MODULE 3

TYPES OF SECURITIES

The views expressed in this paper are the views of the authors and do not necessarily
reflect the views or policies of the Asian Development Bank (ADB), or its Board of
Directors or the governments they represent. ADB makes no representation
concerning and does not guarantee the source, originality, accuracy, completeness or
reliability of any statement, information, data, finding, interpretation, advice, opinion, or
view presented.
MODULE THREE TYPES OF SECURITIES

Learning Objectives The objectives of this module are to provide learners with a
basic understanding of stocks, bonds and a few selected
derivatives and a basic understanding of Islamic principles
of investing and the types of investments available under
the Islamic rules.

CONTENT Page

I BONDS 3

Bearer and Registered Bonds 3

General Obligation and Revenue Bonds 4
Treasury Bonds 4
Treasury Notes 4
Treasury Bills 4
Participating Bonds 5
Convertible Bonds 5
Zero Coupon Bonds 5
High Yield (Junk) Bonds 5
Warrant Bond (Bonds with warrants) 6
Indexed Bonds 6
Sinking Bond Funds 6
Commercial Paper 6
Mortgaged backed Securities 6

II EQUITIES 7

Common Stock 7
Preferred Stock 7
Par Value 8
Book Value 8
Classes of Stock 8
Stock Splits 8
Dividends 9
Ex-Dividend 9
DRIPS 9
Treasury Stock 10
Depository Receipts 10

III COMMODITIES 10

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IV DERIVATIVES 11

Futures 11
Options 12
Covered calls 12
Uncovered calls 12
Index options 12
Warrants 13
Swaps 13
Repurchase Agreements 13

APPENDIX A

PRINCIPLES OF ISLAMIC INVESTING 14

History of Islamic Banking 14

Islamic Investing Banking 15
Islamic Retail Banking 16

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 Where a security is traded (primary or secondary trading) is called a market.
The different types of securities that are traded are also known as markets.
These securities may be traded on separate exchanges or in different over the
counter markets.

I BONDS

This market trades in the debt instruments issued by governments, government

agencies, such as municipalities, and corporations. The bond market usually attracts
more interest from professional and institutional investors than from the general public.
Institutional investors include pension funds, insurance companies, bank trust
departments and collective investment schemes.

A bond is a long-term loan issued in the form of a negotiable security by a corporation,

government, or government agency. Bonds are loans from the bondholder (buyer) to the
issuer (seller). A bond is a promise by the issuer to pay back the amount loaned to it
(called principal) plus an agreed to amount of interest on or before a stated date. The
interest may be paid periodically during the life of the loan or all at once when the loan is
paid back. Bonds are also called fixed income instruments, because the amount of
income that the bond will generate is fixed by the stated interest rate of the bond. The
date when the loan becomes due is called the maturity date of the bond.

The loan is represented by a physical piece of paper and if it pays interest periodically
during the life of the loan, the certificate may also consist of coupons. Coupons are
detachable from the bond certificate itself, usually by a perforation, and are presented to
the paying agent of the issuer, usually a commercial bank, for payment. For this reason
they are called coupon bonds. While coupon bonds are no longer widely used, the
amount of interest that a bond pays is still known as the coupon rate and the bond is
still known as a coupon bond.

Bearer and Registered Bonds

Bonds are also identified by the way they are owned. Bearer bonds, for example,
belong to the person who holds them and ownership is not otherwise recorded.
Eurobonds are issued in this format. While this form of ownership carries the risk of
loosing the certificate, it offers the highest degree of anonymity and that is why in some
countries, the United States for example, they are no longer allowed.

The other common type of format is a fully registered bond, either in certificate form or in
book entry. The owner’s name is recorded with a transfer agent and interest payments
are made either by check or electronic credit. The book entry method, where no
certificate is issued and ownership is merely recorded in a ledger, is growing in
popularity because it reduces transfer costs, simplifies handling, and decreases the
probability of loosing the certificate or having it stolen.

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The reason a bond is called a debt instrument is because there are no ownership rights
in a bond. The promise to pay is what distinguishes bonds from stocks. The holder of a
bond is a creditor, the holder or a stock is an owner. Although the holders of corporate
bonds lack voting rights and have no participation in net profits, they may demand full
payment of their bonds even if it means forcing the company into bankruptcy. Owners of
stock have no such claim. In the case of liquidation or bankruptcy of the issuer, the
bondholders are paid before shareholders. Bondholders are said to have a superior
claim on the assets of the issuer. They are superior creditors in the eyes of the law.

General Obligation and Revenue Bonds

General obligation bonds usually refer to government bonds and are backed by the full
faith and credit of the taxing power (country, municipality, etc.) that issues them.

Revenue bonds are payable only from some specific source of taxes (highways tolls,
water bills, etc.) and are not subject to the general taxing power of the issuer.

Treasury/Government Bonds

A country’s long term financing needs are met by issuing bonds that mature from
anywhere after one year up to essentially as long as a country wants and to which the
public is willing to commit its money. Average lengths run to 20 or 30 years and are
called long-term bonds. These long-term bonds are watched closely by the market as
an indication of where long-term interest rates will be heading.

Long -term bonds may be subject to being called before they mature. Callable means
that the issuer has the right to pay off the bond sooner than the maturity date. If a bond
is subject to being called before it matures, both dates are mentioned in its listing. Thus
a bond that pays 5% and matures in June 2010, but is callable after June of 2005 is
referred to as the 5% of June 2005-2010. Treasury’s usually issue split-date callable
bonds during periods of high interest rates in order to have the opportunity to pay them
off sooner if interest rates drop. The government would then issue new bonds at a lower
rate.

Treasury/Government Notes

Notes usually have a maturity of from 2 to 10 years and are known as intermediate term
investment instruments. Notes are not callable before their maturity date. Notes usually
pay interest semiannually.

Treasury/Government Bills

T-bills, or bills, are the shortest term Treasury security and usually mature in 3, 6, 9 or 12
months. T-bills carry no coupon rate of interest but are sold at a discount from par. Par
is the face amount of the bond. This means that the price paid for a T-bill is less than its
value at maturity. Thus a 12 month T-bill yielding 5% would be sold at a 5% discount
from the face value of the bond.

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 Participating Bonds

These bonds not only bear a fixed rate of interest, but also have a profit-sharing feature.
The bondholder is entitled to participate along with shareholders in earnings of the
corporation to the extent described in the bond contract. These are used widely in
Europe and are usually issued by weak companies as an added inducement to attract
buyers.

Convertible Bonds

Usually all that the bondholder is promised is the principal and interest. There is an
exception to this rule and it is called a convertible bond. This is a bond that at its
maturity, or some other stated date, may be converted to a stated number of common
shares in a corporation. A new corporation without much money or track record for
paying off bonds or a corporation with a low credit rating might offer convertible bonds
because the borrowing costs of straight bonds would be prohibitive. Convertible bonds
rank below conventional bonds but ahead of any equity in their claim on the assets of a
company.

Zero Coupon Bonds

Zeros, as they are frequently referred to, are issued at a discount from their par value.
Unlike a conventional bond, zeros pay no interest between issuance and redemption but
only at maturity. Although the bondholder forfeits immediate income from the zero, the
yield to maturity is computed on the assumption that the coupon interest is reinvested at
the prevailing rate when received. Consequently, as interest rates fall the reinvestment
is presumed to be at the lower rate, reducing the yield but increasing the price of the
bond. Likewise, if interest rates rise, the bond’s price will fall, but the coupons are
reinvested at the higher rate, raising the yield to maturity. With no cash flow from
coupon payments to act as a cushion, zero prices swing rapidly up and down in
response to even minor changes in the interest rate. In times of high interest rates,
zeros are very popular in order to lock in those high rates.

High Yield (Junk) Bonds

The top four rankings of any rating service are usually known as investment grades.
Bonds in these categories may generally be bought for fiduciary accounts unless
specifically restricted. Fiduciary accounts include pension plans and some bank trust
accounts. Any bond below investment grade is referred to as a “ junk” bond. but, in the
terms of the market, it is called a high-yield bond. It is called junk, because it describes
the quality of the bond. Brokers and dealers prefer the term high yield because it
sounds better and also because it describes the yield. The yield is how much a bond
pays, or the interest rate. The bond must pay a high level of interest because of its low
rating. The risk of the issuer not being able to pay off the bonds is high, so the potential
return to the investor must also be high in order to justify taking the risk. The low rating is

5
a result of the rating service determining that the issuer is not in sound financial shape
and may not be able to honor its commitment to pay off the bonds.

Warrant Bonds or Bonds with Warrants

These bonds contain the right (warrants) to purchase shares of common stock at a
specified price. Usually the warrant price is higher than the current market price.

Indexed Bonds

These bonds are used in periods of high inflation. The interest payments are indexed to
the inflation rate.

Sinking Bond Funds

This is not technically a separate category of bonds. Any bond issue may have a
“sinking” feature. With this feature, the issuer agrees to set aside a certain amount of
money each and every year for the eventual retirement of the bond issue. A bond issue
is retired when it is fully paid. After a specified period, redemptions may begin and
bonds may be called. This results in the shortening of the life of the issue so that even if
an issue was originally offered with a 20-year maturity, the bonds might be called after
10 or 15 years. Because the sinking fund deposits are to be used only for the retirement
of a specific outstanding issue, the existence of a “sinker” increases the bond’s safety
and marketability. Payments by the issuer to a sinking fund are mandatory and the
failure to make them in a timely manner could threaten the issuer with default.
Bondholders should not assume that a sinking fund absolutely protects them from loss,
although it may help increase the level of confidence that the bonds will be fully paid

Commercial Paper

Commercial paper is short- term debt issued by a corporation. Commercial paper has a
maturity date of less than one year, sometimes just a few months. It is an unsecured
promissory note and may be issued at a discount to the par value. Interest on
commercial paper is usually paid only at the maturity date.

Mortgage backed securities

Mortgages are a conveyance of title to property that is given as security for the payment
of a debt. When a person obtains a mortgage on a house he or she actually signs two
instruments. The first is the note that is a simple promise to pay, like any other note.
The mortgage document is the document that transfers title of the house to the name of
the institution or person lending the money as security for the note. The house is put up
as security in order that the lender will have an asset behind the note in case the debtor
defaults on the payments. If the debtor does default, the lender has the right to sell the
house in order to cover the debt.

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Mortgages are combined with other mortgages to create what is called mortgage backed
securities. These securities are backed by the mortgages attached. The payments are
passed through from the debtor to the investor. These mortgages can then be sold in
the open market and do not have to be held until the entire debt is paid off. The process
of converting assets into a negotiable security for resale in the financial markets is
known as securitizing the asset. Mortgage backed securities may be sold with the
principal and interest, principal only, or interest only being passed through to the buyer.

II EQUITIES

The principal focus of securities regulation is on the equities market because it attracts
much more interest from the general public which are usually less sophisticated than
professional or institutional investors. This market trades shares of common stocks
issued by corporations.

Common Stock

All corporations issue a stock that has the last claim on the corporation’s assets. The
most frequently used term for this kind of stock is common stock, although in the United
Kingdom an Australia they are called ordinary shares. It is the first security to be issued
and the last to be retired. Common stock represents the chief ownership of a
corporation and usually is the only issue that has a vote in managing the corporation.
Should a company go bankrupt, holders of senior securities like bonds and preferred
stock, will be paid first. Common stock owners, therefore, may receive nothing for their
shares in the event the corporation becomes bankrupt or is forced into liquidation.
Common stock is also usually the only stock that can vote for the members of the board
of directors of a corporation, although there are exceptions, such as some issues of
preferred stock.

Preferred Stock

The term preferred stock is almost a misnomer. This type of stock usually does not have
any voting rights and is often retired after a certain period of time, usually about 10
years. The “preference” comes in that these shares are entitled to dividend payments or
claims on assets in the case of bankruptcy before any payment to the common stock
holders, but still only after all bondholders have been paid. Dividends are usually, but not
always, cumulative. Dividends are a distribution to stockholders declared by a
corporation’s board of directors based upon profits. Dividends may be declared either in
cash or additional stock. Cumulative means that if a dividend payment is missed
because there are no profits to pay the dividend, the preferred stock holders must be
paid all missed dividends before the common stock holders can be paid anything.

Preferred stock may also be issued in a form known as convertible preferred stock. This
means that the preferred stock may be converted into common stock (much like a
convertible bond). When a convertible preferred stock is issued it usually has voting
rights equal to the terms of convertibility.

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 Par Value

Common stock is issued with a par, face or stated value. These terms are of more
concern to the accountants than they are to the investor. Par value is usually arbitrarily
fixed based upon some financial or tax criteria. Par value is usually set as low as
possible. Some stock carries no par value. If there is a listed par value for a stock, the
only significance to the investor is that the stock cannot be issued by the corporation for
less than its par value. Any stock issued below the par value is known as watered
stock. Depending upon the laws of each country, an investor who purchases watered
stock may be liable to the corporation for the difference between the par value and what
the investor actually paid. Par value for stock is only relevant with respect to the original
issue by the company. The stock may sell at any price above or below the stated par
value in subsequent trades in the secondary market.

Unlike stock, par value for bonds is very important and is the face amount of the bond.

Book Value

Book value is the stated value of the assets of the corporation behind each share of
common stock. It is determined by adding the par value, capital surplus and retained
earnings, subtracting any intangible assets and dividing by the number of shares
outstanding. The importance of book value is not universally agreed upon. Some
believe that it is important as a test to determine the investment value of the stock. If the
market value, the price at which the stock is selling on the open market, is less than the
book value, speculators believe that some raider may purchase the company and sell it
off in pieces. The value of the separate pieces is known as its breakup value and in this
case the breakup value would be more than the book value. Others believe that the
book value is not a very accurate value. They believe that since the assets of a
corporation are carried on the books at cost less depreciation, the actual replacement
costs of these assets, or their value if sold, may not be fairly reflected.

Classes of Stock

Sometimes a corporation will issue more than one class of common stock. The
difference between the classes is usually based upon their voting rights. Some classes
have superior (called weighted) voting rights. Some classes have no voting rights at all.
Different classes are usually labeled by letters such a class A or class B.

Stock Splits

A stock split occurs when a company divides its shares. The split has no effect on the
company’s net worth or the value of the shareholder’s investment. A split just spreads
the investment over more shares. For example, if a corporation with 1 million shares
outstanding should increase that number to 2 million, then it would be said that the
corporation split the shares 2 for 1 and the price of the share would be divided by 2.

8
Therefore, the owner of 100 shares of this company that were priced at US$10.00,
would, after the split, own 200 shares priced at US$5.00. Corporations usually split a
stock in order to lower the price and increase the potential number of owners by making
the stock more affordable. A company usually wants to broaden ownership in order to
meet some exchange rule or to make itself more visible to the investment community.
By being owned by a larger number of investors and being more affordable, it is easier
for a broker to sell those shares to others.

A reverse stock split, on the other hand, reduces the number of shares and increases
the price of the stock. Some exchanges require a minimum stock price to be listed and
a reverse split may be done to comply with this requirement. Very low priced shares are
frequently referred to as “penny stocks”, even though they may be selling for more than
that and are not very well regarded by the investment community. A reverse stock split
would raise the price of the stock and perhaps the profile of the company in the market
place. Reverse stock splits may indicate that a company is in financial trouble.

Dividends

Dividends, earnings from stocks, are declared by the board of directors and usually paid
in either cash or additional shares. A corporation’s dividend policy depends upon such
factors as cash position, growth prospects, stability of earning, capital spending needs
and reputation. Many investors buy stocks because of the company’s dividend history
and rely on the cash distributions for income. Generally, the larger and older companies
pay dividends in cash and the smaller and newer companies pay dividends, if they pay
them at all, in additional shares. Since cash dividends are paid out of current earnings
of the company, the smaller and newer companies that find it necessary to retain the
cash for future growth cannot afford to pay cash dividends.

Dividends may also be paid in the form of other property, such as shares in another
company such as a subsidiary.

Ex-Dividend

A stock is said to be selling ex-dividend when the dividend declared by the company is
not available to the purchaser of the stock. The dividend is usually not available to the
purchaser because the stock was bought too late for the purchaser to be the record
holder of the security on the date necessary to receive the dividend (the record date).

On days when a stock trades ex-dividend, its market price is reduced by the amount of
the dividend. The purchaser buys at the price of the stock minus the price of the
dividend.

DRIPS

Dividend Re-Investment Plans, or DRIPS as they are commonly known, are plans that
are sponsored by most large companies. These plans allow the shareholder to reinvest
all cash dividends directly into the purchase of additional shares of the corporation.
These shares are purchased directly from the corporation in the primary market. The re-
investment is automatic and handled by the corporation. No share certificates are

9
issued, the shares are book entry holdings, and usually include fractional shares that
could not be purchased in the secondary market.

Treasury Stock

Shares that have been issued to the public in the primary market and then repurchased
by a company from its own shareholders in the secondary market are referred to as
treasury shares because they are returned to the treasury of the company. These
shares have no voting rights, receive no dividends and are not used in the computation
of earnings per share in the corporation’s financial records. The corporation may use
treasury stock for employee stock purchase plans, to fund executive stock options or
bonuses, as a vehicle to acquire the assets of another corporation through an exchange
of stock tender offer, or simply as an investment because the board of directors believes
that the stock is under priced and may even be below book value.

Treasury stock, or the acquisition of treasury stock, may also be used as a defense
against a raid on the company. By taking a large amount of stock out of the market, the
management would have greater control because treasury stock cannot be voted
against management.

Depository Receipts

Depository receipts evidence shares of a corporation that is incorporated outside the

country in which the receipts are traded. So, for example, a company domiciled in
Japan (SONY) could list on the Jakarta Stock Exchange through the use of Indonesian
depository receipts and be traded on the Jakarta market. Depository receipts are usually
named after the country in which they sell and are usually referred to by an acronym
made up of the first letter of the selling country followed by DR for depository receipts.
So in our example, an Indonesian would buy Sony IDRs.

Transactions in the depository receipts are made in lieu of trading in the security itself.
The depository receipts are usually issued by a foreign branch of a domestic bank for
the shares of the underlying company held in custody in the country of the corporation’s
domicile. If authorized by law, depository receipts could also be issued based upon
deposits held in the local central depository of the country of domicile. Depository
receipts are usually listed and traded according to the rules of the exchanges on which
they appear.

The listing of depository receipts simplifies the complicated foreign transfer and
settlement process and allows domestic investors to receive dividends in their local
currency and financial reports in their local language.

III COMMODITIES

A commodity is not technically a security, but the contract to buy or sell the commodity
is a security. Because it is the contracts to buy or sell that are being traded, investors
deal with these securities without ever seeing the commodity that is the subject of the
contract. The commodity is described in the contract and the need to see or handle the

10
actual commodity does not arise. The commodities market involves the purchase or sale
of products such as oil, gold, silver, copper, and many agricultural product.

Currency markets have become the ultimate commodity markets with worldwide
influence. Interest rates and specific stock indexes are two other of the most recently
introduced subjects of commodity contracts.

Since some commodities cannot be delivered (interest rates) and most commodity
traders don’t want the commodity delivered, (pork bellies), commodity contracts may
also be settled for cash rather than the underlying commodity that is the subject matter
of the contract. The price of the settlement is determined by the difference in the cost of
the commodity at the time of purchase or sale and the cost of the commodity at the time
of the expiration of the contract.

Commodity positions may also be closed out by purchasing the opposite position, rather
than the commodity or cash. For example, if a trader has bought a commodity he or she
will sell the same amount of the same commodity before the expiration of the contract.
Likewise, a seller will buy back the contract in order to avoid having to deliver. Both
traders are speculating, of course, that they will make a profit between the first and
second action.

IV DERIVATIVES

The word derivative means taken from something else. In securities, it usually means
taken from a direct security such as a bond or stock. These securities are direct
obligations or investments. Everything else is derived from one of these instruments.
Financial products that were once called “hedging instruments” are now called
derivatives but are still widely used for the purpose of hedging. The most common
derivatives are futures, options, warrants, swaps and repurchase agreements.

Futures

Futures are contracts that create an obligation to buy or sell another security on or
before a specified future date. For example, you may hold a futures contract to buy or
sell a specified stock, bond or commodity. Futures markets in particular, and derivatives
markets in general, are more for the sophisticated investor or trader. A trader who has
bought a futures contract and has agreed to accept delivery is known as being long.
The trader who has sold the futures contract and has agreed to make the delivery is
known as being short. The difference between the cash price (called spot price) for a
commodity and the price listed in the futures contract is called the basis or spread.

The futures market is very sophisticated and carries with it great risk. Mostly this risk
comes from the concept of leveraging made possible by the existence of margins.
Leveraging means that a trader may acquire for a small initial outlay (the margin) a
much larger position than that amount of money would otherwise purchase if the entire
position would have had to be paid for in full. For example, a trader may be required to
place a 10% margin on a position. That means that the trader only has to pay 10% of
the price that the whole position would otherwise costs. Because of margins and
leverage, large profits and losses are possible in relatively small variations in price.

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Because of the highly speculative nature of futures, most exchanges place both a
position limit on the number of contracts an account may hold and a limit on the amount
that the price of a contract may fluctuate in any one day.

Options

Options are contracts that give the owner the right, but not the obligation, to buy or sell a
specified asset (the underlying asset or underlying) at a specified price on or before a
specified date. The holder of an option is not obligated to buy or sell (exercise) the
financial instrument that is the subject of the option. Options for the purchase of a
security are known as call options or calls. Options for the sale of a security are known
as put options or puts. The price at which the option can be exercised is known as the
strike price or strike. The price paid for the option is known as the premium. If an
option is not exercised by the due date it is said to lapse.

The buyer of an option is sometimes called the taker and the seller of an option is
sometimes called the writer. It makes no difference whether the option is a put or a call.

The intrinsic value of an option is the difference between the exercise price of the
option and the market value of the underlying security. An option is also said to have a
time value that represents the volatility of the value of the underlying stock during the
time that the option is effective.

Call options on stocks that are currently trading below the strike price are said to be
“underwater” or “out-of-the-money”. Call options on stocks that are currently trading
above the strike price are said to be “in-the-money”. Conversely, put options that are
currently trading above the strike price are out-of-the-money and those that are trading
below the strike price are in-the-money.

Covered Calls are call options sold against the holdings of

common stock owned by the seller of the call. That is, the seller of the option agrees to
sell stock that he or she already owns at a fixed price at a future date. If the price of the
stock goes above the strike price, the buyer of the option will exercise it and the seller
will have to sell the stock. If the price of the stock goes below the strike price the buyer
of the option will most likely not exercise the right to buy and the owner of the stock, who
is also the seller of the option, will keep the stock as well as the money received for
selling the option.

Uncovered calls, also known as naked calls, are calls against

stock that the seller of the option does not own. If the option is exercised, the seller of
the option must go into the market and buy the stock to cover the call. In some
countries, this is not legal.

Index options are contracts that permit the investor to focus on

major market moves without actually having to choose individual stocks. All investment
purchases involve a risk, some risks are greater than others. If you choose an individual
stock you run a stock specific risk that the stock will not act in the same manner as the
entire market. The market may go up, but your stock may go down. Stock index options
allow the investor to buy (or sell) the whole market. Index options are used as a popular
hedge against a broad market rise or fall.

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To complicate the matter even more, it is possible to buy a derivative of a derivative of a
security. For example, you can purchase an option on a future of a stock, bond,
commodity or an index.

In Asia, options either follow the American style or the European style. The American
style is that the option may be exercised at any time up to and including the expiration
date. The European style means that an option may only be exercised on the expiration
date.

Warrants

Warrants are standardized options but typically with a more distant expiration date.
There are warrants on bonds, equities, commodities, and currencies.

Warrants are frequently issued as part of a bond. These bonds act much like a
convertible bond and to a large degree the price of the bond reflects the performance of
the underlying equity. The warrants allow for the bondholder to purchase a certain
stated amount of common stock.

Swaps

Swaps are contracts whereby two parties agree to make periodic payments to each
other. For example, an interest rate swap would involve one party paying interest at a
fixed rate, while the other party to the contract would pay interest at a floating rate (such
as the prime rate in effect at the payment date). In a currency swap, one party agrees to
pay a certain amount in a stated currency and the other party makes its payment in a
different currency. Both sides, of course, are betting that the value of their method of
payments will decrease and the other side will increase. For example, in a currency
swap, two parties agree to swap HK$1million for the equivalent amount of Singapore
dollars on the date the contract is made. The party paying on the payment date in HK$
is betting that the value of the HK$ will fall and be worth less when the payment is due
and the value of the S$ that he will receive will be worth more.

Repurchase Agreements

Repurchase agreements, or repos, are contracts where the party selling a security to
another party agrees to buy back that security at a future date at a specified amount.
The party selling, therefore, is betting that the securities will be worth more than the
specified amount on the date of the repurchase and the party buying is betting that the
securities will be worth less.

Appendix A

ISLAMIC INVESTING PRINCIPLES

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Halal –Islamic and approved

Haram- non-Islamic and prohibited

The Islamic Capital Market is similar to conventional capital markets and is represented
by both equity and bond markets. Fundamental to Islamic capital market operation, is
that all financial transactions must conform with the Syariah principles. The main
prohibited (haram) actions under the Syariah principals are riba and gharar.

Riba means literally an increase or addition. Technically, in a loan transaction, it

denotes any increase or advantage obtained by the lender as a condition of the loan. It
is generally interpreted to mean that interest cannot be charged on loans. It also means
that in practice rather than charging interest on loans, the investor takes a share in the
profits, if any, and is liable for any losses. The activity therefore involves investing not
lending and is more similar to the German, Japanese and Spanish banking systems
rather than the British or American systems.

With Islamic investments, therefore, interest is converted into capital gains. Profit and
loss sharing, with the profit sharing ratio predetermined, is Hallal. Under the Syariah
principals, then, zero-coupon or discount bonds are approved, since these instruments
forgo interest and take any profits in the form of capital gains. Any equity or derivative
would also seem to be approved since they are profit sharing instruments and not
interest paying.

Gharar denotes deception, uncertainty or ambiguity and generally refers to the

existence of an element of deception in the trade or exchange through ignorance of the
goods or the price through faulty description of the goods
Another principle of Islamic investing is governed by the Quran that distinguishes
between interest and trade. This principle urges Muslims to receive only the principal
sum loaned and the principal should only be taken back subject to the ability of the
borrower to repay it. The distinction between interest and trade allows various Islamic
financial instruments to “mark up” deferred payments or early payment discounts, trade
financing commissions and leasing transactions Less clear is what is meant by “ability
to repay” and what triggers such an inability.

Islamic loans are, therefore, a good deal more risky than conventional interest bearing
securitiized loans.

Islamic investments exclude tobacco, alcohol, gaming and other undesirable sectors.
These investments, therefore, are similar to what in the West is known as “socially
conscience” or “ethical” investments. Many Western collective investment schemess are
operated under these principles.

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 ISLAMIC INVESTMENT BANKING TERMS

Islamic borrowers are reluctant to give away a share in the profits of their enterprise and
therefore Islamic banking takes the form of a “mark-up” rather than profit sharing. The
mark up method is favored because it is simple in design, profitable in return and its
short-term nature is ideal for managing liquidity in a market with little or no inter-bank
facility.

Al-Wadiah Yad Dhamanah (safekeeping with guarantee) refers to goods and deposits
that have been deposited with another person who is not the owner for safekeeping.
Wadiah is a trust and the depository becomes the guarantor who guarantees repayment
of the whole amount of the deposit or any part thereof outstanding in the account of the
depositors when demanded. The depositors are not entitled to any share of the profits
but the depository may provide returns as a gift

Bai ‘al-Istijar refers to an agreement between the client and the supplier, whereby, the
supplier agrees to supply a product on an ongoing basis at an agreed price and on the
basis of an agreed mode of payment.

Bai ‘al salam involves the advance payment for goods to be delivered later. There is no
sale unless goods exist at the time of the deal or are defined and a date is fixed. At first
glance this looks like a commodities future except that the parties cannot reserve the
option of rescinding the contract. If the product is defective on delivery there is redress.
This is typically used to fund agricultural production to help a farmer buy seed.

Ijara is the Islamic form of leasing. The bank buys machinery or other equipment and
leases it out under installment plans. As with western leasing there may be an option to
buy the goods built into the contract. Ijara wa iqtina is renting then purchasing at the
end of the contract.

Istisna is a contract for the acquisition of goods by specific order where the price is paid
progressively in accordance with the progress of job completion. This is used, for
example, in the construction of a house where payments made to the builder or the
developer are made according to the stages of work completed.

Murabahah is cost-plus financing. The bank finances the purchase of an asset by

buying it on behalf of its client. The bank then adds a “mark-up” in its sale price to its
client who pays for it on an installment basis. The bank stands in between the buyer and
the seller and is liable if anything goes wrong. There is thus some sort of guarantee with
respect to the quality of the goods provided. Title to the goods financed may pass to
the client at the outset or on a deferred basis.

Mudharabah/Muqaradhah is trust financing and is similar to a loan, except that there is

no interest paid and the principal is at risk. The lenders/investors (rabb al-mals) “invest”
through a borrower/entrepreneur (mudarib) who manages the project. Profits are
shared on a pre-agreed basis, but losses are born only by the rabb al-mals, or investors.
The rabb al-mals have no control over the management of the project.

Musyaraka is financing through equity participation in a partnership. Here the partners

or shareholders use their capital through a joint venture. Profits are split between the

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shareholders according to some agreed to formula linked to the investment ratio. The
ratio takes into account the resources contributed by each party, not just financial but
also experience and expertise. Losses are shared strictly on the basis of equity
participation. Management of the project may be carried out by either, both or only one
of the parties.

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