The nexus, downside risk and asset allocation between oil and Islamic stock markets: A cross-country analysis

Abstract

This study performs empirical analyses on Islamic stock markets of 20 countries disaggregated into oil-importing, oil-exporting, and moderately oil-dependent countries. We investigate the asymmetric dynamic linkages between oil and Islamic stock prices for the period from May 2002 to February 2018 based on a nonlinear-Autoregressive Distributed Lag (ARDL) framework using both global and domestic oil prices. For comparison purposes, we also investigate conventional stock markets of the same countries and during the same sample period. Our results show five interesting findings. First, Islamic stock markets react to oil price shocks differently across time horizons and markets. Second, in the long run, our results support that a negative shock in oil prices significantly increases stock prices of all Islamic stock markets irrespective of the country's category (importing, exporting, or moderate oil dependency). Third, in the long run, a divergent reaction is established (regarding magnitude) across markets depending on their oil net position. Islamic stock markets in oil-exporting countries specifically exhibit a more aggressive reaction to negative oil price shocks (world and domestic) than their oil-importing and moderately oil-dependent counterparts. Finally, in the short run, we find that negative oil price changes have a more significant effect on Islamic indices than positive ones. For the conventional counterparts, findings indicate that the long-run effect of oil price changes is not significant for all countries. The short-run results show that, independently from the country's category, the effect of the negative oil price shocks seems to be more significant than oil price increases and that the reaction is similar between countries, in terms of influence. These findings are confirmed through an out-of-sample predictive accuracy test, highlighting that asymmetric specifications improve the predictability of the both Islamic and conventional stock prices of the studied markets. We also examine the implications for risk management in the presence of oil risk. We find evidence of diversification benefits and oil downside risk reduction in a two-assets, Oil-Islamic stocks, investment portfolio, being greater than for their conventional counterparts. The implications of this study will be of interest to Islamic portfolio managers and market regulators to better adopt proactive awareness regarding Islamic stock market behavior, as well as for international investors since it suggests Islamic stocks as an alternative to conventional stocks concerning Oil risk reduction.