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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 I BONDS Bearer and Registered Bonds General Obligation and Revenue Bonds Treasury Bonds Treasury Notes Treasury Bills Participating Bonds Convertible Bonds Zero Coupon Bonds High Yield (Junk) Bonds Warrant Bond (Bonds with warrants) Indexed Bonds Sinking Bond Funds Commercial Paper Mortgaged backed Securities II EQUITIES Common Stock Preferred Stock Par Value Book Value Classes of Stock Stock Splits Dividends Ex-Dividend DRIPS Treasury Stock Depository Receipts III COMMODITIES

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IV

DERIVATIVES Futures Options Covered calls Uncovered calls Index options Warrants Swaps Repurchase Agreements

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APPENDIX A PRINCIPLES OF ISLAMIC INVESTING History of Islamic Banking Islamic Investing Banking Islamic Retail Banking 14 14 15 16

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.

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 owners 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.

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 countrys 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. Treasurys 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. 4

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 bonds 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 bonds 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.

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 corporations 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 corporations 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.

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 companys net worth or the value of the shareholders 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 corporations 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 companys 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 reinvestment 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 corporations 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 corporations 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

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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 dont 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. 11

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 15

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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