The linkages between oil market uncertainty and Islamic stock markets: Evidence from quantile-on-quantile approach

Highlights

• Investigating linkages between oil market uncertainty and Islamic stock markets from the perspective of the national level

• OVX is used as an indicator for oil market uncertainty, and this paper covers four typical countries' Islamic stock markets.

• The quantile-on-quantile (QQ) approach is applied to empirical analysis.

• We find overall negative linkages between OVX and Islamic stocks.

• The relationship between OVX and the Islamic stock markets does have heterogeneity and asymmetry.

Abstract

In recent years, Islamic finance has become increasingly influential, especially Islamic stocks, which have created huge investment attractiveness. At the same time, the financialization of oil has made the international oil market increasingly uncertain and more likely to affect other markets. To effectively understand the correlation between the two markets, we empirically analyze the cases of four typical countries from the perspective of oil market uncertainty. This paper utilizes OVX as an accurate measure of oil market uncertainty and applies quantile-on-quantile approach to detect the asymmetric and heterogeneous relations between the variables. Our results show overall negative linkages between OVX changes and Islamic stock returns, and there is indeed asymmetry. Namely, the effects of oil market uncertainty will be more pronounced when it is at higher quantiles. Further comparing the results of the selected four countries, we find some heterogeneities. Oil-importing countries are more sensitive than oil-exporting countries, and Islamic countries are more sensitive than non-Islamic countries. The findings of this article about the linkages between oil market uncertainty and Islamic stock markets is meaningful to the research and financial practice in related fields.

Introduction

Islamic finance is deeply influenced by Islamic doctrine and has a series of guidelines that distinguish it from other financial markets. More specifically, there are several unique basic principles for it, such as prohibiting the sharing of interests and risks, prohibiting exploitation and prohibiting the financing of criminal activities. Recently, as the emerging of the Islamic commercial society and the development of the world economy, the Islamic finance has been experiencing enormous growth with its inherent advantages and attracting many international investors. Islamic stock is a typical part of Islamic finance, which has the same characteristics as other Islamic financial assets. Thus, its risk and revenue sharing bring more capability of risk aversion, more and more stock investors are focusing on the Islamic stock markets.

With the growing attention to it, several studies compared the Islamic and conventional stock markets then recognize some differences between them (see e.g., Al-Khazali et al., 2014; Al-Khazali et al., 2016; Ftiti and Hadhri, 2019; Majdoub et al., 2016; Shahzad et al., 2019). And a few studies conduct deep exploration on the relationships between Islamic stock markets and other assets or commodities, for instance, interest rates (Hammoudeh et al., 2016), exchange rates (Hussin et al., 2012), precious metals (Hussin et al., 2013; Mensi et al., 2015; Raza et al., 2016), crude oil (Abdullah et al., 2016; Mezghani and Boujelbene, 2018; Badeeb and Lean, 2018; Narayan et al., 2019) and etc. These studies have found that the Islamic stock market differs from the conventional stock market in terms of market efficiency, information transmission, risk aversion, and linkages with other financial or commodity markets. These processes prove the need for targeted analyses of Islamic stock markets. Though various researches have focused on the characteristics and cross-market relationships of Islamic stock market, existing research barely explored the effects of the uncertainty of related financial market on Islamic stock markets. Among them, an appropriate work is based on the oil market uncertainty, since oil price volatility would always have a profound impact on financial markets.

Specifically, the deepening of oil financialization has gradually made oil an important consideration in portfolio strategies (Fattouh et al., 2013; Lin and Su, 2020), some studies have already analyzed a lot on this area (see Arouri and Nguyen, 2010; Mensi et al., 2017). Given that crude oil has obvious financial characteristics, oil price usually fluctuates drastically. Thus, uncertainty regarding its prices should also be fully considered when constructing an effective portfolio strategy (Henriques and Sadorsky, 2011). In fact, oil price uncertainty refers to the degree and state of volatility in oil prices (Elder and Serletis, 2010). A high degree of uncertainty in oil prices indicates that oil prices are in a more violent state, while the opposite indicates that oil prices are in a stable situation (Gong and Lin, 2017). Oil price uncertainty can delay or change important decisions about production, consumption, investments, and other issues. Thus, uncertainty is inevitably transmitted to the economic and financial system and affects the return of the asset. Further theoretically, whether the net present value is greater than the option value of waiting determines the final investment behavior. As oil price uncertainty rises and the options value of waiting subsequently increases, stock investors may delay their investment decisions, so stock returns will be affected accordingly to fall (Liu et al., 2013; Wang et al., 2017; Maghyereh and Abdoh, 2020). As a special type of the stock markets, the Islamic stock market only filter the industries that conflict with Islamic doctrine, such as gambling, alcohol and pork, so it will also be affected by the uncertainty of oil prices through similar transmission mechanisms. Meanwhile, Islamic stock market follows the principles of revenue and risk sharing, resulting in less speculative activities (Mensi et al., 2016). This may lead to a smoother transmission procedure of the impact from oil market uncertainty to Islamic stock market. In other words, by a similar path, oil market uncertainty could affect both conventional and Islamic stock market, but the impact on the two will be unequal.

Some investigators have demonstrated the financial impact of the oil market uncertainty through empirical researches. They found that oil market uncertainty shows an overall negative impact on the stock returns (Park and Ratti, 2008), and this impact will be asymmetric and long term (Huang et al., 2017; Liu et al., 2013; Xiao et al., 2019; Xiao et al., 2018). Despite the substantial literature considering it, less progress has been made in the area of the linkages between oil market uncertainty and Islamic stock markets. Considering the important status of Islamic stock markets and the inadequacies of the existing researches, we are motivated to unearth some findings in this domain.

In parallel, the previous studies observing the oil market uncertainty are always based on GARCH models (Dutta et al., 2017; Xiao et al., 2018). However, a distinct shortcoming could be found in this method. That is, it can only reflect the historical situation of the oil market but neglects the investors' expectations for future movement. Thus, this paper utilizes the crude oil volatility index (OVX) to indicate the oil market uncertainty, which is proposed by the Chicago Board Options Exchange (CBOE) and contains both historical and future expected information. From prior research works (Campos et al., 2017), OVX appears to be a superior indicator to measure oil market uncertainty, and the proliferation of futures and options on OVX furtherly made it more practical. In addition, a recent literature (Karim and Masih, 2019) furtherly made an initial attempt to investigate the responsiveness of the Islamic stock market returns to the realized volatility of oil price and OVX, which further reveals that Islamic stock market returns are more sensitive to OVX. This directly proves that OVX is a more efficient projection than others, therefore we choose this index as the main proxy of oil uncertainty.

From a methodological perspective, the existing studies have addressed several kinds of methods to detect the relationship between oil and stock markets, such as SVAR, quantile regression, NARDL and etc. (Wen et al., 2019). However, there are always various complexities and heterogeneities in the linkages between two financial variables that made the estimate potentially difficult with these standard econometric techniques (Sim and Zhou, 2015). Theoretically, different countries will have different conditions in oil trade and Islamic prosperity. Net oil importers are more dependent on crude oil than net oil exporters, as a result, when oil uncertainty changes, the net oil importers get more influenced than the latter. This has been empirically demonstrated by Boldanov et al. (2016) and Zhou et al. (2019). Meanwhile, when a country has Muslims as its main religious group, there are naturally more Islamic trading stocks in its financial markets than non-Islamic countries, so the relationship between oil uncertainty and its Islamic stock market may also be different from the national level (Gazdar et al., 2019). In addition, many previous studies (e.g., Antoniou et al., 1998; Chinzara, 2011; Hu et al., 2018) confirmed that the impact of external uncertainties on the stock market is often asymmetric. And Fatima et al. (2019) reveal a similar conclusion which also holds in the Islamic stock market, negative shocks or bad news have stronger effects on Islamic stock as compared to positive shocks or good news. To investigate these possible heterogeneities or asymmetry, we employ a new nonparametric quantile method developed by Sim and Zhou (2015), namely quantile-on-quantile (QQ) approach, and conduct comparative research from the national level. This approach regresses a quantile of explanatory variables on another quantile of explained variables, thus, containing more information and is more flexible than standard quantile regression. Different quantiles of explanatory variables reflect the shocks with different sign and size, for example, 2nd percentile OVX is a large negative shock from oil market uncertainty. That is to say, the quantiles indicate the states of the independent variables, and the QQ approach involves all different states. Thence, it can resolve the heterogenous problem that is ignored by standard econometric techniques.

In summary, analyzing the linkages between oil market uncertainty and Islamic stock markets have important practical significance for promoting portfolios and reduce systemic risks for Islamic investors. The potential connection and inadequate related researches prompt us to work in this area. This study finally made three main contributions. Firstly, we fill the vacuum in the area about oil uncertainty-Islamic stock nexus and shed some new light on the investigation of Islamic finance. Secondly, few studies have studied Islamic stock markets at the national level and compared their different responses to financial uncertainties. In this regard, we premeditate the possible heterogeneities and analyze the cases of four typical countries. Thirdly, most oil uncertainty proxies only contain historical volatility information and traditional methodology is insufficient to detect whether the theoretically asymmetric responses also exist in Islamic stock markets. To overcome these deficits, this research uses the OVX as the main projection for oil uncertainty and employs a more flexible quantile approach, then uncovers comprehensive linkages between OVX changes and Islamic stock returns.

The remainder of this paper is organized as follows. Section 2 introduces the literature review. Section 3 describes methodology used in this study. Section 4 describes the research data. Section 5 presents and analyzes the main empirical results of this work. Section 6 discusses the main conclusion and the implication of this study.