Economic globalization is increasing the co-movement of stock exchanges. Islamic equities, characterized primarily as having relatively low leverage, may be less susceptible to contagion from financial shocks originating in the United States and Asia Pacific.
What’s Inside?
Contagion occurs when diverse equity markets, separated by geographical boundaries, exhibit increasing co-movement along with increasing volatility during periods of financial crisis. The authors examine the co-movement of Islamic and mainstream equity markets across the United States and Asia Pacific to better understand the role of contagion during financial crises and to determine whether Islamic equity markets are more or less exposed to the effects of financial contagion.
How Is This Research Useful to Practitioners?
The screening criteria used to identify Islamic equity markets result in indexes that are distinctly characterized as having less leverage, smaller firms, and less diversification when compared with conventional equity markets. The low leverage of Islamic equities suggests that they would be less susceptible to financial shocks, but this effect may be somewhat offset owing to less diversification and higher concentration in fewer sectors within Islamic markets.
The crises examined include the 1997 Asian financial crisis, the 1998 Russian financial crisis, the 2000 dot-com collapse, and the 2007 subprime mortgage collapse, among others. During these crises, US Islamic stocks are generally less exposed to shocks originating from within the region but more exposed to shocks from outside the region. Islamic Asia-Pacific stocks absorb less shock regardless of where the crisis originates, but shocks originating in the United States affect the Asia-Pacific economy via traditional trade links. In addition, Islamic indexes have relatively higher allocations in real sector stocks, which increases their vulnerability to fundamental-based contagion. The Islamic Asia-Pacific region experiences more long-term volatility during shocks related to trade links. Overall, Islamic stocks perform better than their conventional counterparts during market downturns.
These findings are useful for investors of shari’a-compliant funds and portfolio managers who may benefit from understanding how the nature of financial shocks relates to their contagion risks. Contagion should be considered when selecting managers, and shari’a-compliant funds may help offset investments in highly leveraged firms.
How Did the Authors Conduct This Research?
The authors create custom Islamic indexes by screening companies for compliance with shari’a standards. This filter removes companies associated with things prohibited in Islam, such as alcohol or gambling, as well as companies with greater than 33% of debt financing or those with interest income of 10% or more of total income.
The sample dataset contains daily prices of the Islamic, as well as conventional, equity indexes for the United States and Asia Pacific covering the period 1996–2014, resulting in a total of 4,956 observations. This period is broad enough to include numerous financial shocks. Thus, the authors have several occurrences of crises from which to gather evidence of market co-movements.
Multi-timescale analysis with Morlet wavelet decomposition is used to assess both the time- and frequency-varying features of co-movement. This method accounts for heteroskedasticity bias because volatility should affect both low- and high-timescale correlations. The wavelet analysis provides information about the underlying dynamic structure and causal structure at varying frequencies, which allows the authors to differentiate contagion from interdependence. Cross-wavelets provide information about the relationships between index returns in the time-frequency domain, whereas the wavelet phase difference provides information about the lead–lag relationship. Monte Carlo simulations are used to determine statistical significance at the 95% confidence level.