Financial Markets?

• Capital markets?

• Islamic Capital Markets?

Market?

A place/facility whereby players exchange items (goods or services) of value

Market Players?• Suppliers:

– sellers of goods or providers of services• Demanders

– Buyers of goods or users of services

Interaction between market players determine market price

Financial Markets

• A market which facilitate exchange of financial “goods” and “services”

• Examples:– Market for loanable funds• Suppliers: players with excess liquidity• Demanders: players with shortage of liquidity

– Stock market– Bond market

Financial Institutions?

• also known as financial intermediaries• facilitate flows of funds from savers; called

surplus saving units (SSUs) to borrowers; deficit spending units (DSUs). e.g. banks, finance companies etc.

Function of a financial system

Key role played by financial system is to act as financial intermediaries (channelling funds from savers (surplus units) to borrowers (deficit units)

SSU = Surplus Spending UnitsDSU = Deficit Spending UnitSSU lend to financial institution who then lend to DSU.

DSU(-)Financial intermediary

SSU(+)

Function of a financial system

Economic units/players may be classified asEach unit must operates within the budgetary constraints1. Households (+ wages and salaries; - goods, services)2. Business firms (+ sell goods and services; - wages,

purchases, costs…)3. Governments (+ collect taxes, fees; - services,

welfare, etc…)-local, state, fed

Deficit unit (-)Financial intermediary

Surplus unit (+)

Budget positions: The Budget positions of any economic unit can be : Surplus or deficit or balanced in a given budget period • Any unit within a group can have;• Balanced Budget (income =Expenditure)• Surplus saving position (saving units ( SSUs) have income for

the period that exceeds deficit spending units (DSUs), resulting in savings.

– Other words for “SSU” are saver, lender, or investor. Most SSUs are households.

• Deficit Position (DSUs- have spending for the period that exceeds income). – Another word for “DSU” is “borrower”. Most DSUs are

businesses or governments.The financial system is concerned with funneling purchasing

power from SSU’s to DSU’s.The problem is how efficiently we can transfer SSUs excess to

DSUs

Financial Claims (IOU):

• Is a written promise by DSU to pay sum of money plus interest, – it is an assets for SSU and liability for DSU, if IOU

can be resold, it called "marketability".• If the borrower wants to borrow, he issues

financial claims- IOU.• If the lender wants to lend, he buys financial

claims.

Transfer of funds

Effective channelling of funds from surplus to deficit units may be possible by:• Direct financing (direct exchange of money

and financial claims, facilitation)• Indirect financing (via financial intermediaries)

Transfer of Funds

How do financial intermediaries make money?

• Accept deposits from Surplus units at a lower interest rates and lend to deficit units at higher interest rates

• Direct investments

• Other services

Intermediaries perform 5 basic services as they transform claims.

• Denomination Divisibility – pool savings of many small SSUs into large investments and vice versa.

• Currency Transformation – buy and sell financial claims denominated in various currencies.

• Maturity Flexibility – Offer different ranges of

maturities to both DSUs and SSUs.

Intermediation Services, cont.

• Credit Risk Diversification – Assume credit risks of DSUs; spread risk over many different types of DSUs.(don’t put your eggs into one basket).

• Liquidity – Give SSUs and DSUs different choices about when, to what extent, and for how long to commit to financial relationships e.g. checking accounts.

Capital Marketshttp://www.investing-in-mutual-funds.com/capital-markets.html

Markets that raise financial capital

who raise capital and why?Corporations, government to expand existing or initiate new projects

HOW?Through Issuing securities (IPO Initial public offering)

Capital Marketshttp://www.investing-in-mutual-funds.com/capital-markets.html

HOW?Through Issuing securities (IPO Initial public offering)

• Debt based securities (such as bonds)– Bond holders receive interest payments only with no

ownership rights

• Equity bases securities (such as shares)– Shareholders have ownership rights and share in profit and

loss

Basics of Capital Markets

• GO to http://education.optionseducation.org/oic_courses/OIC101C/standalone.php for more details

Capital Markets Vs Money MarketMoney Market:

Deal in Short term financing

Capital MarketsDeal in long-term financing

Why would someone need long term financing?• Projects with lag in returns or income stream

Question: what if you need your money sooner?* use Secondary Market

Capital Markets

It is generally divided into:• Primary market (issuing and trading new securities, raising new

capital)– The role of an underwriter (http://www.youtube.com/watch?v=xlYDonZLoHg&feature=related)

• Secondary market (facilitates trading of previously issued securities)– Derivatives

• Futures• Options• Swaps

– Short selling and day-trading– Hedging

Efficiency in financial markets

• Allocational Efficiency: highest/best use of funds(highest return)– DSUs try to fund projects with best cost/benefit ratios – SSUs try to invest for best possible return for given

maturity and risk

• Informational Efficiency: prices reflect relevant information– Informationally efficient markets re-price quickly on

new information; – Informationally inefficient markets offer opportunities

to buy “underpriced” assets or sell “overpriced” assets

• Operational Efficiency: transactions costs minimized

Risks of Financial Institutions

• Credit or default risk: risk that a DSU may not pay as agreed. Can be managed by diversification, credit analysis and monitoring of borrower.

• Interest rate risk: fluctuations in a security's price or reinvestment income caused by changes in market interest rates

• Liquidity risk: risk that a financial institution may be unable to disburse required cash outflows, even if essentially profitable

Risks of Financial Institutions, cont.

• Foreign exchange risk: effect of exchange rate fluctuations on profit of financial institution

• Political risk: risk of government or regulatory action harmful to interests of financial institution.

• An Introduction to Finanacial Marketshttp://www.youtube.com/watch?v=6OoMQiClXCs&feature=related

• Introduction to Capital marketshttp://www.youtube.com/watch?v=ujLFsZfa_MY

Islamic Capital Markets

• We will dig a bit more deeper in concepts related to Capital markets when appropriate

• Capital Markets is all about raising capital

Next week. We will start looking at– What’s is unacceptable in conventional capital markets from

shariah point of view?– How do you raise capital in a shariah compliant manner?– What is allowed and what is not?– What are the guiding principles?