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Emerging Markets Review 35 (2018) 120–136

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Emerging Markets Review


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Can Islamic banks have their own benchmark?


A.S.M.S. Azad a,⁎, Saad Azmat b, Abdelaziz Chazi c, Amirul Ahsan a
a
Department of Finance, Deakin Business School, Faculty of Business and Law, Deakin University, 221 Burwood Highway, Burwood, Vic 3125, Australia
b
Suleman Dawood School of Business, Lahore University of Management Sciences, Sector U, DHA, Lahore Cantt. 54792, Pakistan
c
Department of Finance, School of Business Administration, American University of Sharjah, United Arab Emirates

a r t i c l e i n f o a b s t r a c t

Article history: This paper attempts to answer whether Islamic banks can have their own benchmark rate. In
Received 28 February 2017 so doing, the paper investigates the nature of the relationship Islamic interbank benchmark
Received in revised form 30 October 2017 rate (IIBR) and its comparable conventional counterpart, London interbank offer rate (LIBOR).
Accepted 16 February 2018
The dynamics of the two series are investigated to examine the stability of the spread between
Available online 21 February 2018
IIBR and LIBOR, referred to as ‘Islamic premium’ or ‘piety premium’. The findings suggest that
there are both long-term and short-term dynamic relationships between the two rates provid-
JEL classification: ing significant evidence of their convergence and co-movement. Our results also show that the
G15
existence of the IIBR-LIBOR spread is a reflection of the cost of funding and profit potential of
Keywords: the participating IIBR rate-setters. We find that, in addition to the determinants of the credit
IIBR spreads, fundamental news of the panel banks are dominant factors driving the ‘piety pre-
LIBOR mium’. We argue that the Islamic banking industry is operating in a global context, where it
Islamic premium
is highly improbable that its rates can decouple from the global benchmarks. Given that Islamic
Structural model
banking products and their risk return profile are similar to conventional products, arbitrage
activities force Islamic rates to converge with the global benchmark rates.
© 2018 Elsevier B.V. All rights reserved.

1. Introduction

Extant literature on Islamic capital markets tends to suggest strong correlations between the movement of Islamic indices and
their conventional counterparts (see, e.g., Ajmi et al., 2014, Al-Khazali et al., 2014, Aloui et al., 2015, Fakhfekh et al., 2016 and
Alexakis et al., 2017, for a review). Our study is in line with these studies, albeit, extends to interest rate benchmarks used in Is-
lamic as well as conventional banking systems.
In the last decade or so, Islamic banking industry has tried to create its own benchmark rate in order to price Islamic products
more effectively and have a unique rate decoupled from the conventional bank rates. This paper explains why the early efforts to
have an Islamic benchmark rate have failed. We also examine whether there is any likelihood of the Islamic benchmark rate
succeeding in the future as the size of the Islamic banking industry grows.
The size of the Islamic banking industry poses different challenges to its success and credibility. Given the smaller market size (i.e.,
only 1% of the total global banking system) compared to conventional banking, Islamic benchmarks are strongly dependent on inter-
national benchmarks like LIBOR.1 It is plausible that the Islamic benchmark would co-move and converge with the conventional
benchmarks. This trend is unlikely to change substantially in the future even as the size of the Islamic banking industry increases. Mar-
ket forces and the continuous competition between Islamic and conventional banks would ensure convergence between their rates.
⁎ Corresponding author.
E-mail addresses: s.azad@deakin.edu.au (A.S.M.S. Azad), saad.azmat@lums.edu.pk (S. Azmat), achazi@aus.edu (A. Chazi), amirul.ahsan@deakin.edu.au (A. Ahsan).
1
See Alaoui et al. (2015) for a discussion on the impact of LIBOR on the Islamic DFM-UAE return.

https://doi.org/10.1016/j.ememar.2018.02.002
1566-0141/© 2018 Elsevier B.V. All rights reserved.
A.S.M.S. Azad et al. / Emerging Markets Review 35 (2018) 120–136 121

This paper suggests that for the industry to have its own benchmark it should offer financial products that are distinct in na-
ture, with unique risk-return profiles, and not compete with the financial products offered by conventional banks. Otherwise, Is-
lamic banks would remain a sub-set of the conventional banks with similar products and rates.
A number of aspects of asset pricing in the area of Islamic finance has been investigated. However, to the best of our knowl-
edge, no study has so far investigated the co-movement between IIBR and LIBOR, though this subject carries a great deal of im-
portance in the field of Islamic finance. The purpose of creation of IIBR is to have an independent benchmark that would be
different from any other conventional interbank offer rate such as LIBOR. Since Islamic banks operate based on Shariah principles,
it is expected, theoretically, that IIBR would not have any significant dynamic relationship with LIBOR, and no convergence would
exist between these two rates. Our research is motivated by this context as we investigate whether any relationship exist between
IIBR and LIBOR in both the short- and long-term. Further, we investigate the factors that contribute to the relationship between
IIBOR and LIBOR.
Since the inception of the Islamic finance industry, it was envisaged that as the industry would grow and capture a significant
proportion of the banking industry, it could have its own benchmark rate. More importantly, this rate would be decoupled from
the conventional rate and move independent of it (see Khan, 2010). The Islamic benchmark would be representative of the risk of
the Islamic banking industry. This, in a way, would enable the industry to come out of the shadow of the conventional banking
and emerge as a representative industry of a unique asset class. In the presence of a distinct rate, the competition between Islamic
and conventional banking would be like that of two distinct asset classes, such as banks and mutual funds, where each would
impact the other but only partially (see Azmat et al., 2016).
In this paper, we first analyse whether the Islamic finance industry has in any way succeeded in achieving the feat of an in-
dependent benchmark. We use Islamic Interbank Benchmark Rate (IIBR), developed by sixteen Middle Eastern banks from six
Middle Eastern countries in conjunction with Thomson Reuters, as a proxy for the Islamic rate.2 The IIBR rate's US dollar
denominated value is used.3 For the conventional rate, we use the US dollar denominated London Interbank offer rate (LIBOR),
which is a global benchmark. To gauge the nature of relationship between IIBR and LIBOR, we analyse the long term equilibrium
and short-term dynamic relationships between the two rates using daily data from April 14, 2012 to October 9, 2015.4 We use the
standard Johansen cointegration method to test the long-term relationship, and Engle's (2002) dynamic conditional correlation
(DCC) to examine the short-term dynamic relationship. While the pricing has important implications from the practical viewpoint
of delinking IIBR from LIBOR, the stability of the relationship between these two benchmarks has implications for the rate-setters,
investors, arbitragers and speculators.
We also test whether the difference between the two rates is simply a reflection of the expected cost of short term interbank
Shariah compliant funding transactions, as claimed by Islamic banks, or is also affected by other market forces. In so doing, we first
examine the causal link between stock returns of the IIBR panel banks and premium. We then model this premium using
Longstaff and Schwartz (1995)'s structural model of credit spreads as used by Covrig et al. (2004) among others. This second
part of empirical analysis includes variables that capture market risk, intrinsic Islamic bank risk, news related to IIBR panel
bank performance, and their credit ratings upgrade or downgrade.
The findings suggest that there are both long-term and short-term dynamic relationships between the two rates (IIBR and
LIBOR), which provides significant evidence for convergence and co-movement. We also find that the premium between the
two rates is stable as shown by the long-term cointegration tests and dynamic conditional correlation (DCC) method. The causal
link between IIBR-LIBOR spread and stock returns of the panel banks illustrates that the IIBR-LIBOR spread (i.e., piety premium) is
a reflection of the cost of funding and profit potential of the participating IIBR rate-setters. However, this does not reflect whether
a ‘piety premium’ is only affected by the cost and profitability of the Islamic banking or whether other variables influence the
IIBR-LIBOR spread as well.
Hence, we proceeded to the structural model of credit spread to capture whether the ‘piety premium’ is associated with its
determinants as used in conventional asset pricing, plus the fundamental news of the panel banks. Our analysis shows that a flat-
ter yield curve resulting in a high Islamic premium implies that a local interest rate set by the central bank has an impact on IIBR.
We also find the stock index volatility, which captures intrinsic risk of the Islamic finance industry, to be the most determining
factor of Islamic premium. This supports the assertion that the premium is a reflection of the cost of funding and profit potential
of the participating IIBR rate-setters. Moreover, supplying Shariah compliant finance, combined with good news and credit ratings,
seems to provide panel banks enough room to charge a higher rate over their conventional counterparts.
The findings of short-term and long-term relationships between IIBR and LIBOR suggest that the Islamic benchmark is strongly
influenced by, and dependent on, international benchmark rates. Any difference therein is just an outcome of the individual coun-
try, industry, or bank level, differences in cost and risks. This inference is corroborated by the findings of the structural model of
credit spread, which suggest that it is not only the banks' fundamental information but market forces also have substantial influ-
ence on their relationship and spread.

2
The official Contributor Panel for the IIBR as of 22 November 2011 is comprised of 17 members as follows: Abu Dhabi Islamic Bank, Ahli United Bank, Al Baraka Bank,
Al Hilal Bank, Al Salam Bank, Alinma Bank, Bahrain Islamic Bank, Barwa Bank, Dubai Islamic Bank, Ithmaar Bank, Kuwait Finance House, Masraf Al Rayan, National Bank
of Kuwait, National Commercial Bank (Al Ahli), Noor Islamic Bank, Qatar Islamic Bank, Sharjah Islamic Bank.
3
The reason to provide the IIBR in US dollar is to have uniformity across all contributors, which have substantial reserves in US dollars and five of the six countries peg
their currencies to the US dollar.
4
The data ends in October, 2015 for two reasons: (i) the IIBR rates were reported in bid rates since late 2015 and (ii) Thomson Reuters temporarily suspended the
IIBR rates.
122 A.S.M.S. Azad et al. / Emerging Markets Review 35 (2018) 120–136

Furthermore, the above findings indicate that the Islamic banking industry is operating in a global context, where it is highly
improbable that its rates would decouple from the global benchmarks. Given that Islamic banking products and their risk return
profile are similar to conventional products, arbitragers would ensure that Islamic rates converge with global benchmark rates.
The comparison of the Islamic rate with the global benchmark suggests also that the convergence and co-movement are unlikely
to change with the size of the Islamic finance industry. Even if the size of the Islamic finance industry reaches a significantly high
proportion in a country, it would still be affected by the global finance industry because of their interrelationships and interde-
pendencies stemming from economic globalisation. Our findings imply that only a significant change in the way Islamic banks
carry out their business, and structure their products, could ensure that they emerge as an alternative asset class with a unique
benchmark rate.
The study contributes to two distinct strands of the literature: the Islamic finance and the interbank credit spread literature. In
the Islamic finance literature, this study contributes to the body of research that questions the observed similarities of the industry
with conventional finance (see for instance, Chong and Liu, 2009; Khan, 2010; Beck et al., 2013). The majority of the research re-
lated to Islamic finance compares the performance between Islamic and conventional banking or performance between Islamic
and conventional indexes. Our research goes beyond this as it aims to identify the co-movement between IIBR and LIBOR. Further,
our research also contributes significantly to the debate on whether Islamic finance has been able to perform independently from
its conventional counterpart. In the interbank credit spread literature (Collin-Dufresne et al., 2001; Covrig et al., 2004), this is, to
the best of our knowledge, the first study that investigates the relationship between IIBR and LIBOR. It is also the first of its kind
to analyse the determinants of the IIBR-LIBOR spread or ‘Islamic premium’.
The study has implications for Islamic banks, policy makers and investors/arbitragers. For Islamic banks and policy makers, the
study suggests that the introduction of IIBR has not been a successful experiment. Given the global context in which the Islamic
finance industry is operating, it is unlikely that its benchmark rate would decouple from the conventional rates. We suggest that
the industry should make significant changes to the way it conducts its business before any changes could be expected. For the
investors/arbitragers the study suggests that the ‘Islamic premium’ is not an opportunity for arbitrage but rather reflects the in-
trinsic Islamic banking industry risk.
The remainder of this paper is organised as follows. Section 2 discusses the institutional details of the two benchmarks namely
IIBR and LIBOR. Hypotheses are developed in Section 3. Section 4 provides a brief summary of data while the methodology is
discussed in Section 5. Section 6 presents the results and Section 7 provides the summary and conclusion.

2. Institutional details: IIBR and LIBOR

Prior to IIBR, LIBOR was used as a benchmark in the pricing of Islamic financial instruments. Islamic bankers and Shariah ad-
visors were much aware of this shortcoming and tried to come up with a benchmark different from conventional LIBOR. In accor-
dance with Shariah requirements, a relevant benchmark was needed to reflect the average expected cost of short term interbank
Shariah compliant funding transactions (such as Murabaha, Ijarah and Mudarabah). This resulted in some GCC (Gulf Cooperation
Council) high profile Islamic banks, in collaboration with Thomson Reuters, introducing a benchmark rate that is congruent with
the Islamic law and intended to provide a robust indicator of the average expected cost of short term interbank market funding.
The next sub-section provides a snapshot of IIBR and LIBOR setting process and the Islamic premium (IIBR-LIBOR spread).

2.1. IIBR and LIBOR setting process

The procedure of fixing and final publication of the IIBR, as shown in Fig. 1 (Appendix B), is different from that of LIBOR. Fig. 1
suggests that the final rate fixing of IIBR is strictly guided by two committees: Shariah Committee and Islamic Benchmark Com-
mittee. The Shariah Committee, comprised of four members ensures Shariah compliance of IIBR and regulates the selection, admis-
sion and exclusion of contributor panel banks. The Islamic Benchmark Committee, provides the commercial and technical
expertise required for the proper implementation and continuing integrity of the IIBR. The Islamic Benchmark Committee includes
contributor panel banks, internationally renowned Shariah scholars and organisations like Thomson Reuters, Islamic Development
Bank, and the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI). Unlike LIBOR, these bodies confirm
that the final IIBR is based on the actual rate of return on capital as practiced by Islamic banks or the opportunity cost of capital
that is used as the basis for transaction in the market. IIBR also captures the average profit rate at which bids are offered for in-
terbank Shariah compliant funding transactions between prime Islamic banks and fully segregated Islamic banking windows
within the Gulf Cooperation Council (GCC) interbank market. The panel banks contribute on each working day, Sunday through
Thursday, the profit rates to be expected from Shariah compliant funding transactions for various tenors.5 To make sure that the
rates are genuine and error-free, Thomson Reuters undertakes both automated and manual audit and review procedures. In ad-
dition, the rates are based on pre-defined questions specified by the Islamic Benchmark Committee and approved by the Shariah
Committee.
IIBR is fixed at 11:00 am, Makkah time (GMT + 3). Contributions for the IIBR are accepted from 9:00 am to10:44 am, Makkah
time and a minimum of 8 banks need to contribute to each tenor/maturity. A participating bank has to supply rates to all points
on the curve (all tenors) on every day. A contributor is permitted to keep the same rates for one additional day. After collecting

5
Because of differences in weekdays/weekends between the GCC countries and the rest of the western world, we have confirmed with Thomson Reuters that IIBR
rates are moved to a Friday date from coming Sunday. Monday to Thursday IIBR match with LIBOR dating.
A.S.M.S. Azad et al. / Emerging Markets Review 35 (2018) 120–136 123

and processing the data, Thomson Reuters publishes the IIBR benchmark rates for different tenors. Publication of the official rate
for that particular day is at 11.00 am, while the value dates for settlement are T + 0 for overnight funds and T + 2 for all other
tenors. So far, 8 different tenors (overnight, 1 week, 1 month, 2 months, 3 months, 6 months, 9 months and 12 months) have been
introduced. To ensure that outliers do not influence the distribution, as in LIBOR, the top and bottom quartiles (25%) of the
rates are excluded and the average of the remaining mid quartiles' rates is calculated to produce the IIBR, rounded to 5 decimal
places. The panel banks come to know the final rate only after the rate is published by Thomson Reuters. The current maximum
time lag (assuming LIBOR updates at 11:59:59 am, London time) between IIBR and LIBOR is 4 h. The implications arising out of
this timing difference on the determination of the “Islamic premium” are explained in this paper. Appendix A shows a screenshot
of the IIBR rates for different tenors on a particular day.
Until January 31, 2014, the LIBOR was fixed by the British Bankers' Association (BBA), hence known as BBA LIBOR. However,
due to some manipulations, since February 1, 2014, Intercontinental Exchange Benchmark Administration Limited took over the
administration of the LIBOR, changing it to the ICE LIBOR. LIBOR is fixed each day between 11:10 am and 11:59:59 am, London
time. The rate is used as the basis for the calculation of short-term interest rates globally and is used as the benchmark for set-
tlement of interest rate contracts on many of the world's major futures and options exchanges. The final rate determination goes
through a number of steps. First, each of the contributing panel members supplies a rate shortly before 11:00 am each business
day. Second, these rates are ranked in order and only the middle two quartiles are averaged in determining LIBOR. According to
recent ICE LIBOR, there are currently 18 banks that contribute quotes for the dollar LIBOR.

2.2. IIBR-LIBOR spread or “Islamic premium”

Fig. 2 shows the daily 6-month IIBR and LIBOR rates both in US dollar from 14 November 2011 to October 09, 2015. In the first
few months after commencement, IIBR rate was lower than LIBOR, as IIBR reported bid rates instead of offer rates. However, this
mistake was later corrected and since 16th April 2012 panel banks started to use offer rates, which exceeded LIBOR for all tenors,
thus indicating IIBR-LIBOR spread as shown in Fig. 3. For a better visual inspection, this figure shows only two tenors (overnight
and 6-month). Fig. 3 clearly states that IIBR-LIBOR spread is positive for the entire sample period. As can be seen from this figure,
this spread has even exceeded 50 basis points for 6-month tenor. Interbank borrowers are ready to pay this spread as a “piety
premium” to the short-term lenders that strictly follow the Shariah law. Since this spread persists over the entire sample period,
it is important to explore the relationship between these two benchmark rates as well as the factors/determinants driving the
spread. An empirical investigation of the relationship should provide policy implications to the investors, panel banks, central
banks of the panel bank countries, and the regulators of IIBR benchmark settings.

3. Literature review and hypothesis development

This section discusses the literature and develops the necessary hypotheses related to the relationship between the two bench-
mark rates and the determinants of the ‘Islamic premium’. The section starts with a discussion of the Islamic prohibition of inter-
est and the use of interest-based pricing in financial instruments. The impact of these practices on a possible IIBR-LIBOR
convergence is then examined to develop hypotheses for this study.

Fig. 2. IIBR-LIBOR rates (6-month). This figure shows the daily 6-month Islamic interbank benchmark rate (IIBR) and London interbank offered rate (LIBOR) both in
US dollar. The rates are shown in percentage points. The sample covers the daily data from November 14, 2011 through October 09, 2015. The figure is based on
the data collected from DataStream.
124 A.S.M.S. Azad et al. / Emerging Markets Review 35 (2018) 120–136

Fig. 3. IIBR-LIBOR spread for overnight and 6-month tenors. This figure shows the daily Islamic Premium (IIBR-LIBOR Spread) for overnight (ON) and 6-month
maturities in US dollar. The spreads are shown in percentage points. The Islamic Premium or IIBR-LIBOR Spread for a given maturity is calculated as the difference
between Islamic interbank benchmark rate (IIBR) and London interbank offered rate (LIBOR). The data for calculating the spread are collected from DataStream.
The sample covers the daily data from April 16, 2012 through October 09, 2015.

3.1. IIBR-LIBOR convergence

Islamic law prohibits any excess to the principal in a loan contract. To neutralize this prohibition, Islamic instruments are ei-
ther joint venture- (e.g., Musharakah/Mudarabah) or trade-based (e.g., Murabaha and Ijarah) (Ayub, 2007). Joint venture based in-
struments involve a profit and loss sharing arrangements where participant's principal and return are not guaranteed but depend
on the performance of the underlying venture. These instruments are more commonly reported on the liability side of Islamic
banks rather than on the asset side (Khan, 2010). Since a typical Islamic bank deposits are joint venture based they are, in theory,
more risky for depositors than conventional banks as withdrawal requests can be refused and any asset side losses can be passed
on to the depositors.
The Islamic bank's asset side is dominated by trade or sale based instruments mainly Murabaha and Ijarah. A typical trade
based instrument involves a bank converting a debt contract into a sale or lease. The bank instead of giving a loan asks the client
to specify the underlying asset for which it needs financing. The Islamic bank then adopts a legal stratagem such that the under-
lying asset temporarily comes under bank's ownership before it is sold (or leased) to the client at a higher price on the basis of
deferred payment.
The profit rate that Islamic banks offer on their joint venture style deposits accounts and trade based asset side are pegged to
conventional interest rate benchmarks (Ayub, 2007). This interest based pricing has been declared Shariah compliant by regula-
tory bodies as long as the underlying asset is not debt based. Though considered Shariah compliant, this practice has always
been a point of contention between Islamic finance participants as it creates an illusion of similarity with the prohibited transac-
tions and compromises the industry's distinct nature and identity (Chong and Liu, 2009). There have been efforts to create a
unique Islamic benchmark that would be distinct from conventional interest rates. It was thought that any effort to create an in-
dependent Islamic benchmark would fail due to its limited size and to potential arbitrage. That is, Islamic finance industry's rel-
atively small size, competition with conventional banking, and arbitrage would ensure that IIBR would eventually converge with
conventional interest benchmarks.
Although the Islamic finance industry has experienced rapid expansion, it represents only 1% of the total finance industry. This
means that Islamic banks in their initial years can only be price takers. While being Shariah compliant, Islamic banks had to op-
erate in an environment where conventional interest rate was viewed as an alternative and used as their opportunity. This meant
that Islamic banks had to match the conventional rate to attract customers who were not highly Shariah conscious. Also, since the
industry's initial focus was on survival, much of the products were replicas of conventional financial instruments (Khan, 2010). In
the absence of a stringent regulatory framework, these products, which have much in common with conventional products, are
thriving. From a pure finance perspective, their underlying risk is no different from a conventional financial product and hence,
the IIBR is expected to be positively correlated with the LIBOR for a corresponding maturity. Therefore, if priced differently,
and the Islamic premium is found to be stable, then they could generate significant opportunities for arbitrage.

3.2. Determinants of Islamic premium

The literature suggests that a differential between two interbank benchmark rates is dependent on intrinsic bank risk and mar-
ket wide factors (see Longstaff and Schwartz, 1995; Collin-Dufresne et al., 2001; Covrig et al., 2004). These factors can be
A.S.M.S. Azad et al. / Emerging Markets Review 35 (2018) 120–136 125

explained by changes in treasury rate, slope of yield curve (long term minus short term rate), change in stock price, volatility of
stock price index, liquidity risk, news, and credit rating change of panel banks (Covrig et al., 2004).
For conventional banks, the treasury rate is supposed to have a negative impact on interest rate spread (see for instance,
Covrig et al., 2004). Covrig et al., 2004 find that TIBOR-LIBOR spread (TIBOR-Tokyo interbank offered rate) is negatively associated
with treasury rate. Longstaff and Schwartz's (1995) argue that an increase in the treasury rate raises the drift in the value of the
firm, which in turn reduces the default probability. Covrig et al. (2004) explain that, for conventional banks where the deposits
rates are almost rigid, such as in Japan, any increase in the lending rates would increase banks' profit and reduce default risk.
For Islamic banks, however, the size and magnitude of the impact of change in treasury rate might be slightly different. Since
the liability side of Islamic banks is joint venture based, part of the increase in profits on the asset side has to be passed on to
depositors. Therefore, their effect would slightly be subdued compared to conventional banks.
Another variable that could affect the Islamic spread is the slope of the yield curve, which reflects the future expectations of
short terms rates. A steeper slope might reflect a future increase in the short term rates, which decreases the bank's default prob-
ability and has a negative impact on the LIBOR spread (Covrig et al., 2004). For Islamic banks, this variable would reflect the IIBR
dependence on the local interest rate. In most jurisdictions, the central bank acts as the lender of last resort for both Islamic and
conventional banks. Moreover, the interest rate that the central bank quotes to Islamic banks is similar to that of conventional
banks, though the underlying products on which the financial transaction takes place are Shariah compliant. Increase in treasury
rate and slope of the yield curve, therefore, should reduce Islamic bank default risk and have a negative impact on IIBR-LIBOR
premium.
Interbank offer rates are a reflection of the industry's riskiness, which can be captured by changes in stock index and its vol-
atility. For conventional banks, an increase in the value of stock price would reflect that the industry, on average, is distanced from
default. Therefore, stock price should have a negative impact on the spread (see Merton, 1974; Longstaff and Schwartz, 1995 and
Covrig et al., 2004). Moreover, volatility of stock price is a measure of the industry's risk and should be accompanied with a higher
premium (see Merton, 1974; Rigobon and Sack, 2003; Bedendo et al., 2007 and Churm and Panigirtzoglou, 2005).
Theoretically, Islamic banks neither offer a predetermined return on customer deposits nor assure the principal. The deposits,
in most cases, are not debt contracts but joint venture style investment accounts. Compared to a conventional debt-based system
where capital/principal is rewarded on the basis of a rate that is fixed ex-ante, the Islamic financial system rewards capital on the
basis of ex-post return. In case of bank default, since the deposit accounts are joint venture based, the Islamic bank can refuse
withdrawal payments. If the Islamic bank makes high profit then the depositors would be entitled to higher returns. Thus, pro-
hibitions of interests do not imply that the opportunity cost of capital is zero, instead, the system allows and promotes business,
equity participation, and direct sharing of risk and reward. In the Islamic finance framework, the incentive to invest depends on
the prospective profitability, where the investor continues to invest until the marginal productivity becomes equal to the marginal
cost of capital. In line with this argument the IIBR rate should be a reflection of the cost of funding and profit potential of the
participating Islamic banks. In essence, Islamic banks' deposits are a form of additional equity having features similar to share-
holders', as opposed to conventional banks' deposits for which the returns are guaranteed and do not represent any such owner-
ship claims. Since Islamic banks are joint venture based and have a more pronounced link with their equity, the value of the stock
price index and its volatility are likely to have a significant impact on the banks' profitability.
A voluminous prior literature including Duffie and Singleton (1997), Grinblatt (2001) and Liu et al. (2006) argue that conven-
tional credit spread and liquidity risk premium are positively related. Islamic financial institutions do not enjoy scale benefits sim-
ilar to conventional banks and have additional cost of providing Shariah compliant funding to their borrowers. We proxy the
liquidity premium as the difference between the offered and bid of six months profit/interest rates from the panel banks' coun-
tries. Data are obtained from Thomson Reuters (DataStream).
Banks' news and credit rating changes are other factors that may explain the spread (see Covrig et al., 2004). Good news or a
credit rating upgrade reflect banks' better performance and hence reduces the pressure on banks to offer higher rates to attract
clients. Thus, good news or a credit rating upgrade of the panel bank(s) should decrease the interbank premium while bad
news or a credit rating downgrade should increase it.

4. Data

The hypotheses developed in Section 3 are tested using the daily IIBR and LIBOR rates of the following tenors: overnight, 1-
week, 1-month, 3-month, 6-month and 12-month or 1-year. We collect these IIBR and LIBOR rates from DataStream Interna-
tional.6 We began with the inception of the IIBR but had to remove the first couple of months due to mistake in reporting IIBR
rates. Even so, the final data cover almost the entire sample of IIBR starting from 16 April, 2012 to October 9, 2015. As noted ear-
lier, the sample period ends in October, 2015 for two reasons: (i) the IIBR rates were reported in bid rates since late 2015 and (ii)
Thomson Reuters temporarily suspended the IIBR rates due to insufficient contributions from the IIBR panel banks. It is worth
mentioning that Middle Eastern markets are open on Sundays but are closed on Fridays, while London market is open on Fridays
but is closed on Sundays. Thomson Reuters, however, confirmed that IIBR rates are moved to a Friday date from following Sunday.
For robustness check we use both approaches: including and excluding Friday/Sunday data points. In addition, we also check the

6
Analysis for other tenors is available from authors on request.
126 A.S.M.S. Azad et al. / Emerging Markets Review 35 (2018) 120–136

results on contemporaneous rates of IIBR and LIBOR, and lagged LIBOR because of timing difference between IIBR and LIBOR de-
termination. The treasury rates, slope of the yield curve, changes in stock market index and its volatility are collected from
DataStream International. The timing difference between Makkah and London is important as far as the flow of information
and IIBR pricing are concerned. Thus, it is not only important to know the day that a relevant information is received by the mar-
ket, but also important to know the exact time of the news arrival. We use Islamic Finance Information Services (IFIS), Global Cap-
ital and Bloomberg news pages to find the exact timing of the news announcement and rating information. This enables us to
place each event in the proper time period. For example, using the IIBR and LIBOR pricing details as noted in Section 2, news an-
nounced prior to 10:44 am Makkah time is taken as a same day news and news announced after 10:45 am is moved to next day
news. Zero-one dummies are created for each good or bad news and credit rating upgrades or downgrades.7 Sub-section 5.2 pro-
vides more details on the explanatory variables.

5. Methodology

5.1. Methodology for testing relationship between IIBR and LIBOR

For testing long-term equilibrium relationship between the IIBR and LIBOR rates we use standard Johansen cointegration tests,
and for testing short-term dynamic relationship, we use dynamic conditional correlation (DCC) model of Engle (2002). For
Johansen cointegration test, it is necessary to ensure that the series exhibit unit roots at the same degree of integration. To test
for the presence of unit roots, we use the standard Augmented Dickey-Fuller (ADF) unit root test. The DCC model for testing
short-term dynamic relationship between IIBR and LIBOR is discussed in Appendix C.8
After analysing both long-term equilibrium relationship and short-term dynamic relationship, we search for the determinants
of the IIBR-LIBOR spread or “Islamic premium”, IP, which can be defined as follows:

IP t ¼ IIBRt −LIBORt ð1Þ

where, IPt is the Islamic premium of a maturity for day t. IIBRtis the Islamic interbank benchmark rate of a maturity for day t,
while LIBORt is the London interbank offered rate of a maturity for day t. Eq. (1) will be explained later in details.

5.2. Methodology for investigating the determinants of Islamic premium

We us the structural model of credit spreads such as that developed by Longstaff and Schwartz (1995) to investigate the de-
terminants of Islamic premium. The structural model is used by Collin-Dufresne et al. (2001) and Covrig et al. (2004). Specifi-
cally, Covrig et al. (2004) use this model to analyse the determinants of the spread between TIBOR (Tokyo interbank offered
rate) and LIBOR. The structural model suggests that firm value follows the dynamic process in which the value of the firm is a
function of the risk-free rate, firm volatility and default risk. Following Covrig et al. (2004), who use the empirical version of
the structural model of credit spread by Longstaff and Schwartz (1995), we model the determinants of the Islamic premium
as in Eq. (2):

IP i;t ¼ a0 þ a1 TRt−1 þ a2 slopet−1 þ a3 stockt−1 þ a4 volt−1 þ a5 liqt−1 þ a6 goodnewst þ a7 badnewst þ a8 upgradest


þ a9 downgradest þ εt ð2Þ

In the cases when we have very few observations for ratings, we use Eq. (3), which combines the good news and rating up-
grade into one news variable and, a bad news and rating downgrade into another news variable:

IP i;t ¼ a0 þ a1 TRt−1 þ a2 slopet−1 þ a3 stockt−1 þ a4 volt−1 þ a5 liqt−1 þ a6 gn rateupt þ a7 bn ratedownt þ εt ð3Þ

We define the Islamic premium (IPi, t) for maturity i = 1, 2, 3, …, 6 (i.e., 1-day, 1-week, 1-month, 3-month, 6-month and 1-
year) as the difference between IIBR on day t and LIBOR on the prior day (i.e. IIBRt − LIBORt−1). This choice of definition is jus-
tified by the timing difference and the relevant events between the two financial markets. Use of contemporaneous premium (i.e.,
IIBRt − LIBORt as in Eq. (1)) indicates that news arriving between the time of the IIBR fixing and the LIBOR fixing will most im-
mediately affect the next LIBOR fixing. Instead, to avoid such spurious regressions and results, we calculate Islamic premium as
follows: IPi, t = IIBRt − LIBORt−1.
Explanatory variables are as follows:
TR = change in 3-month Treasury bill rate,

7
A good news example is “Dar Al Arkan's (Saudia Arabia) 5.75% five year Sukuk has performed well in secondary markets” and a bad news example is “Abu Dhabi
Islamic Bank share price dropped for the second time”. An example of credit rating upgrade is “Dubai Islamic Bank sees upgrade to A from BB” and an example of down-
grade is “Bahrain Islamic Bank downgraded into BA3”. Also to note, all the Sukuk enhancing news involving the panel bank has been taken as a good news.
8
It is worth noting that there are various methodologies to capture the long-term and short-term relationships between two time series. However, for simplicity, we
only use one method from each category of relationship that are frequently used in the finance or economics literature. Copula applications also have been used in re-
cent literature (see, for related literature, Al Rahahleh and Bhatti (2017)).
A.S.M.S. Azad et al. / Emerging Markets Review 35 (2018) 120–136 127

slope = slope of yield curve,


stock = change in log of daily stock price index,
vol = equity market volatility as measured by a GARCH model,
liq = bid-ask spread of six-month interest rate,
goodnews = dummy for good news received,
badnews = dummy for bad news received,
upgrades = dummy for credit upgrades
downgrades = dummy for credit downgrades.

Table 1
Explanatory variables, hypotheses, data structure and the source of data.
This table discusses, in details, the explanatory variables, their predicted sign and hypotheses, the data that are used for analysis and the source of data.

Explanatory Predicted Hypothesis Data and estimation Source of data


Variables sign

TR_change Negative Longstaff and Schwartz (1995) suggest that an Change in average of 3-month GCC TR/interbank Thomson Reuters
increase in the interest rate increases the drift of offered rates.a (DataStream)
the risk-neutral process for V (value of the firm),
which in turn makes the risk-neutral probability of
a default lower. Hence, one can expect that a
change in the interest rate will reduce the Islamic
premium.
Slope_change Negative The level of interest rates and the slope of the term The difference between 10-year and 3-month Thomson Reuters
structure have been frequently used in empirical TR/interbank offered rates. (DataStream)
models of credit spreads (see, for a review of
literature, Azad et al. (2011)). A positive/steeper
slope is indicative of higher future short-term
interest rate and lower credit spread. The reverse is
true for a negative or inverted slope, which implies
an expectation of interest rate fall and higher credit
spread. Hence, we expect that the Islamic premium
is associated negatively with the slope of the yield
curve.
Stock price Negative Changes in stock prices for panel banks should Change in the daily stock prices of the panel banks. Thomson Reuters
contain information related to the credit risk (DataStream)
associated with interbank loans. An increase
(decrease) in the stock price should have a negative
(positive) impact on the Islamic premium.
Volatility of Positive While the theoretical pricing of default risk in Various measures: Dow Jones Islamic Titan 100 Thomson Reuters
stock price Merton (1974) implies that stock price volatility price index & Dow Jones Islamic World Emerging (DataStream)
and the associated higher volatility of firm value Market Index (DJIWEM) etc. (equity market
increases the default risk, the empirical studies volatility as measured by the conditional variance
including Rigobon and Sack (2003), Churm and of stock price index from a GARCH model).
Panigirtzoglou (2005) and Bedendo et al. (2007)
among others show that default probability
increases with stock market volatility. Accordingly,
credit spreads (i.e., Islamic premium) should rise
with volatility of firm value, which is reflected in
stock price volatility.
Liquidity Positive Liquidity premium of Islamic financial institutions Offered minus bid rates for 6-months interest rate Thomson Reuters
premium are found to be higher due to cost-plus approach of the panel banks' countries. (DataStream)
and additional cost of Shariah compliance. Thus, we
expect a positive association between liquidity risk
and Islamic premium similar to that of
conventional finance (Duffie and Singleton, 1997,
Grinblatt, 2001 and Liu et al., 2006)
Bad news Positive Firm related bad news including credit rating Bad news related to panel banks and the Islamic Finance
and credit downgrade by the rating agencies causes a higher downgrade of credit rating by either or all of the Information Service
rating probability of a negative jump in firm value and a following rating agencies: Fitch, S&P, Moody's and (IFIS/Global Capital),
downgrade rise in the credit spread. Hence a bad public news Capital Intelligence. Used zero-one dummies. Bloomberg
regarding panel banks performance and/or their
credit rating downgrade are expected to increase
Islamic premium.
Good news Negative Good news and credit rating upgrade should have Good news related to panel banks and the upgrade IFIS/Global Capital,
and credit an opposite effect than the bad news and credit of credit rating by either or all of the following Bloomberg
rating rating downgrade. We expect that any good news rating agencies: Fitch, S&P, Moody's and Capital
upgrade causes a higher probability of a positive jump in the Intelligence. Used zero-one dummies.
firm value and decrease the credit spread of the
panel banks.
a
In the case, when the TR is not available for some countries, we use the 3-month swap or interbank offered rates, whichever is available. Swap rate is also considered
as risk-free rate in pricing credit risk (Blanco et al., 2005).
128 A.S.M.S. Azad et al. / Emerging Markets Review 35 (2018) 120–136

Table 2
Descriptive statistics and correlation matrix.
Panel A of this table shows the descriptive statistics of the IIBR and LIBOR rates (in percentages), while Panel B shows the correlation matrix between IIBR and LIBOR
rates for eight different tenors The analysis is based on daily data from April 16, 2012 to October 9, 2015. All data are collected from DataStream International. J-B stands
for Jarque-Berra statistics, which is significance at 1%.

Panel A: Descriptive statistics

IIBRON LIBORON IIBR1M LIBOR1M IIBR3M LIBOR3M IIBR6M LIBOR6M IIBR1Y LIBOR1Y

Mean 0.1786 0.1233 0.3639 0.1861 0.5436 0.2888 0.7246 0.4434 1.0346 0.7239
Median 0.1750 0.1220 0.3433 0.1841 0.4917 0.2723 0.6459 0.4042 0.9533 0.6883
Maximum 0.2350 0.1705 0.6000 0.2488 0.8500 0.4679 1.1933 0.7379 1.5383 1.0712
Minimum 0.1350 0.0795 0.2375 0.1478 0.3300 0.2229 0.4525 0.3194 0.6525 0.5335
Std. dev. 0.0226 0.0262 0.0683 0.0277 0.1309 0.0681 0.1850 0.1280 0.2127 0.1633
Skewness 0.2536 0.1077 0.7462 0.5623 0.6644 1.5504 0.7940 1.1754 0.6984 0.8102
Kurtosis 1.8980 1.6699 2.7207 2.4111 2.0543 4.4088 2.2621 3.2632 2.2053 2.5758
Jarque-Bera 55.7974 68.8419 87.4041 61.1114 100.8569 439.8230 116.2552 212.1521 97.9241 106.3728
Observations 910 910 910 910 910 910 910 910 910 910

Panel B: Correlation matrix

IIBRON LIBORON IIBR1M LIBOR1M IIBR3M LIBOR3M IIBR6M LIBOR6M IIBR1Y LIBOR1Y

IIBRON 1
LIBORON 0.728 1
IIBR1M 0.902 0.804 1
LIBOR1M 0.777 0.922 0.895 1
IIBR3M 0.912 0.823 0.971 0.879 1
LIBOR3M 0.671 0.759 0.839 0.929 0.796 1
IIBR6M 0.902 0.817 0.971 0.884 0.989 0.822 1
LIBOR6M 0.703 0.817 0.864 0.956 0.836 0.986 0.858 1
IIBR1Y 0.882 0.838 0.965 0.905 0.981 0.831 0.987 0.871 1
LIBOR1Y 0.679 0.860 0.844 0.965 0.819 0.963 0.837 0.989 0.859 1

It is to be noted that the explanatory variables are considered as lagged variables as these are public information released one
day before the IIBR rates are set next morning. Hypotheses related to the aforementioned determinants of “Islamic premium” are
discussed in Table 1 with details of source and structure of the data. We have included news and credit rating data into our model
to investigate whether traditional structural model could be applied to evaluate investors' reactions on the banks' profitability. The
significance of these variables would imply that banks' share prices are affected by markets reactions in addition to the fundamen-
tals, while an insignificant role of these variables would imply that banks' returns and profitability are mainly driven by
fundamentals.

6. Results and discussion

We first present summary statistics and the correlation matrix for IIBR and LIBOR in Table 2. Panel A of Table 2 shows that, as
expected, IIBR has a higher mean than LIBOR. Over the sample period, IIBR (LIBOR) reached a maximum value of 1.5383%
(1.0712%) and a minimum value of 0.1350% (0.0795%) with 1-year and overnight rates, respectively. Based upon the Jarque-
Berra statistics, we can reject the hypothesis of normality for each variable in terms of its skewness and kurtosis. Panel B of
Table 2 shows that the correlation between IIBR and LIBOR over the sample period is highly positive. This infers that IIBR and
LIBOR co-move and the spread, if any, between the two, is highly persistent. In the next sub-section we further examine these
results and provide practical implications for the practitioners, panel banks and policy makers. In particular, we present the
test results for the long-term equilibrium relationship and short-term dynamic relationship between the two benchmark rates.

6.1. Relationship between IIBR and LIBOR

The empirical analysis using Johansen cointegration technique is applied to the full sample data commencing from 16th April,
2012 to October 9, 2015. The analysis, shown in panel A of Table 3, suggests that there is a long-term equilibrium relationship
between IIBR and LIBOR for all tenors/maturities. The degree of integration between IIBR and LIBOR has a significant influence
on the statistical properties of the spread (Islamic premium). Since both rates are cointegrated, the spread is expected to be stable
and the Islamic banks' lending at IIBR will attract piety premium. Since, the IIBR is considered as cost plus funding (where LIBOR
is assumed to be the cost of funding), the lending banks will make losses if the spread becomes negative.
To corroborate our findings from Johansen cointegration tests, we investigate the short-term dynamic relationship between
IIBR and LIBOR rates using Engle's two-stage DCC process.9 This method looks at the time-changing relationship between the
two series. The DCC parameters and their significance are reported in panel B of Table 3. Overall, the results seem to be consistent

9
We also have the results for the vector error correction results, which are available on request. Moreover, GARCH based estimates are considered superior to the
error correction results, hence, we provide here the dynamic relationship results based on DCC.
A.S.M.S. Azad et al. / Emerging Markets Review 35 (2018) 120–136 129

Table 3
IIBR and LIBOR Relationships: Johansen Cointegration test and time-varying DCC test.
Panel A shows the Johansen cointegration test results using the daily data from April 16, 2012 to October 9, 2015. The data are collected from DataStream. The table
reports results for testing the number of cointegrating relations. For each maturity, two types of test statistics are reported: trace statistics and maximum eigenvalue sta-
tistics. Critical values, as shown in parentheses, are reported in 5% level of significance. ⁎⁎⁎ and ⁎⁎ indicate that the time-varying correlation is significant at 1% and 5%,
respectively. Panel B shows the coefficient, standard error and the level of significance of the two DCC parameters, θ1 and θ2. See Appendix B for details of the Engle's DCC
approach and how the correlation between IIBR and LIBOR is estimated. θ1 indicates the effects of previous standardized shocks and θ2 indicates the correlation persis-
tence. Standard errors of the estimated coefficients are in parentheses. ⁎⁎⁎ and ⁎⁎ indicate that the time-varying correlation is significant at 1% and 5%, respectively.

Panel A: Johansen cointegration test of IIBR and LIBOR

3 month 6 month 1 year

Hypothesis Trace stats (critical Max-Eigen stats (critical Trace stats (critical Max-Eigen stats (critical Trace stats (critical Max-Eigen stats (critical
value) value) value) value) value) value)
Ho: r = 0 45.3180⁎⁎⁎ 35.007⁎⁎⁎ (19.387) 25.1329⁎⁎⁎ 18.5933⁎⁎⁎ (14.2646) 30.0841⁎⁎⁎ 25.6267⁎⁎⁎ (14.2646)
(25.8721) (15.4947) (15.4947)
H1: r = 1 10.3112 (12.5180) 10.3112 (12.5180) 6.5396⁎⁎⁎ (3.8415) 6.5396⁎⁎⁎ (3.8415) 4.4574⁎⁎ (3.8415) 4.4574⁎⁎ (3.8415)

Panel B: DCC: Time-varying DCC parameters for IIBR-LIBOR

Correlation parameters 3 month 6 month 1 year

θ1 −0.024⁎⁎⁎ (0.0002) −0.028⁎⁎ (0.0147) 0.0229⁎⁎⁎ (0.0019)


θ2 0.9973⁎⁎⁎ (0.0047) 0.5294 (1.2677) 0.9820⁎⁎⁎ (0.002)

with the Johansen cointegration test, and support our first hypothesis, implying that there is a long-term equilibrium relationship
and a short-term dynamic relationship between IIBR and LIBOR. This reflects two important phenomena: (1) while the rates are
independently determined reflecting their own market characteristics, the spread is expected to be highly stable reinforcing the
lending banks to continue to engage in IIBR/Shariah compliant lending, and (2) the borrowing bank is willing to pay the piety
premium to the lending bank for providing Shariah compliant funding.

6.2. Results on the determinants of Islamic premium

6.2.1. Descriptive statistics and correlation matrix


Before we report the estimation results of the determinants of the Islamic premium we present, in panel A of Table 4, the de-
scriptive statistics including mean, standard deviation (Std.Dev.), minimum (Min) and maximum (Max) of both dependent and
independent variables in our sample. The dependent variables are the Islamic premium for different maturities ranging from 1-
month to 1- year.
The minimum and maximum Islamic premia are 8.20 bps (basis points) and 53.517 bps, respectively with 1-month and 1-year
maturity. A maximum of approximately 36.125 bps is found for the shortest maturity (1-month). Table 4 also presents the de-
scriptive statistics for the explanatory variables, of which, good news are 305, bad news are 102, rating upgrades are 19 and rating
downgrades are 4. Since we have only few observations for rating upgrades and downgrades, we combine rating upgrade with
good news and rating downgrade with bad news. Overall, the number of good news and rating upgrades are higher than the
number of bad news and rating downgrades, which implies that Middle Eastern countries and their Islamic banks are exhibiting
a positive performance.
The correlation matrix in panel B of Table 4 shows that the correlations between various spreads are high. Those of closest
maturities are relatively higher (between 1 month and 3 month) than the distant maturities (between 1 month and 1 year).
The correlations between dependent and explanatory variables are also consistent with our prediction with the exception of
the news and rating dummies, which exhibit slightly mixed results. This is somewhat similar to what we observed in the descrip-
tive statistics. That is, given the higher number of good news and rating upgrades, Islamic banks are found to charge a premium
over the conventional lending rates. This could be due to shortage of Shariah compliant funding and additional Shariah compliance
costs, which are not borne by conventional banks.

6.2.2. Contemporaneous spread and its determinants


We now present and analyse the OLS regression results for the contemporaneous spread (IIBRt – LIBORt) in Table 5. The results
show that, with few exceptions, the coefficient signs of the explanatory variables are consistent with our predictions. The shorter
maturities have the highest adjusted R square. The size of the coefficient of the stock return volatility is the highest of all explan-
atory variables. This supports the assertion that Islamic banks have a more pronounced link with equity, and, hence, premium is
the reflection of the cost of funding and profit potential of the participating IIBR rate-setters. This also emphasizes the distinct na-
ture of Islamic finance, where the most important aspect is the equity participation and direct sharing of risk and rewards (Iqbal,
2002).
As discussed in Section 3.2, equity participation and direct sharing of risk and rewards form the basis of Islamic banking (Iqbal
(2002)). Accordingly, the IIBR rate should reflect the cost of funding and profit potential of the participating panel members of the
IIBR. That is, the stock price of the panel banks is expected to exert influence on the pricing of the IIBR rates and the IIBR-LIBOR
130 A.S.M.S. Azad et al. / Emerging Markets Review 35 (2018) 120–136

Table 4
Descriptive statistics and correlation matrix.
This table presents the descriptive statistics and correlation matrix of the dependent and explanatory variables. Dependent variables are the Islamic premiums for dif-
ferent maturities, obtained as the difference between IIBR and LIBOR of the corresponding maturity. The IIBR and LIBOR data are obtained from Thomson Reuters
DataStream. Sample covers the daily data from April 16, 2012 to October 9, 2015. TR (the change in average of 3-month TB or swap rates of panel bank member coun-
tries), Slope (change in the difference between the average of 10-year and 3-month swap rates of panel bank member countries), Stock (the average change in stock
prices of listed panel banks), Vol (equity market volatility as measured by the conditional variance of Dow Jones Islamic Titan 100 price index from a GARCH model) are
all obtained from DataStream. News and rating variables are obtained from Bloomberg, IFIS and Global Capital. To match the IIBR pricing time, any news/rating of the
panel banks beyond 10:45 am (Makkah time) are moved to next day news.

Panel A: Descriptive statistics

IP_1M IP_3M IP_6M IP_1YR ΔTR ΔSLOPE STOCK_RET VOL LIQ GN_RUP BN_RDOWN

Mean 0.1810 0.2641 0.2970 0.3296 0.0002 2.6204 0.0113 0.0000 0.5454 0.4099 0.129383
Median 0.1760 0.2577 0.2990 0.3448 −0.0017 2.5688 0.0000 0.0000 0.5233 0.0000 0
Maximum 0.3613 0.4598 0.5171 0.5352 0.3275 3.4983 2.3614 0.0002 1.0400 2.0000 2
Minimum 0.0820 0.0847 0.0666 0.0472 −0.3650 2.0025 −1.7470 0.0000 0.1783 0.0000 0
Std. Dev. 0.0458 0.0856 0.0901 0.0970 0.1049 0.3098 0.3182 0.0000 0.1815 0.5300 0.342961
Skewness 0.4306 0.2140 −0.0129 −0.4230 0.1371 0.4085 0.7540 1.9303 0.3178 0.7541 2.387279
Kurtosis 2.8315 1.9565 2.4585 2.5091 3.4010 2.3171 15.3123 8.8648 2.3270 2.3613 7.347817
Jarque-Bera 26.5292 43.83225 10.12512 32.96753 8.130699 39.07021 5302.013 1698.768 29.52739 92.44121 1436.909
Observations 910 910 910 910 910 910 910 910 910 324 106

Panel B: Correlation matrix

IP_1M IP_3M IP_6M IP_1YR ΔTR ΔSLOPE STOCK_RET VOL LIQ GN_RUP BN_RDOWN

IP_1M 1.000
IP_3M 0.844 1.000
IP_6M 0.807 0.948 1.000
IP_1YR 0.738 0.882 0.937 1.000
ΔTR −0.009 −0.009 −0.021 −0.021 1.000
ΔSLOPE −0.253 −0.245 −0.139 −0.030 −0.170 1.000
STOCK_RET −0.016 −0.026 −0.004 0.008 0.009 0.036 1.000
VOL 0.225 0.122 0.093 0.046 0.010 −0.269 0.064 1.000
LIQ 0.229 0.075 0.023 0.012 0.112 −0.397 0.040 0.176 1.000
GN_RUP 0.309 0.278 0.311 0.321 0.113 0.049 0.041 −0.013 0.084 1.000
BN_RDOWN 0.079 0.065 0.095 0.126 0.033 0.134 −0.046 −0.079 −0.029 0.174 1.000

Table 5
Determinants of contemporaneous Islamic premium.
This table presents the OLS estimation results of the following credit spread (Islamic premium) model:

IPi;t ¼ a0 þ a1 TRt−1 þ a2 slopet−1 þ a3 stockt−1 þ a4 volt−1 þ a5 liqt−1 þ a6 gn rateupt þ a7 bn ratedownt þ εt:

where, dependent variables are the Islamic premiums for different maturities, obtained as the difference between IIBR and LIBOR of the corresponding maturity. The
IIBR and LIBOR data are obtained from Thomson Reuters DataStream. Sample covers the daily data from April 16, 2012 to October 9, 2015. TR (the change in average
of 3-month TB or swap rates of panel bank member countries), Slope (change in the difference between the average of 10-year and 3-month swap rates of panel bank
member countries), Stock (the average change in stock prices of listed panel banks), Vol (equity market volatility as measured by the conditional variance of Dow Jones
Islamic Titan 100 price index from a GARCH model) and Liq (Offered minus bid rates for 6-months interest rate of the panel banks' countries) are all obtained from
DataStream. News and rating variables are obtained from Bloomberg, IFIS and Global Capital. To match the IIBR pricing time, any news/rating of the panel banks beyond
10:45 am (Makkah time) are moved to next day news. The numbers in parentheses represent the t-stats which are adjusted for autocorrelation and heteroskedasticity
by using the Newey-West method with automatic lag length. ⁎⁎⁎, ⁎⁎ and ⁎ denote level of significance at 1%, 5% and 10%, respectively.

Overnight 1 week 1 month 3 month 6 month 1 year

Constant −0.0577 0.0132 0.2193 0.4584 0.4344 0.3723


(−4.2685)⁎⁎⁎ (1.0592) (13.5211)⁎⁎⁎ (4.0300)⁎⁎⁎ (3.6975)⁎⁎⁎ (9.3995)⁎⁎⁎
ΔTRt-1 0.0149 0.0066 −0.0238 −0.0374 −0.0312 0.0022
(4.8797)⁎⁎⁎ (1.0592) (−1.7335)⁎ (−2.0295)⁎⁎ (−1.7436)⁎ (0.0775)
ΔSLOPE t-1 0.0392 0.0203 −0.0309 −0.0812 −0.0589 −0.0253
(8.6439)⁎⁎⁎ (5.5098)⁎⁎⁎ (−6.4539)⁎⁎⁎ (−2.3117)⁎⁎ (−1.6893)⁎ (−2.1530)⁎⁎
STOCK_RET t-1 0.0003 −0.0015 −0.0057 −0.0099 −0.0055 −0.0029
(0.2035) (−0.6422) (−1.0805) (−1.2157) (−0.7439) (−0.3150)
VOL t-1 −17.2360 114.6164 301.8131 234.8637 190.0131 148.5814
(−0.3644) (1.8885)⁎ (4.5220)⁎⁎⁎ (0.8014) (0.6904) (1.1986)
LIQ t-1 0.0197 0.0225 0.0304 −0.0249 −0.0297 −0.0179
(5.1691)⁎⁎⁎ (3.9413)⁎⁎⁎ (3.3436)⁎⁎⁎ (−0.6390) (−0.7755) (−0.9226)
GN_RUP 0.0052 0.0111 0.0274 0.0477 0.0541 0.0576
(3.091491)⁎⁎⁎ (7.3045)⁎⁎⁎ (10.7690)⁎⁎⁎ (4.5168)⁎⁎⁎ (4.7473)⁎⁎⁎ (10.4003)⁎⁎⁎
BN_RDOWN 0.0031 0.0053 0.0085 0.0149 0.0187 0.0239
(2.3229)⁎ (3.2332)⁎⁎⁎ (2.2538)⁎⁎ (1.7187)⁎ (2.0521)⁎⁎ (3.0347)⁎⁎⁎
Adjusted R2 0.4720 0.2128 0.2081 0.1569 0.1312 0.1082
A.S.M.S. Azad et al. / Emerging Markets Review 35 (2018) 120–136 131

spread. This result is further corroborated with the Granger causality test between IIBR-LIBOR spread and stock prices of the panel
banks.10 The analysis suggests that the causal flow is largely unidirectional from the stock price to the IIBR-LIBOR spread, further
reflecting Islamic finance industry's unique characteristics in determining the Islamic benchmark rate.
Liquidity premium is positive and significant for the shorter maturities, while the good news seems to provide a further jus-
tification as to why the Islamic banks charge additional premium for providing Shariah compliant short term financing. Although
the bad news has some positive impact on the Islamic premium, we can see that the coefficient of good news is larger than the
bad news providing a cushion to Islamic banks in charging higher premium. One explanation related to positive coefficient of
good news and negative coefficient of bad news is that a good news accompanied with the provision of Shariah compliant finance
might prompt Islamic banks to charge a higher profit rate compared to conventional banks. So, unlike conventional finance, good
news and bad news could have opposite impacts on the determination of the IIBR-LIBOR premium.

6.2.3. Intraday timing of information and the determinants of Islamic premium


The market opening and closing time between London and Makkah varies by 3 h. That is, since the IIBR fixing precedes the
LIBOR fixing, one should take into account the impact of the news between 11:00 AM Makkah time and 11:00 AM London
time. This requires us to calculate the Islamic premium as the difference between IIBR in day t and LIBOR in the previous day
(i.e., IIBRt − LIBORt−1) and consistent with this, we need to place all variables on a proper timing window such that the Islamic
panel banks reflect all available information into day t's corresponding IIBR rates. The regression results for lagged spread (IIBRt –
LIBORt−1) are presented in Table 6. The results are very much consistent with what we observed for contemporary spread as the
coefficient signs are consistent with our predictions. The shorter maturities have the highest adjusted R square. TR, slope, and
news variables are found to be significant for all tenors, while liquidity and volatility are found to be significant for short-term
maturities.

6.3. Are the results robust to alternative specifications?

A natural question arises as to whether the results obtained are robust to alternative specifications. For investigating the rela-
tionship between IIBR and LIBOR, we take various samples and considerations: First, we exclude the Friday data and conduct the
analysis using Monday to Thursday data because of the differences in weekends in the Middle-East and London. Second, combin-
ing the implications of weekend difference and timing difference between Makkah and London, we consider only Tuesday to
Thursday data and take the Islamic premium as the difference between Monday's LIBOR and Tuesday's IIBR. Finally, we take dif-
ferent proxies of stock market returns and volatility, the key variables, to search for the determinants of Islamic premium. Inter-
estingly, use of all the above alternative specifications neither changes the IIBR-LIBOR relationship nor the relationship between
the Islamic spread and the explanatory variables.
Table 7 presents the results of Tuesday to Thursday data on contemporaneous basis (such that IPt = IIBRt − LIBORt), while
Table 8 presents the results taking into consideration the timing difference between the two markets (such that IPt = IIBRt −
LIBORt−1). Both results in Tables 7 and 8 are consistent with our findings in Tables 5 and 6, respectively. These results confirm
that there exists an Islamic premium in the interbank lending rates and this premium might lead to an arbitrage activity
among the banks and fund managers. However, provision of Shariah compliance liquidity accompanied with the good news
seems to motivate rent-seeking behaviour among Islamic panel banks as they serve the niche client needs. In fact, Azmat et al.
(2014), among others, find that risk associated with Shariah compliance liquidity, the unique risk of profit-and-loss sharing and
asset based financing structures, the stability of Islamic banks, and lower default risk induce rent-seeking behaviour among Is-
lamic banks. This cannot be refuted given the dominance of rent-seeking Shariah arbitrageurs in the growth of Islamic finance
(El-Gamal, 2007).

7. Concluding remarks

Islamic finance industry has experienced rapid growth in the last decade but the industry's success has also brought
about much criticism particularly with regards to its similarity with conventional finance. While Islam prohibits all inter-
est-related transactions, the Islamic finance industry has struggled to insulate itself from the ‘rate of interest’. Most Islamic
finance products are structured in such a way that the forbidden ‘interest’ component is removed by replacing the underly-
ing debt with an asset. The pricing of these Islamic instruments, however, is linked to the conventional interest rate bench-
marks. The strong correlation in pricing threatens the industry's religious legitimacy as it draws the attention of the Islamic
customer away from its uniqueness and more towards its similarity with conventional banking. It was earlier thought that
the challenge of similar pricing would erode with the increase in the industry’ size and development of its benchmark. How-
ever, the stability of the spread implies that the first experiment of implementing a unique Islamic benchmark rate has not
succeeded without controversy.
The analysis shows that there are both long-term and short-term dynamic relationships between the two rates (IIBR and
LIBOR), which provides significant evidence for convergence and co-movement. Islamic interbank rate has always been

10
The results are not reported but can be obtained from the authors on request.
132 A.S.M.S. Azad et al. / Emerging Markets Review 35 (2018) 120–136

Table 6
Determinants of lagged Islamic premium.
This table presents the OLS estimation results of the following credit spread (Islamic premium) model:

IPi;t ¼ a0 þ a1 TRt−1 þ a2 slopet−1 þ a3 stockt−1 þ a4 volt−1 þ a5 liqt−1 þ a6 gn rateupt þ a7 bn ratedownt þ εt

where, dependent variables are the Islamic premiums for different maturities, obtained as the difference between IIBR in day t and LIBOR in the previous day, (i.e., IIBRt –
LIBORt-1). The IIBR and LIBOR data are obtained from Thomson Reuters DataStream. TR (the change in average of 3-month TB or swap rates of panel bank member coun-
tries), Slope (change in the difference between the average of 10-year and 3-month swap rates of panel bank member countries), Stock (the average change in stock
prices of listed panel banks), Vol (equity market volatility as measured by the conditional variance of Dow Jones Islamic Titan 100 price index from a GARCH model) and
Liq (Offered minus bid rates for 6-months interest rate of the panel banks' countries) are all obtained from DataStream. News and rating variables are obtained from
Bloomberg, IFIS and Global Capital. To match the IIBR pricing time, any news/rating of the panel banks beyond 10:45 am (Makkah time) are moved to next day news.
The numbers in parentheses represent the t-stats which are adjusted for autocorrelation and heteroskedasticity by using the Newey-West method with automatic lag
length. ⁎⁎⁎, ⁎⁎ and ⁎ denote level of significance at 1%, 5% and 10%, respectively. Sample covers the daily data from April 16, 2012 to October 9, 2015.

Overnight 1 week 1 month 3 month 6 month 1 year

Constant −0.0046 0.0178 0.0952 0.1639 0.2013 0.2049


(−0.2782) (3.2819)⁎⁎⁎ (6.8246)⁎⁎⁎ (12.6124)⁎⁎⁎ (11.5399)⁎⁎⁎ (38.7863)⁎⁎⁎
ΔTRt-1 0.0854 0.0858 0.0667 0.0506 0.0170 0.0115
(1.2796) (0.9650) (0.8639) (0.7033) (0.3531) (0.1231)
ΔSLOPE t-1 0.0888 0.0911 0.0721 0.0578 0.0326 0.0164
(372668) (1.1236) (0.9922) (0.8506) (0.6962) (0.1972)
STOCK_RET t-1 −0.9382 −1.0105 −1.0653 −0.5421 −0.2730 −0.3034
(−2.0068)⁎⁎ (−2.3084)⁎⁎ (−2.2368)⁎⁎ (−1.2547) (−0.7658) (−0.6242)
VOL t-1 284.6401 324.5442 347.3944 248.3264 46.7254 196.8280
(1.45709) (4.4569)⁎⁎⁎ (1.8284)⁎ (1.6902)⁎ (0.3331) (3.7901)⁎⁎⁎
LIQ t-1 0.0823 0.0931 0.1097 0.1235 0.1112 0.1325
(4.4733)⁎⁎⁎ (26.3636)⁎⁎⁎ (11.2409)⁎⁎⁎ (15.4037)⁎⁎⁎ (8.8200)⁎⁎⁎ (49.3011)⁎⁎⁎
GN_RUP 0.0034 0.0051 0.0102 0.0187 0.0284 0.0342
(1.2464) (3.2890)⁎⁎⁎ (3.3287)⁎⁎⁎ (3.7358)⁎⁎⁎ (4.0113)⁎⁎⁎ (9.4643)⁎⁎⁎
BN_RDOWN 0.0081 0.0077 0.0065 0.0124 0.0195 0.0291
(2.4119)⁎⁎ (2.3029)⁎⁎ (1.4996) (1.9086)⁎ (2.8351)⁎⁎⁎ (4.1112)⁎⁎⁎
Adjusted R2 0.4697 0.5165 0.5932 0.6950 0.7970 0.7352

found to be above the LIBOR for any given maturity, showing an evidence of Islamic premium. In a typical scenarios this is
viewed as an arbitrage opportunity: borrowing cheap in LIBOR and lending in IIBR, although the premium is seen to be an
incentive for the lending banks to design Shariah compliant product for the borrower. However, provision of Shariah

Table 7
Determinants of contemporaneous Islamic premium excluding weekend data.
This table presents the OLS estimation results of the following credit spread (Islamic premium) model:

IPi;t ¼ a0 þ a1 TRt−1 þ a2 slopet−1 þ a3 stockt−1 þ a4 volt−1 þ a5 liqt−1 þ a6 gn rateupt þ a7 bn ratedownt þ εt

where, dependent variables are the Islamic premiums for different maturities, obtained as the difference between IIBR and LIBOR of the corresponding maturity such
that IPt = IIBRt − LIBORt. The IIBR and LIBOR data are obtained from Thomson Reuters DataStream. Sample covers the daily data from April 16, 2012 to October 9, 2015.
TR (the change in average of 3-month TB or swap rates of panel bank member countries), Slope (change in the difference between the average of 10-year and 3-month
swap rates of panel bank member countries), Stock (the average change in stock prices of listed panel banks), Vol (equity market volatility as measured by the condi-
tional variance of Dow Jones Islamic Titan 100 price index from a GARCH model) and Liq (Offered minus bid rates for 6-months interest rate of the panel banks' coun-
tries) are all obtained from DataStream. News and rating variables are obtained from Bloomberg, IFIS and Global Capital. To match the IIBR pricing time, any news/rating
of the panel banks beyond 10:45 am (Makkah time) are moved to next day news. The numbers in parentheses represent the t-stats which are adjusted for autocorre-
lation and heteroskedasticity by using the Newey-West method with automatic lag length. ⁎⁎⁎, ⁎⁎ and ⁎ denote level of significance at 1%, 5% and 10%, respectively.

Overnight 1 week 1 month 3 month 6 month 1 year

Constant −0.0563 0.0118 0.2328 0.4845 0.4477 0.3988


(−3.947)⁎⁎⁎ (0.6636) (4.7786)⁎⁎⁎ (4.0301)⁎⁎⁎ (3.5191)⁎⁎⁎ (3.1108)⁎⁎⁎
ΔTRt-1 0.0082 −0.0021 −0.0264 −0.0493 −0.054 −0.0044
(1.7292)⁎ (−0.2787) (−1.8128)⁎ (−1.829)⁎ (−1.9214)⁎ (−0.1526)
ΔSLOPE t-1 0.0386 0.0201 −0.0349 −0.0885 −0.0634 −0.0327
(8.1644)⁎⁎⁎ (3.8428)⁎⁎⁎ (−2.327)⁎⁎ (−2.3950)⁎⁎ (−1.6778)⁎ (−0.8418)
STOCK_RET t-1 0.0005 −0.0007 −0.0066 −0.0123 −0.0097 −0.0052
(0.3682) (−0.3124) (−1.005) (−1.0064) (−0.7889) (−0.3384)
VOL t-1 −14.8635 142.5929 294.5549 180.9864 194.0819 112.9758
(−0.2695) (1.7271)⁎ (1.5281) (0.5657) (0.6406) (0.4078)
LIQ t-1 0.0199 0.0225 0.0207 −0.0425 −0.0434 −0.0389
(4.1502)⁎⁎⁎ (2.9054)⁎⁎⁎ (0.9688) (−1.0306) (−1.0275) (−0.9020)
GN_RUP 0.0054 0.0108 0.0280 0.0467 0.0545 0.0582
(2.7870)⁎⁎⁎ (4.3538)⁎⁎⁎ (4.8038)⁎⁎⁎ (4.2299)⁎⁎⁎ (4.3512)⁎⁎⁎ (4.3175)⁎⁎⁎
BN_RDOWN 0.002083 0.0058 0.0114 0.0245 0.0283 0.0326
(1.313737) (2.5653)⁎⁎ (2.5443)⁎⁎ (2.5483)⁎⁎ (2.6565)⁎⁎⁎ (3.0992)⁎⁎⁎
Adjusted R2 0.4684 0.2340 0.2377 0.1757 0.1507 0.1307
A.S.M.S. Azad et al. / Emerging Markets Review 35 (2018) 120–136 133

Table 8
Determinants of lagged Islamic premium excluding weekend data.
This table presents the OLS estimation results of the following credit spread (Islamic premium) model:

IPi;t ¼ a0 þ a1 TRt−1 þ a2 slopet−1 þ a3 stockt−1 þ a4 volt−1 þ a5 liqt−1 þ a6 gn rateupt þ a7 bn ratedownt þ εt

where, dependent variables are the Islamic premiums for different maturities, obtained as the difference between IIBR in day t and LIBOR in the previous day, (i.e., IIBRt –
LIBORt-1). The IIBR and LIBOR data are obtained from Thomson Reuters DataStream. Sample covers the daily data from April 16, 2012 to October 9, 2015. TR (the change
in average of 3-month TB or swap rates of panel bank member countries), Slope (change in the difference between the average of 10-year and 3-month swap rates of
panel bank member countries), Stock (the average change in stock prices of listed panel banks), Vol (equity market volatility as measured by the conditional variance of
Dow Jones Islamic Titan 100 price index from a GARCH model) and Liq (Offered minus bid rates for 6-months interest rate of the panel banks' countries) are all obtained
from DataStream. News and rating variables are obtained from Bloomberg, IFIS and Global Capital. To match the IIBR pricing time, any news/rating of the panel banks
beyond 10:45 am (Makkah time) are moved to next day news. The numbers in parentheses represent the t-stats which are adjusted for autocorrelation and
heteroskedasticity by using the Newey-West method with automatic lag length. ⁎⁎⁎, ⁎⁎ and ⁎ denote level of significance at 1%, 5% and 10%, respectively.

Overnight 1 week 1 month 3 month 6 month 1 year

Constant −0.0559 0.0125 0.2325 0.4834 0.4445 0.3946


(−3.8617)⁎⁎⁎ (0.7079) (5.8363)⁎⁎⁎ (4.5021)⁎⁎⁎ (3.5193)⁎⁎⁎ (3.0910)⁎⁎⁎
ΔTRt-1 0.0095 −0.0020 −0.0262 −0.0490 −0.0535 −0.0047
(2.0582)⁎⁎ (−0.2640) (−1.6981)⁎ (−1.7644)⁎ (−1.9113)⁎ (−0.1645)
ΔSLOPE t-1 0.0385 0.0199 −0.0349 −0.0880 −0.0623 −0.0312
(7.9779)⁎⁎⁎ (3.8386)⁎⁎⁎ (−2.9003)⁎⁎⁎ (−2.7177)⁎⁎⁎ (−1.6639)⁎ (−0.8075)
STOCK_RET t-1 0.0006 −0.0009 −0.0064 −0.0123 −0.0099 −0.0048
(0.3890) (−0.3734) (−1.0629) (−1.0459) (−0.8132) (−0.3124)
VOL t-1 −15.5915 140.5716 297.7211 184.8366 197.7270 102.9503
(−0.2789) (1.7021)⁎ (1.6499)⁎ (0.5857) (0.6530) (0.3712)
LIQ t-1 0.0198 0.0228 0.0207 −0.0433 −0.0432 −0.0376
(4.1219)⁎⁎⁎ (2.9661)⁎⁎⁎ (1.2387) (−1.1901) (−1.0291) (−0.8734)
GN_RUP 0.0054 0.0106 0.0280 0.0465 0.0539 0.0577
(2.7256)⁎⁎⁎ (4.3309)⁎⁎⁎ (6.1943)⁎⁎⁎ (4.9842)⁎⁎⁎ (4.3432)⁎⁎⁎ (4.3073)⁎⁎⁎
BN_RDOWN 0.0017 0.0061 0.0113 0.0243 0.0281 0.0317
(1.1014) (2.6649)⁎⁎⁎ (2.6602)⁎⁎⁎ (2.7505)⁎⁎⁎ (2.6471)⁎⁎⁎ (3.0282)⁎⁎⁎
Adjusted R2 0.4627 0.2336 0.2390 0.1752 0.1490 0.1288

compliance liquidity accompanied with the unique risk of profit-and-loss sharing and asset based financing structures, the
stability of Islamic banks, and lower default risk induce rent-seeking behaviour among Islamic banks as they serve the
niche client needs.
Finally, this study tested and supported the hypothesis that ‘Islamic premium’ is a reflection of the cost of funding and
profit potential of the participating IIBR rate-setters. To corroborate this finding, we modelled the determinants of the Is-
lamic premium, which captured the effects of interest rate, stock market index, and news. We found the following system-
atic effects on the spread: short-term treasury rates, slope of the yield curve and Islamic panel bank stock returns reduce the
premium, while volatile stock prices, liquidity and good news raise the premium. Finally, banks related news and credit rat-
ing announcements were found to exert influence in determining the Islamic premium. Positive effect of liquidity premium
combined with good news encourages Islamic panel banks to charge higher rates compared to conventional interbank short
term lending.
We suggest that before initiating their own benchmark rates, Islamic banks should change the way they conduct their
business. These changes would then be reflected in their benchmark rates, making them distinct from conventional
banks.
Findings from this research suggest the rejection of the decoupling hypothesis of Islamic benchmark rate from conventional
benchmark rate such as LIBOR. Further, it also gives an indication to policy maker that introduction of IIBR could not establish
itself as an independent reference rate so far. This might bring doubt among investors and users about the reference rate.
Hence, policy makers are expected to re-design the IIBR so that it can be used independently.
Our research primarily focuses on co-movement between IIBR and LIBOR and the determinants of the Islamic premium ob-
served in the interbank markets. This research could be extended to investigate the co-movement between IIBR and other con-
ventional reference rates and search for other factors that could drive the piety premium.

Acknowledgment

We thank the Conference participants of ICIEF 2016 Makkah, IBF 2014, Lancaster University, APAD-2013, Busan/South Korea
and Seminar participants at American University of Sharjah, as well as the editor, associate editor and two anonymous referees
for valuable comments and suggestions. Previously this paper was presented in different seminars and conferences in the follow-
ing title: “IIBR-LIBOR Relationship and the Nature and Determinants of Islamic Premium”. We acknowledge the ICAA (Institute of
Chartered Accountants in Australia) for granting financial assistance to undertake this project. The fund came through the then
School of Accounting, Economics and Finance (AEF), of Deakin University in 2013.
134 A.S.M.S. Azad et al. / Emerging Markets Review 35 (2018) 120–136

Appendix A. A snapshot of the IIBR pricing (obtained from Thomson Reuters)

Appendix B. Procedure of fixing and final publication of IIBR

Fig. 1. Procedure of fixing and final publication of IIBR. This figure shows the process of fixing and final publication of the Islamic interbank benchmark rate (IIBR).
Source: Thomson Reuters (www.financial.thomsonreuters.com/islamicbenchmark).
A.S.M.S. Azad et al. / Emerging Markets Review 35 (2018) 120–136 135

Appendix C. Modelling time-varying correlations between IIBR and LIBOR

This appendix explains Engle's (2002) DCC approach, which is used to calculate the correlation between the IIBR and LIBOR
(both in US$). To explain Engle's (2002) DCC model, let yt = [y1, ty12, t]′ be a 2 × 1 vector containing changes in the IIBR and
LIBOR series for different tenors. The conditional distribution of these series/tenors can be modelled using the Engle's DCC ap-
proach as follows:

yt ¼ εt  N ð0; H t Þ∀t ¼ 1; …; T ðC:1Þ

ε t ¼ Dt ηt ðC:2Þ

where, εt = (ε1t, ε2t)′, ηt = (η1t, η2t)′ and Ht is a conditional variance co-variance matrix, which is explained below.
qffiffiffiffiffiffiffiffi qffiffiffiffiffiffiffiffi
½ 
Dt ¼ diag h1;t ; h2;t is a 2 × 2 diagonal matrix of time-varying standard deviations from univariate GARCH models and ηt
is the standardized shock. The elements in Eq. (C.2) follow the univariate GARCH (1,1) processes in the following manner:

2
hi;t ¼ c0i;t þ c1i;t εi;t−1 þ c2i;t hi;t−1 ∀i ¼ 1; 2 ðC:3Þ

 0 
H t ¼ E þ εt εt j F t−1 ¼ Dt Rt Dt ðC:4Þ

−1 −1
Rt ¼ Q t QtQt ðC:5Þ

0
Q t ¼ ð1−θ1 −θ2 ÞQ þ θ1 ηt−1 ηt−1 þ θ2 Q t−1 ðC:6Þ

 pffiffiffiffiffiffiffi 
 q11 0
where hi, t is the conditional variance of IIBR and LIBOR rates i = 1,  and LIBOR) Q t ¼
 2 (i.e., IIBR pffiffiffiffiffiffiffi is the diagonal
q11 q12 0 q22
component of the square root of the diagonal elements of Q t ¼ . The key element of interest in Rt is ρ12;t ¼ q12 =
pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi q 21 q 22
q11;t q22;t , which represents the time varying conditional correlation between the two reference rates. The conditional covariance
is updated by Eq. (C.6). The scale parameters θ1 and θ2 represent the effects of previous standardized shock and conditional cor-
relation persistence, respectively. Whether time-varying correlation exists between the two benchmarks rates of two financial sys-
tem (Islamic vs Non-Islamic) is examined through the significance of either of these scale parameters.

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