Chapter 2

The Capital Markets:

Introduction and Overview

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2012.
Topics Covered

• Overview of the Capital Markets

• Economic Role of Capital Markets

• Main Components

• Equity, Debt, Forex, and Derivative Markets

• Capital Market Risks

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Overview of the Capital Markets

• The capital markets play a very important role in the development of

a nation.
• In many ways, capital markets are at the heart of a nation’s financial
system.
• Economists often divide the overall economy into two sectors, the
real sector and the financial sector.
• While the real sector of the economy produces the nation’s output of
goods and services, the financial sector plays the vital role of
providing the financing needed to fund this productive capacity.
• This it does by mobilizing the savings of surplus units and channeling
them to productive units that need the funds.

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Capital Markets and the Economy

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Capital Markets and the Economy

• Capital markets are a subsector of the overall financial sector.

• Equity and debt markets are key components.
• Derivatives and foreign exchange markets form the remaining
components of capital markets.
• Capital markets in Muslim countries are still small compared to their
respective banking sectors due to dearth of products and so on.
• From the investor’s perspective:

Capital Markets Banks

Direct access Indirect access

Direct risk Indirect risk

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2012.
Components of Capital Markets

The Capital Market

Equity Debt

Stock Market Money Market

Bond Market

Foreign Exchange / Derivatives Market

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What Do Capital Markets Do?

Traditionally capital markets have had four functions

attributed to them:

1. Intermediation between surplus and deficit units.

2. Providing the payments system.
3. Enabling intertemporal transfers.
4. Medium for monetary policy transmission.

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Modern capital markets have an expanded role.

• Means and avenue for risk management—derivative markets.

• Price discovery—interest rates, cost of funds (cost of debt,
equity).
• Assimilate the actions of participants and reflect them as market
information.

The ability of capital markets to disseminate information in a timely

manner and in a cost-effective way is perhaps the most important
function of markets these days.

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Trends

Globalization
 Faster transmission of information

Liberalization
 Economic development
Rise of Islamic Finance and Capital Markets
 Equity screening
 Redesign of bonds
 Islamic derivatives and structured products

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Capital Market Components

• Equity Markets
• Equity financing is essentially risk-sharing finance.
• Unlike debt, there is no fixity in returns.
• The returns to equity are linked directly to returns of the
underlying business.
• Thus, from a philosophical viewpoint, equity is congruent
to Shariah requirements for risk sharing.
• Still, there is a need to avoid investing in stocks of
businesses that are in noncompliant activities.
• This is done by way of Shariah stock screening ( Chapter
9).

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Stock Exchanges of the Islamic world
Country Stock Market Name of Year of
Exchange Capitalization Exchange Establishment
Code
Saudi Arabia TASI US$339.54 billion Tadawul 1993
(Sept. 2010)

Malaysia KLCI US$336 billion Bursa Malaysia 1960

(June 2010)
Turkey XU100 US$270.46 billion Istanbul Stock 1985
(Aug. 2010) Exchange

Indonesia JKSE US$269.9 billion Bursa Efek 1989

(June 2010) Indonesia

Qatar DSM US$109.94 billion Doha Securities 1997

(Sept. 2010) Market

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Stock Exchanges of the Islamic World
Country Stock Market Name of Year of
Exchange Capitalization Exchange Establishment
Code
Kuwait KWSE US$109.86 billion Kuwait Stock 1962
(Sept. 2010) Exchange

Egypt EGX 30 US$75.72 billion Egyptian Stock 1998

(Sep. 2010) Exchange

Iran TSE US$72 billion Teheran Stock 1967

(July 2010) Exchange

Pakistan KSE US$32.5 billion Karachi Stock 1949

(Aug. 2010) Exchange

Oman MSI US$17.82 Muscat Stock 1988

billion(Sept. 2010) Market

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Some Key Stock Exchanges

• Tadawul (Saudi Arabia):

– Establishment of Saudi Arabian Monetary Authority in 1984 aided
the development of capital markets.
– The Capital Market Authority established in 2003 oversees the
exchange.
– The Tadawul all-stock exchange (TASI) consists of 128 stocks.

• Bursa Malaysia:
– In 1996, the Malaysian stock market was the leader among Asia’s
star exchanges such as those of South Korea, Taiwan, and
Singapore.
– By 2010, 1,025 companies were listed in the exchange, a fourfold
increase from 1973.

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Some Key Stock Exchanges

– A second board was added to aid smaller companies with less

than RM 20 million in size.
– Malaysia is probably one of the few Islamic countries that come
close to what economists would call “a complete market.”

- Overall, the stock markets of the Islamic world are small relative to
those of developed countries.

- Aside from inadequate emphasis on stock market development on the

part of authorities, it is also a reflection of other inadequacies, like lack
of good governance, rule of law, and transparency.

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The Debt Markets

• Unlike developed markets, the debt (bond) markets in emerging

markets are less developed and much smaller.

• Recently, sukuk has enabled the development of debt markets is

Muslim countries.

• Tax reforms and incentives fuel the growth of the sukuk market—
Malaysia is the leader in sukuk origination (S&P, Zawya, 2009).

• Challenges for sukuk market.

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The Money Markets

• Enable banks to issue short-term loans.

• Liquidity purposes.
• Represent the short end of the yield curve.
• Money markets in the Islamic world:
– Islamic Interbank Money Market, Malaysia
– Liquidity Management Center, Bahrain

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The Derivatives Market

• Derives value from underlying asset.

• Used for managing different types of risk or hedging.

• Potential for speculation leads to Shariah noncompliance

issue.

• Traded in certain stock exchanges in the Islamic world—

Kuwait, Egypt, and Malaysia.

• Islamic structured products are the new growth area.

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Risks in Capital Markets

• Risk, in finance, refers to uncertainties associated with returns.

• Standard deviation of returns is the common measure of risk.

• Types of risk:
– Market/price risk: Refers to changes in asset price due to
changes in market conditions.
• All market-traded instruments are exposed to price risk.
– Interest rate risk: Refers to changes in asset values due to
changes in nominal interest rates.
• Interest rates and bond values are inversely proportional to each
other.

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Types of Risk
– Default/credit risk: Refers to financial integrity of the counterparty.
• Also known as counterparty risk.

– Liquidity risk: Refers to the inability to dispose of thinly traded

assets quickly.
• Arises due to mismatch between assets and liabilities.

– Political risk: Occurs due to unfavorable regulatory changes or

political climate.

– Regulatory risk: Occurs due to sudden change in banking

regulation or government policy.
• Government’s support to financial institutions to lend irrespective of
risk.

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Types of Risk

– Transparency risk: Occurs mainly due to “intelligent”

accounting practices leading to overstating of profits
or hiding of losses and so on.
• A borrower may understate profits in a partnership.

– Shariah risk: Refers to the possibility that transactions

or instruments deemed acceptable as per Shariah
may subsequently become prohibited.
• Example: BBA and tawarruq.

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 Q&A

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