FIN 431 Islamic 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 Units DSU = Deficit Spending Unit SSU lend to financial institution who then lend to DSU. DSU(-) Financial intermediary SSU(+)

Function of a financial system Economic units/players may be classified as Each unit must operates within the budgetary constraints 1. 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 Markets 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 Markets 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 e.php for more details e.php

Capital Markets Vs Money Market Money Market: Deal in Short term financing Capital Markets Deal 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 ( 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 Markets Introduction to Capital markets

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?