Global uncertainty and the spillover of tail risk between green and Islamic markets: A time-frequency domain approach with portfolio implications

Abstract

This study first calculates the left tail risks in the renewable energy, green, sustainable, Islamic equity and Islamic bond markets using CAViaR models. Then, applying TVP-VAR based connectedness method it estimates various measures of dynamic connectedness and spillover of the tail risks at short, medium, and long term. Furthermore, through wavelet coherence analysis it examines how various global uncertainties impact such connectedness in time and frequency domain. Lastly, it estimates hedging effectiveness, optimal portfolio weights and Sharpe Ratios to provide practical implications for the market participants. The results show that the tail risk connectedness and spillover are mainly driven by the short-term dynamics emphasizing the importance of short-lived noises in the transmission of down-side risks. Usually, the connectedness of the tail risks is higher during the period of COVID-19 and Russia-Ukraine war. Though the tail risks of Islamic bond and developing Islamic equity markets are mostly isolated in the full sample showing hedging potential of these markets, the network analysis shows their increased connectedness with other markets during the period of COVID-19 and Russia-Ukraine war. In general, mature market indices such as Dow Jones Sustainable World and MSCI global environment indices, Dow Jones Islamic World, US and UK market indices are consistently net contributors/transmitters of tail risk shocks while Islamic bond and developing Islamic equity market indices are net receivers of shocks when they are connected to the network. Two uncertainty indices, that follow volatility related to gold and US dollar, demonstrate hedging potential and predictive power on the connectedness. Dow Jones Islamic World market index usually carries significant weights in optimal portfolio allocations while Islamic bonds from GCC countries have higher Sharpe Ratios indicating their promise as instruments for risk-adjusted profit.