Testing the Conventional and Islamic Financial Market Contagion: Evidence from Wavelet Analysis

Abstract

This study is a first attempt at testing the extent of contagion for conventional and Shari’ah-compliant stock indices. We examine the period surrounding the U.S. subprime crisis of 2007–9 and the Lehman Brothers collapse of 2008 to determine the relative extent of contagion. We find no clear evidence of contagion during the subprime crisis however, during the Lehman collapse most conventional indices showed contagion. Interestingly, the Shari’ah-compliant indices mostly do not show evidence of contagion. Collectively, our results have important implications for fund managers in terms of asset allocation risk and policymakers seeking an optimal policy response to crises.

KEY WORDS:

• contagion
• conventional compliant stock markets
• Shari’ah-compliant stock markets
• interdependence
• wavelet coherence
• wavelet correlation
• wavelet time-frequency decompositions

Acknowledgments

The authors are deeply grateful to Professor Ali Kutan (the editor) and three anonymous reviewers for their valuable comments which improved the quality of the article greatly. The authors also gratefully acknowledge the helpful comments of the participants at the 14th Malaysian Finance Association annual conference, organized by the Malaysian Finance Association held at Penang, Malaysia at which an earlier version of this article was awarded the “Best Ph.D. Work-in-Progress” Prize.

Notes

^1. Case for Islamic Asset Management by CIMB bank, June 30, 2010.

^2. http://www1.worldbank.org/economicpolicy/managing%20volatility/contagion/index.html.

^3. All computations have been performed using the waveslim package developed by Whitcher (and available at http://www.cgd.ucar.edu/~whitcher) running under the R statistical computing environment (R Development Core Team 2006; Gallegati 2009).