TOPIC 7 & 8

ISLAMIC
BANKING AND
FINANCE
Part 1
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7.1 BANKING AND FINANCIAL SYSTEMS

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• In other words financial
system can be known where
ever the exist the exchange
of financial medium(money)
while there is an reallocation
of funds into the needy areas
(financial markets, business
firms, banks) to utilize the
potential of ideal money and
place them in use to get
benefits out of them.
• This whole mechanism is
known as financial system.
• Money, credit, and finance are used as medium of exchange in
financial systems. They serve as a medium of known value for
which goods and services can be exchanged as an alternative to
bartering.
• A modern financial system may include banks (public sector or
private sector), financial markets, financial instruments, and
financial services. Financial systems allow funds to be allocated,
invested, or moved between economic sectors. They enable
individuals and companies to share the associated risks.
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What is the difference between banking and
finance?
Finance is generally related to all types of
financial, this could be accounting, insurances,
and policies. Whereas banking is everything
that happens in a bank only. Banking and
finance is also referred to as a term of
managing your money by investing it in either
banks or other financial institutions.

Why is banking and finance important?

A well-functioning financial system is fundamental to a modern economy, and banks
perform important functions for society. ... Banks should be able to lend money to
consumers and businesses in both upturns and downturns. In addition, payments for
goods and services should be processed swiftly, safely and at low cost.

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7.2 THE COMPONENTS OF A FINANCIAL SYSTEM

Financial institutions
Financial institutions provide financial services for members and clients. It is also termed as financial
intermediaries because they act as middlemen between the savers and borrowers.

Banks
Banks are financial intermediaries that lend money to borrowers to generate revenue and accept deposits . They
are typically regulated heavily, as they provide market stability and consumer protection.

Banks include: *Public banks *Commercial banks *Central banks *Cooperative banks *State-managed
cooperative banks
*State-managed land development banks

Non-bank financial institutions

Non-bank financial institutions facilitate financial services like investment, risk pooling, and market brokering.
They generally do not have full banking licenses.

Non-bank financial institutions include: *Finance and loan companies *Insurance companies *Mutual funds
*Commodity traders
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Financial markets
Financial markets are markets in which securities,
commodities, and fungible items are traded at prices
representing supply and demand. The term "market" typically
means the institution of aggregate exchanges of possible
buyers and sellers of such items.

Primary markets
The primary market (or initial market) generally refers to new
issues of stocks, bonds, or other financial instruments. The
primary market is divided in two segment, the money market
and the capital market.

Secondary markets
The secondary market refers to transactions in financial
instruments that were previously issued.

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Financial instruments
Financial instruments are tradable financial assets of any kind. They
include money, evidence of ownership interest in an entity, and
contracts.[7]

Cash instruments
A cash instrument's value is determined directly by markets. They may
include securities, loans, and deposits.

Derivative instruments
A derivative instrument is a contract that derives its value from one or
more underlying entities (including an asset, index, or interest rate).

Financial services
Financial services are offered by a large number of businesses that
encompass the finance industry. These include credit unions, banks,
credit card companies, insurance companies, stock brokerages, and
investment funds.

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Central Banks

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THE FOUR BASIC PRINCIPLES OF FINANCE

PRINCIPLE 1: Money has a Time Value

PRINCIPLE 2: There is a Risk-Return Trade-off
PRINCIPLE 3: Cash Flows are the Source of Value
PRINCIPLE 4: Market Prices Reflect Information

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PRINCIPLE 1: MONEY HAS A TIME VALUE
A dollar received today is worth more
than a dollar received in the future.
Conversely, a dollar received in the future
is worth less than a dollar received today.

Because we can earn interest on money

received today, it is better to receive
money sooner rather than later.

For example, suppose you have a choice

of receiving $1000 either today or one
year from now. If you decide to receive it
a year from now, you will have passed up
the opportunity to earn a year’s interest
on the money. Economists would say you
suffered an ”opportunity loss” or an
“opportunity cost”.
The time value of money (TVM) is the concept that money available
at the present time is worth more than the identical sum in the future
due to its potential earning capacity. This core principle of finance
holds that, provided money can earn interest, any amount
of money is worth more the sooner it is received.

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PRINCIPLE 2: THERE IS A RISK-RETURN TRADEOFF
• Principle 2 is based on the idea that individuals are risk-averse. They prefer to get a certain return on
their investment rather than an uncertain return.
• The world, however is a risky place. So, some individuals will have to make investments that are risky.

How are investors induced to hold risky investment?

By offering investors a higher expected rate of return

on the riskier investments.

*Notice that we refer to expected return rather than

actual return.

The risk-return relationship will be a key concept as

we value assets and proposed new investment
project throughout this course.

High risk high return, low risk low return.

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PRINCIPLE 3: CASH FLOWS ARE THE SOURCE OF VALUE

• Profit is an accounting concept designed to measure a business’s performance over an

interval of time.
• Cash flow is the amount of cash that can actually be taken out of the business over this
same interval.

A company’s profit can differ

• Cash flows represent actual money that can be spent.
dramatically from its cash
• Cash flows are what determines an investment’s value.
flows.

• Investors make the best choices when they look at marginal, or incremental cash flows.
• That is why we focus on the incremental cash flow to the company as a whole that is
produced as a consequence of a decision.
• The incremental cash flow to the company as a whole is the difference between the cash
flows the company will produce with the potential new investment it’s thinking about
making, and the cash flows it would produce without that investment.
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• To understand this concept, let’s think
about the incremental cash flows of a
movie like Pirates of the Caribbean. Not
only did Disney make money at the box
office from the movie, but also the
movie increased the number of people
attracted to Disney theme parks to go
on the “Pirates of the Caribbean” ride.

• So, if you were to evaluate that movie,

you’d want to include its impact
throughout the entire company.

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PRINCIPLE 4: MARKET PRICES REFLECT INFORMATION
• Investors respond to new information by buying and selling their investments.
• The speed with which investors act and the way that prices respond to the information
determine the efficiency of the market.
• When earnings reports come out, prices adjust immediately to the new information,
moving upward if the information is better than expected and downward if it is worse
than expected.
• In efficient markets like U.S. and other developed countries, this process takes place very
quickly.
Managers can expect their company’s share prices to respond quickly to the
decisions they make. Good decisions will result in higher stock prices. Bad decisions
will result in lower stock prices.

NEWS RELEASE 15
• One day, in November 2005 while Nike CEO William Perez flew aboard the company’s Gulfstream jet,
traders on the ground sold off a significant amount of Nike’s stock.
• Why?
• Because the plane’s landing gear was malfunctioning, and they were watching TV coverage of the
event! While Perez was still in the air, Nike’s stock dropped 1.4%.
• Once Perez’s plane landed safely, Nike’s stock price immediately bounced back.

In the financial markets there are ever-vigilant investors who are looking to act even in anticipation of the release of
new information.

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7.3 ISLAMIC BANKING AND FINANCE

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