Islamic approach for Financial Market
Islamic financial market is the market where the financial instruments are traded in ways that do not conflict with the Shari’ah principles; it plays an important role in generating economic growth and complimenting and broadening the Islamic banking. Islamic financial market transactions are required to be carried out in ways that do not conflict with the Shari’ah so that the market is free from activities prohibited by Islam such as excess encompassing Riba, Maysir and Gharar. Therefore, there is a need to review the present practices prevailing in the financial market to identify which of these practices needed to be reformed from an Islamic point of view and which of them may be acceptable.
The objectives of the Islamic financial market are to ensure the equitable allocation of capital to sectors which would yield the best of returns to the owners of capital and to ensure that there exists sufficient investments opportunities to attract surplus funds in accordance with the owners' preferences in terms of the extent of risk involvement, rate of return as well as the period of investment. Equity-based securities that don’t guarantee any return and don’t include forbidden businesses can constitute investments in line with Islamic financial law. Whereas debt-based securities that carry a fixed return until maturity, such as debentures, bonds, preferred stocks and commercial paper, are inconsistent with Islamic principles and it would therefore be necessary for new instruments to be designed to replace them. Preferred stocks can match within the Islamic framework by turning them into redeemable equities with an element of participation in both earnings and the proceeds of liquidation.
However, debt and preferred stocks would be replaced by Islamic instruments. In fact, Islamic financial instruments have particular characteristics to comply with the Shari’ah rules, they should represent share in equity, real assets, usufruct or a combination of some or all of these, they should not earn money on debt and their holders must be the owners of whatever rights these instruments represent and bearers of all related risks. The tradability of an instrument related to a debt must in accordance with Shari’ah rules and it should not be allowed to earn any return. In addition, at the Issuance of Islamic financial instruments based on Mudarabah or Musharakah, the issuers should keep separate accounts for each specific project (ziaahmed.org; 09.2009), the prospectus should include full disclosure of the nature of the activities, contractual relationships and obligations between the parties involved and ratio of profit sharing and the profit and loss accounts must be declared at the date mentioned in the prospectus and balance sheets; the Principle and expected return on investment cannot be guaranteed. An example of fixed-return contract approved by the Shari’ah is Ijarah and it is possible to raise funds by this mean through the Stock Market. Lease-stocks will give ownership to the stockholders of the leased equipment, from which they will receive a known flow of rent. This is allowed in Shari’ah since they will have to borne the risk of the eventual value being much lower than was estimated.
Furthermore, since the entire capital resources, both short-term and long-term, in Islamic system are equity-based and not debt-based there is a need for a continuous pricing mechanism to the Islamic financial system to prevent it from major shocks and crashes (ziaahmed.org; 09.2009). For this purpose, there are three key areas of the market that need to be constantly reviewed that are speculation, information disclosure standards and the regulations guiding operations and trading practices. Speculation can cause wild swings in the market through misallocation of resources resulting in losses and gains entirely unrelated to real economic effects. Such results are like the results of gambling, involving transfer of resources among the participants but adding nothing to the initial stock of resources. The adequate flow of public information is what protects investors by ensuring that significant changes in shareholding are not the result of some people having inside information not available to the public. And the regulations guiding operations and trading practices require restrictions to ensure an adequate flow of information about the business whose securities are being traded and to control the trading practices in the market. These define the role of brokers and dealers, set margin limits and control fees and commissions.
The objectives of the Islamic financial market are to ensure the equitable allocation of capital to sectors which would yield the best of returns to the owners of capital and to ensure that there exists sufficient investments opportunities to attract surplus funds in accordance with the owners' preferences in terms of the extent of risk involvement, rate of return as well as the period of investment. Equity-based securities that don’t guarantee any return and don’t include forbidden businesses can constitute investments in line with Islamic financial law. Whereas debt-based securities that carry a fixed return until maturity, such as debentures, bonds, preferred stocks and commercial paper, are inconsistent with Islamic principles and it would therefore be necessary for new instruments to be designed to replace them. Preferred stocks can match within the Islamic framework by turning them into redeemable equities with an element of participation in both earnings and the proceeds of liquidation.
However, debt and preferred stocks would be replaced by Islamic instruments. In fact, Islamic financial instruments have particular characteristics to comply with the Shari’ah rules, they should represent share in equity, real assets, usufruct or a combination of some or all of these, they should not earn money on debt and their holders must be the owners of whatever rights these instruments represent and bearers of all related risks. The tradability of an instrument related to a debt must in accordance with Shari’ah rules and it should not be allowed to earn any return. In addition, at the Issuance of Islamic financial instruments based on Mudarabah or Musharakah, the issuers should keep separate accounts for each specific project (ziaahmed.org; 09.2009), the prospectus should include full disclosure of the nature of the activities, contractual relationships and obligations between the parties involved and ratio of profit sharing and the profit and loss accounts must be declared at the date mentioned in the prospectus and balance sheets; the Principle and expected return on investment cannot be guaranteed. An example of fixed-return contract approved by the Shari’ah is Ijarah and it is possible to raise funds by this mean through the Stock Market. Lease-stocks will give ownership to the stockholders of the leased equipment, from which they will receive a known flow of rent. This is allowed in Shari’ah since they will have to borne the risk of the eventual value being much lower than was estimated.
Furthermore, since the entire capital resources, both short-term and long-term, in Islamic system are equity-based and not debt-based there is a need for a continuous pricing mechanism to the Islamic financial system to prevent it from major shocks and crashes (ziaahmed.org; 09.2009). For this purpose, there are three key areas of the market that need to be constantly reviewed that are speculation, information disclosure standards and the regulations guiding operations and trading practices. Speculation can cause wild swings in the market through misallocation of resources resulting in losses and gains entirely unrelated to real economic effects. Such results are like the results of gambling, involving transfer of resources among the participants but adding nothing to the initial stock of resources. The adequate flow of public information is what protects investors by ensuring that significant changes in shareholding are not the result of some people having inside information not available to the public. And the regulations guiding operations and trading practices require restrictions to ensure an adequate flow of information about the business whose securities are being traded and to control the trading practices in the market. These define the role of brokers and dealers, set margin limits and control fees and commissions.
Stock market from the point of Sharia'h
Stock market is one of the most important sources for companies to raise money. It is simply a central place where people come together to buy and sell stocks. Investors and security issuers both participate in stock markets. Different sized entities participate in stock market activities, ranging from small investors to the governments, corporations, large hedge fund traders, and banks. The companies involved must be publicly held companies; which mean that they have to be companies that sell stocks to public investors on an open market. In addition to acting as a market place for stock trading, stock markets also act as the clearinghouse for each transaction, meaning that they collect and deliver the shares, and guarantee payment to the seller of a security (articlesbase.com/investing-articles; 09.2009). This eliminates the risk to an individual buyer or seller that the counterparty could default on the transaction. In addition, stock markets provide an effective tool for controlling private sector performance, particularly that of public companies, and offers the facility for the exchange of information about investment opportunities to help improving investors’ decisions
The Stock Market performs a number of useful functions in the economy, the most important one is intermediation; in fact, stock market channels money from savers to investors, this provides long-term capital to business through equity or debt and provides flexibility in the mobilising of funds, giving diversity of risk. The primary market, where securities are sold for a company’s initial public offering, serves to help firms to raise new resources, while the secondary market, which is where investors trade in companies that are already publicly held, facilitates liquidity of investments through the trading of shares. Stock markets also perform the function of valuation of Businesses. In fact, the value of a firm is determined by pricing its securities on the basis of the present value of the expected stream of cash flow generated over the life of the firm. The market value is influenced by various productive aspects of the business, such as earnings potential, debt/equity ratio and entrepreneurial expectations regarding future growth; as well as by the psychology of the buyers and sellers in the market (marketminds.esecfutures.com; 09.2009), which can produce a market valuation, which is totally detached from the real economic strength of the firm and is highly susceptible to speculation. The stock market also provides the necessary infrastructure to ensure the independence of the management from the owners of the firm. This independence enables the management to pursue long-term policies and raise large amounts of capital. Finally, stock market helps to overcome the inherent illiquidity external financial claims. These claims are usually highly illiquid outside the market and can become highly liquid through being listed and traded on the Stock Market.
The major activity in the Stock Market is the buying and selling of equity-based securities, that are, shares in businesses. These investments do not guarantee any return and the investor has an even chance of loss. Therefore, this activity is in line with Islamic financial law. But the true Islamic spirit demands two other conditions for an investment: first, the business invested in must not be one that is forbidden, and second, the entire capital structure of the firm must conform to Islamic financial principles. Debt-based securities such as debentures, bonds, preferred stocks and commercial paper also constitute an important proportion of the capital market. These types of securities carry a fixed return until maturity and are inconsistent with Islamic principles; it is then necessary for new instruments to be designed to replace them. There also the Preferred stocks where, preference stockholders have priority in getting their money back over ordinary share holders in case of bankruptcy. This can be easily adapted to be conforming to profit and loss sharing principles in Shari’ah; however in some cases, after a certain amount of dividend has been paid to preference stockholders, they share in the profits with common holders, this is contrary to the principles of Islamic financing, in fact, any priority in the matter of dividends or assets is completely unacceptable to Islam as no fixed return can be paid to any of the parties in a participative arrangement. Preference holders should be given an element of participation in both earnings and the proceeds of liquidation to be acceptable in Islam. In addition, new types of Islamic instruments can be introduced to stock markets to help mobilising more financial resources. Ijarah, for example, is a type of fixed-return contract approved by the Shari’ah and it is possible to raise funds by this mean through the Stock Market. Lease-stocks will give ownership to the stockholders of the leased equipment, from which they will receive a known flow of rent. The terminal value of the equipment will be shared by the stock holders, but meanwhile they will have borne the risk of the eventual value being much lower than was estimated. Largely, there is need for innovative structures for taking the Islamic stock markets forward without compromising the basic Shari’ah principles at the expense of business rationality, the innovation which should comprise knowledge of cutting-edge financial technology, deep understanding of Islamic commercial law and awareness of the needs and trends in the Islamic financial industry. Some concessions may be needed in certain circumstances; this should not become the norm.
The Stock Market performs a number of useful functions in the economy, the most important one is intermediation; in fact, stock market channels money from savers to investors, this provides long-term capital to business through equity or debt and provides flexibility in the mobilising of funds, giving diversity of risk. The primary market, where securities are sold for a company’s initial public offering, serves to help firms to raise new resources, while the secondary market, which is where investors trade in companies that are already publicly held, facilitates liquidity of investments through the trading of shares. Stock markets also perform the function of valuation of Businesses. In fact, the value of a firm is determined by pricing its securities on the basis of the present value of the expected stream of cash flow generated over the life of the firm. The market value is influenced by various productive aspects of the business, such as earnings potential, debt/equity ratio and entrepreneurial expectations regarding future growth; as well as by the psychology of the buyers and sellers in the market (marketminds.esecfutures.com; 09.2009), which can produce a market valuation, which is totally detached from the real economic strength of the firm and is highly susceptible to speculation. The stock market also provides the necessary infrastructure to ensure the independence of the management from the owners of the firm. This independence enables the management to pursue long-term policies and raise large amounts of capital. Finally, stock market helps to overcome the inherent illiquidity external financial claims. These claims are usually highly illiquid outside the market and can become highly liquid through being listed and traded on the Stock Market.
The major activity in the Stock Market is the buying and selling of equity-based securities, that are, shares in businesses. These investments do not guarantee any return and the investor has an even chance of loss. Therefore, this activity is in line with Islamic financial law. But the true Islamic spirit demands two other conditions for an investment: first, the business invested in must not be one that is forbidden, and second, the entire capital structure of the firm must conform to Islamic financial principles. Debt-based securities such as debentures, bonds, preferred stocks and commercial paper also constitute an important proportion of the capital market. These types of securities carry a fixed return until maturity and are inconsistent with Islamic principles; it is then necessary for new instruments to be designed to replace them. There also the Preferred stocks where, preference stockholders have priority in getting their money back over ordinary share holders in case of bankruptcy. This can be easily adapted to be conforming to profit and loss sharing principles in Shari’ah; however in some cases, after a certain amount of dividend has been paid to preference stockholders, they share in the profits with common holders, this is contrary to the principles of Islamic financing, in fact, any priority in the matter of dividends or assets is completely unacceptable to Islam as no fixed return can be paid to any of the parties in a participative arrangement. Preference holders should be given an element of participation in both earnings and the proceeds of liquidation to be acceptable in Islam. In addition, new types of Islamic instruments can be introduced to stock markets to help mobilising more financial resources. Ijarah, for example, is a type of fixed-return contract approved by the Shari’ah and it is possible to raise funds by this mean through the Stock Market. Lease-stocks will give ownership to the stockholders of the leased equipment, from which they will receive a known flow of rent. The terminal value of the equipment will be shared by the stock holders, but meanwhile they will have borne the risk of the eventual value being much lower than was estimated. Largely, there is need for innovative structures for taking the Islamic stock markets forward without compromising the basic Shari’ah principles at the expense of business rationality, the innovation which should comprise knowledge of cutting-edge financial technology, deep understanding of Islamic commercial law and awareness of the needs and trends in the Islamic financial industry. Some concessions may be needed in certain circumstances; this should not become the norm.
Arbitrage, hedging, speculation and options
A Derivative is a financial product that is derived from some other asset; it can be used by investors to hedge various types of risk by entering into a derivative contract whose value moves in the opposite direction to their underlying position, they can also be used by investors to speculate and to make a profit if the value of the underlying moves the way they expect. Derivatives are generally zero-sum exchanges between two parties; they are not real transactions since they are settled through price differences without delivery or ownership transfer. Only money changes hands at the end of the contract, while the delivery of underlying assets is very rare. Derivatives are used to distribute risk among market participants in accordance with their ability to assume them. Risk is an inevitable challenge for economic progress; however there is a need to reach a balance between the absence of risk and an excessive risk. Islamic financial framework imposes to control by associating it to ownership of real goods and services and to integrate it in real activities.
Practices such as speculation, arbitrage, hedging and options are associated to derivatives. In fact, derivatives can be used to acquire risk, rather than to insure or hedge against risk (wikipedia.org; 08.2009). Thus, some investors enter into a derivative contract to speculate on the value of the underlying asset, betting that the party seeking insurance will be wrong about the future value of the underlying asset. Speculators will want to be able to buy an asset in the future at a low price according to a derivative contract when the future market price is high, or to sell an asset in the future at a high price according to a derivative contract when the future market price is low. Islam allows genuine speculation, but professional speculation, where intention is just to exploit the situation, is not allowed. Investors may also look for arbitrage opportunities, as when the current buying price of an asset falls below the price specified in a futures contract to sell the asset. Arbitrage consists on making money out of the very temporary difference in prices at two markets; the one who is doing arbitrage plays an economic role by stabilising the prices in different markets, as the difference in prices just cannot stay for more than a few seconds in the highly sophisticated international markets. Arbitrage is allowed in the Shari’ah if delivery is actually involved. Moreover, hedging is a common practice designed to eliminate or reduce risk; it occurs when an investor buys an asset and sells it using a futures contract. The investor has access to the asset for a specified amount of time, and then can sell it in the future at a specified price according to the futures contract. Of course, this allows the benefit of holding the asset while reducing the risk that the future selling price will deviate unexpectedly from the market's current assessment of the future value of the asset. Hedging naturally belongs to Islamic economic objectives as long as it does not involve pure speculation and gambling-like activities. In addition, options can be used as a risk-management device by hedging the risk. The idea of a stipulated sale with penalty is quite old. However, as such it was not used for fixing current price to benefit from future price movements, but for real trade transactions. Options are of three types: ‘Call’, ‘Put’ and ‘Put and Call’. In a Call option the buyer has the option of buying at any time during the Call period at today’s price by paying a small premium to the other party; the option will be worth exercising if the price goes above today’s price plus the premium paid. In a Put option the buyer has the option of selling at any time during the Put period at today’s price, by paying a small premium to the writer. A Put and Call option gives the right to sell or buy. The buyer of the option also gets some time for assessing the benefits and costs of entering into the transaction. The majority of scholars do not allow options trading as both the delivery as well as the full price are deferred (ziaahmed.org; 09.2009), as it can be very speculative, but some allow it as it involves a right for purchase/sale. The Shari’ah also does not allow any premium for the option, as it is not an actual sale or purchase; it is only a right, which is an abstract object. In Islamic banking, the closest to an option is the khiyar al-shart contract. There is general agreement that these contracts are valid if and only if the contract itself cannot be bought or sold.
Practices such as speculation, arbitrage, hedging and options are associated to derivatives. In fact, derivatives can be used to acquire risk, rather than to insure or hedge against risk (wikipedia.org; 08.2009). Thus, some investors enter into a derivative contract to speculate on the value of the underlying asset, betting that the party seeking insurance will be wrong about the future value of the underlying asset. Speculators will want to be able to buy an asset in the future at a low price according to a derivative contract when the future market price is high, or to sell an asset in the future at a high price according to a derivative contract when the future market price is low. Islam allows genuine speculation, but professional speculation, where intention is just to exploit the situation, is not allowed. Investors may also look for arbitrage opportunities, as when the current buying price of an asset falls below the price specified in a futures contract to sell the asset. Arbitrage consists on making money out of the very temporary difference in prices at two markets; the one who is doing arbitrage plays an economic role by stabilising the prices in different markets, as the difference in prices just cannot stay for more than a few seconds in the highly sophisticated international markets. Arbitrage is allowed in the Shari’ah if delivery is actually involved. Moreover, hedging is a common practice designed to eliminate or reduce risk; it occurs when an investor buys an asset and sells it using a futures contract. The investor has access to the asset for a specified amount of time, and then can sell it in the future at a specified price according to the futures contract. Of course, this allows the benefit of holding the asset while reducing the risk that the future selling price will deviate unexpectedly from the market's current assessment of the future value of the asset. Hedging naturally belongs to Islamic economic objectives as long as it does not involve pure speculation and gambling-like activities. In addition, options can be used as a risk-management device by hedging the risk. The idea of a stipulated sale with penalty is quite old. However, as such it was not used for fixing current price to benefit from future price movements, but for real trade transactions. Options are of three types: ‘Call’, ‘Put’ and ‘Put and Call’. In a Call option the buyer has the option of buying at any time during the Call period at today’s price by paying a small premium to the other party; the option will be worth exercising if the price goes above today’s price plus the premium paid. In a Put option the buyer has the option of selling at any time during the Put period at today’s price, by paying a small premium to the writer. A Put and Call option gives the right to sell or buy. The buyer of the option also gets some time for assessing the benefits and costs of entering into the transaction. The majority of scholars do not allow options trading as both the delivery as well as the full price are deferred (ziaahmed.org; 09.2009), as it can be very speculative, but some allow it as it involves a right for purchase/sale. The Shari’ah also does not allow any premium for the option, as it is not an actual sale or purchase; it is only a right, which is an abstract object. In Islamic banking, the closest to an option is the khiyar al-shart contract. There is general agreement that these contracts are valid if and only if the contract itself cannot be bought or sold.