Fundamentals of Islamic Money and Capital Markets

Mohd Azmi Omar, PhD, is the Director General of the Islamic Research & Training Institute (IRTI), Islamic Development Bank. He was formerly the Deputy Rector (Deputy Vice-Chancellor) in charge of academics and research at the International Islamic University Malaysia (IIUM). He obtained his bachelor's and master's degrees in finance from Northern Illinois University, USA, and his PhD from Bangor University, United Kingdom. Muhamad Abduh is the Head of Research of IIUM's International Institute of Islamic Business and Finance (IIiBF) and the editor-in-chief of its official journal, the Journal of Islamic Finance. Dr. Raditya Sukmana is an Assistant Professor in the Department of Islamic Economics, Airlangga University, Surabaya, Indonesia. He obtained his BA in finance from Airlangga University; an MS in economics from Georgia State University, USA; and a PhD in Islamic finance from International Islamic University Malaysia in 2010.

Preface xiii

Acknowledgments xv

1 An Introduction to Conventional and Islamic Financial Systems 1

Learning Outcomes 1

Introduction 2

The Roles and Functions of Financial Markets 4

Structures of Financial Markets 6

Based on the Instrument 6

Based on the Issuance of Securities 8

Methods Used in Secondary Markets 8

Based on the Maturity 9

Classification of Financial Markets 9

The Money Market 10

The Capital Market 12

Types of Financial Intermediaries 13

Depository Institutions 14

Contractual Institutions 15

Investments and Finance Institutions 17

A Brief Overview of the Islamic Financial System 17

Evolution of Islamic Finance 18

Chapter Summary 20

Chapter Questions 21

Notes 22

References 22

2 Development of Islamic Capital and Money Markets in Malaysia 23

Learning Outcomes 23

Introduction 24

Development of Islamic Financial Institutions in Malaysia 24

1960 to 1990: Establishment of Islamic Financial Institutions 24

1990 to 2000: Conventional Banks Allowed to Offer Islamic

Financial Products and Services 26

2000 to 2010: Islamic Subsidiaries and the International Integration of the Islamic Banking System 27

Islamic Capital Markets in Malaysia 29

Sukuk 30

Islamic Collective Investments 31

Islamic Stock Broking 32

Malaysia International Islamic Financial Centre (MIFC) 33

Chapter Summary 34

Chapter Questions 36

Notes 36

References 36

3 Regulators and Transactions Platform for Capital and Money Markets 37

Learning Outcomes 37

Introduction 38

Bank Negara Malaysia (BNM) 38

Role and Functions 39

BNM Administered Legislation 40

Role of BNM on ICM Development 42

The Securities Commission (SC) 42

Role of SC on ICM Development 42

Bursa Malaysia (BM) 45

Role of BM on ICM Development 45

Shariah-Compliant Stocks and ETF 46

Islamic Equity Indices 46

Islamic REITs and Sukuk Market 47

Chapter Summary 47

Chapter Questions 48

Notes 48

References 48

Websites 48

4 Islamic Money Market 49

Learning Outcomes 49

Introduction 50

Money Market Participants 50

Functions of the Islamic Money Market 51

Differences between Islamic and Conventional Money Markets 52

Components of the Malaysian Islamic Money Market 53

Islamic Interbank Market 53

Mudarabah Interbank Investment 54

Profit Calculation for Mudarabah Interbank Investment 55

Example: Mudarabah Interbank Investment (MII) 56

Commodity Murabahah 56

Example: Commodity Murabahah Interbank Investment 58

Wakalah Investment 58

Trading of Islamic Money Market Instruments 59

Government Investment Issue (GII) 60

Example: Calculation of GII price 61

Malaysian Islamic Treasury Bills (MITB) 61

Example: Calculation of Proceeds on MITB 62

Bank Negara Monetary Notes (BNMN) 62

Sukuk Bank Negara Malaysia Ijarah (SBNMI) 63

Islamic Negotiable Instruments (INI) 63

Negotiable Islamic Debt Certificate (NIDC) 63

Example: Calculation of Price of NIDC of Less Than One Year 64

Example: Calculation of Price NIDC with Maturity of More Than One Year 65

Islamic Negotiable Instruments of Deposit (INID) 66

Example: Calculation of Proceeds for an INID 66

Islamic Accepted Bill (IAB) 67

Import and Local Purchases 67

Export/ Local Trade 67

Example: Price Calculation of IAB under Bai al-Dayn 68

Sell and Buy Back Agreement (SBBA) 68

Example: Sell and Buy Back Agreement 69

Cagamas Sukuk 70

Sanadat Mudarabah Cagamas (SMC) 70

Example: Sanadat Mudarabah Cagamas (SMC) Calculation 71

Sanadat Cagamas 71

Islamic Corporate Sukuk 72

Chapter Summary 72

Chapter Questions 73

Notes 73

References 74

5 An Overview of Sukuk 77

Learning Outcomes 77

Introduction 78

Comparing Sukuk, Bonds, and Shares 79

Sukuk Types 81

Sukuk Structures 81

Sukuk al-Ijarah 82

Sukuk al-Musharakah 88

Sukuk al-Mudarabah 94

Sukuk al-Salam 99

Sukuk al-Istisna 102

Sukuk al-Murabahah 106

Sukuk al-Istithmar 110

Sukuk al-Wakala 114

Chapter Summary 117

Chapter Questions 118

Notes 118

References 119

6 Shariah-Compliant Equity 121

Learning Outcomes 121

Introduction 122

The Structure of Equity Markets 124

Shariah-Compliant Equity Securities 125

Differences between Shariah and Non–Shariah-Compliant Equity Markets 128

Shariah-Compliant Stocks Screening 130

Malaysia Securities Commission 130

S&P Shariah Indices 131

Pakistan Meezan Islamic Fund 133

Global GCC Islamic Fund Screening 134

Jakarta Islamic Index 135

Chapter Summary 136

Chapter Questions 136

Note 136

References 136

7 Islamic Mutual Funds 139

Learning Outcomes 139

Introduction 140

Closed and Open-Ended Funds 140

Conventional Mutual Funds 141

Active and Passive Management 143

Advantages of Mutual Funds 143

Disadvantages of Mutual Funds 144

Fees and Expenses 145

Islamic Mutual Funds 146

Basic Concept of Islamic Mutual Funds 147

Shariah Stock Screening 147

Purification of Income 148

Types of Islamic Mutual Funds 149

The Role of the Shariah Advisory Board in Islamic Mutual Funds 151

Calculating NAV in the Islamic Mutual Funds 151

Organisation of Islamic Mutual Funds 153

The Process of Investing in Islamic Mutual Funds 154

Islamic Ethical Investment and Ethical Investment 156

Chapter Questions 158

Notes 158

References 158

8 Islamic Real Estate Investment Trusts (I-REITs) 161

Learning Outcomes 161

Introduction 162

Islamic Real Estate Investment Trusts (I-REITs) 165

Shariah-Permissible Investments for I-REITs 166

I-REITs Structure 169

Case Study: Al-’Aqar KPJ REIT 171

Case Study: Al-Hadharah Bousted REIT 174

Difference between Conventional and Islamic REITs 176

Chapter Summary 177

Chapter Questions 178

Notes 178

References 178

9 Islamic Exchange-Traded Funds 179

Learning Outcomes 179

Introduction 180

Open- and Closed-End Funds, and Unit Trust Funds 180

Open-End Funds 180

Closed-End Funds 181

Unit Trust 181

Exchange-Traded Funds (ETFs) 181

Islamic Exchange Trade Funds (I-ETFs) 185

Security Borrowing and Lending in Malaysia 190

Islamic ETFs in Other Countries 195

Challenges in Promoting I-ETFs 195

Chapter Summary 196

Chapter Questions 197

Notes 197

References 197

10 Islamic Derivatives Market 199

Learning Outcomes 199

Introduction 200

Derivative Securities in the Conventional Market 200

Risk Profile 202

Main Players in the Derivative Markets 203

Hedging with a Forward Contract 204

Hedging with Future Contracts 205

Hedging with Swap Contracts 206

Derivative Securities in the Islamic Perspective 211

Islamic Forward and Future Contract 213

Islamic Option Contract 216

Islamic Cross-Currency Swap 218

Islamic Profit Rate Swap 220

Islamic Structured Product 222

Chapter Summary 225

Chapter Questions 226

Notes 226

References 227

Bibliography 229

About the Authors 233

Index 235