An Introduction to Islamic Finance: Theory and Practice

173

CHAPTER

9

Capital Markets

T

he role of capital markets in promoting an effi cient fi nancial system can-
not be overemphasized. Given that a developed fi nancial system can make
positive contributions to economic development, the existence of vibrant capi-
tal markets becomes a necessity for any economy. Capital markets facilitate
long - term fi nancing for businesses and entrepreneurs by attracting savings
from a large pool of investors. These markets provide long - term capital to
entrepreneurs through a series of short - term contracts (securities) with inves-
tors who may enter and exit the market at will. An effi cient capital market is
expected to perform the following functions:

■ To provide a mobilization mechanism leading to an effi cient allocation

of fi nancial resources in the economy.

■ To provide liquidity in the market at the cheapest price; that is, the low-

est transaction cost or low bid - ask spread on the securities being traded

in the market.

■ To ensure transparency in the pricing of securities by determining the

price of the risk premia to refl ect the riskiness of the security.

■ To provide opportunities for constructing well - diversifi ed portfolios and

to reduce the level of risk through diversifi cation across geographic regions

and across time.

Capital markets consist of primary and secondary markets. Whereas pri-
mary markets are important to raise new capital and depend on the supply
of funds, secondary markets make a signifi cant contribution by facilitating
the trading of existing securities. In some ways, secondary markets play an
equally critical role by ensuring liquidity and fair pricing in the market
and by giving valuable signals about the security. In other words, second-
ary markets not only provide liquidity and low transaction costs, they also
determine the prices of the securities and their associated risk on a continu-
ous basis, incorporating relevant new information as it arrives.
Just as capital markets play a critical role in the conventional fi nancial
system, their role in the Islamic fi nancial system is equally important. Whereas
conventional capital markets have an established track record, Islamic capital

An Introduction to Islamic Finance: Theory and Practice, Second Edition

by Zamir Iqbal and Abbas Mirakhor

Copyright © 2011 John Wiley & Sons (Asia) Pte. Ltd.