1 s2.0 S0939362518300748 Main

Economic Systems 44 (2020) 100760
Contents lists available at ScienceDirect
Economic Systems
journal homepage: www.elsevier.com/locate/ecosys
Common shocks, common transmission mechanisms and time-

T
varying connectedness among Dow Jones Islamic stock market
indices and global risk factors
Hedi Ben Haddada,b,*, Imed Mezghania,b, Mohammed Al Dohaimana
a
Department of Finance and Investment, College of Economics and Administrative Sciences, Imam Mohammad Ibn Saud Islamic University (IMSIU),
PO Box 5701, Riyadh, Saudi Arabia
b
University of Sfax, Route de l'Aéroport Km 0.5, BP 1169, Sfax, 3029, Tunisia
A R T IC LE I N F O ABS TRA CT
JEL classification: The purpose of this paper is twofold. First, we examine the importance of permanent versus
C11 transitory shocks as well as their domestic and foreign components in explaining the business
C15 cycle fluctuations of seven Dow Jones Islamic stock markets (DJIM), namely U.S., U.K., Canada,
C32 Europe, Asia-Pacific, Japan and GCC, over the period from April 2003 to November 2018, using
G1
the permanent-transitory (P-T) decompositions approach of Centoni et al. (2007). Second, we
G14
G15
investigate the spillover mechanisms of these shocks across Islamic stock markets and a set of
global risk factors, using the Diebold and Yilmaz (DY) (2012) approach. The P-T decomposition
Keywords: results show that the DJIM U.S., U.K., Europe and GCC indices are sensitive to both domestic and
Dow Jones Islamic equity index foreign shocks, while the DJIM Canada, Japan and Asia-Pacific are most sensitive to domestic
Return and volatility spillovers shocks. The empirical results of the DY approach indicate that: (i) the return and volatility
Global financial crisis spillover intensity increase during financial turmoil, supporting evidence of the contagion phe-
European debt crisis nomenon, (ii) the DJIM U.S. is the main transmitter of return and volatility spillovers, while the
Global risk factors DJIM GCC is identified as the main receiver of both return and volatility spillovers, (iii) the seven
Permanent-transitory decomposition Dow Jones Islamic stock indices are weakly linked to movements of global risk factors, and (iv)
Serial correlation common features
there is evidence of possible portfolio diversification between the selected Islamic stock markets
and the oil commodity market.
1. Introduction
The emergence of Islamic finance as an alternative financial intermediation mode increased the interest in its peculiarities.
Recently, since the global financial crisis (GFC) and the European debt crisis (EDC), scholars have focused more attention on the
linkages and interdependence of Islamic financial markets. The issue is of great importance for two main reasons. First, the GFC and
EDC have increased the correlations between the stock returns of many regions around the world. This phenomenon reflects a
contagion effect or financial shock spillover that has spread across different regions. Thus, it is important to investigate the nature of
co-movements of Islamic stock markets during these crises. Indeed, the study of changes in stock market linkages and inter-
dependence sheds light on the effectiveness of international diversification for global investors in Islamic stock markets. Furthermore,
the great transmission of shocks may have significant consequences for Islamic financial stability.
⁎
Corresponding author at: Department of Finance and Investment, College of Economics and Administrative Sciences, Al Imam, Muhammad Ibn
Saud Islamic University (IMSIU), P.O. Box 5701, Riyadh, Saudi Arabia.
E-mail addresses: hedi.benhaddad@yahoo.fr (H.B. Haddad), imedmezghani@yahoo.fr (I. Mezghani), mdohaiman@gmail.com (M. Al Dohaiman).
https://doi.org/10.1016/j.ecosys.2020.100760
Received 18 February 2018; Received in revised form 4 May 2019; Accepted 15 May 2019
Available online 30 April 2020
0939-3625/ © 2020 Elsevier B.V. All rights reserved.
H.B. Haddad, et al. Economic Systems 44 (2020) 100760
Second, the distinction between Islamic market integration and financial contagion helps us assess their implications for both
investors and policymakers. Indeed, market integration demonstrates the degree of market development, while financial contagion
reflects the extent of market stability and resilience (Aloui et al., 2015; Dewandaru et al., 2013). Thus, investors are concerned with
these phenomena when building their investment strategies, portfolio composition and asset allocation, while the best policy re-
sponses and hedging strategies are the main concern for policymakers (Ftiti et al., 2015).
Recently, some studies attempted to test the financial integration of Islamic equity markets and volatility spillovers across Islamic
and conventional equity markets. Different empirical methods have been used, such as cointegration tests (Hakim and Rashidian,
2002), causality tests (Nazlioglu et al., 2015; Ajmi et al., 2014), vector auto-regressive models (Hkiri et al., 2017; Hammoudeh et al.,
2016), GARCH models (Aloui et al., 2015; Kasssab, 2013; Majdoub and Mansour, 2014; Miniaoui et al., 2015; Kenourgios et al.,
2016), wavelet decomposition (Arshad and Rizvi, 2013; Rizvi et al., 2015; Dewandaru et al., 2014), stochastic volatility models
(Akhtar et al., 2013), and copulas (Hammoudeh et al., 2014).
Although previous empirical studies have examined co-movements and spillovers across Islamic equity markets, little is known
about the contribution of domestic and foreign components of permanent and transitory shocks in explaining the variations of Islamic
equity returns. Thus, the main motivation of our research is to examine (i) whether Islamic stock markets’ co-movements are the
result of existing common trends, common cycles or both, (ii) the extent of time-varying return and volatility spillovers across Islamic
equity markets, and (iii) the time-varying effects of global risk factors (macroeconomic and financial) on return and volatility
spillovers.
Our research will contribute to the existing literature in two ways. First, to investigate the importance of domestic and foreign
components of permanent and transitory shocks, we apply Centoni and Cubadda’s (2003) approach in order to assess the contribution
of common shocks and common transmission mechanisms to Islamic equity return fluctuations. This approach also allows us to
investigate the extent of domestic and foreign components of these shocks. Indeed, for policymakers it is important to distinguish
between the extent of transitory shocks (aggregate demand shocks such as those resulting from changes in interest rates, inflation,
fiscal policy, taste, velocity and autonomous investment) and permanent shocks (aggregate supply shocks, such as technology shocks)
to best monitor monetary policies. On the other hand, reliable information on the degree of sensitivity of stock markets to permanent
and transitory shocks is of great importance in formulating rational investment strategies and risk management decisions (Narayan,
2011; Ftiti et al., 2015).
Second, we extend the analysis by applying Diebold and Yilmaz’s (2012) approach to explore the extent of time-varying spillovers
of common shocks and common transmission mechanisms across Islamic equity markets and global risk factors. This approach has
the advantage of assessing the extent of time-varying directional spillovers of returns and volatility across Islamic equity markets and
a set of macroeconomic and financial factors including the stock market implied volatility index (VIX), the U.S. equity market-related
uncertainty index, the changes in U.S. 10-year Treasury bond yields, and the international crude oil price. Thus, the approach enables
testing the existence of contagion effects and identifying the recipients and transmitter markets of return and volatility spillovers.
Our results reveal that both common shocks and common transmission mechanisms account for business cycle co-movements of
Islamic stock markets. In addition, the estimated return and volatility spillovers across Islamic stock markets and the set of mac-
roeconomic and financial variables exhibit similar patterns and provide evidence of significant inter-market connectedness of Islamic
stock markets, especially during the recent global financial and European debt crises. Moreover, we find that the selected Dow Jones
Islamic stock indices are not sensitive to global risk factors.
This paper is organized as follows. In Section 2, we briefly review the existing literature on Islamic equity markets’ co-movements.
Section 3 outlines the empirical methodology employed, while Section 4 presents a preliminary analysis of the data. Section 5
discusses the empirical results. Section 6 concludes the paper with a discussion of the limits and future perspectives of this study.
2. Literature review
Since the 2007–2009 GFC, there has been renewed interest in Islamic finance as an alternative financial system for stability and
economic growth. Studies on Islamic equity markets focused on the usefulness of shariah-compliant stocks as an alternative for
investment, the diversification advantages/disadvantages of shariah-compliant versus conventional stocks, and the safe character-
istics of shariah-compliant stocks, especially during financial crises. Thus, these studies can be categorized into four main strands
(Ajmi et al., 2014). The first strand deals with the characteristics of Islamic finance (e.g., Bashir, 1983; Robertson, 1990; Usmani,
2002; Iqbal and Mirakhor, 2007). In other words, early studies tried to explain the principles of the Islamic financial system, such as
the prohibition of interest (riba) and the quantitative screening process represented by the financial ratio. The second strand com-
pares the performance of Islamic stock markets to conventional stock markets (e.g., Al-Khazali et al., 2014; Ashraf and Mohammad,
2014; Jawadi et al., 2014; Ho et al., 2014; Rana and Akhter, 2015; Atta, 2000; Hakim and Rashidian, 2004; Charles et al., 2015;
Shamsudin, 2014; Merdad et al., 2015a, 2015b) and shows mixed results regarding the performance of Islamic vis-à-vis conventional
equities. Hakim and Rashidian (2004); Jawadi et al. (2014); Rana and Akhter (2015) and Al-Khazali et al (2016) reveal that Islamic
stock indices are less efficient compared to their conventional counterparts. On the contrary, Atta (2000); Ho et al. (2014); Sensoy
et al. (2015) and Ali et al. (2018) find that Islamic stock indices are more efficient than their conventional counterparts, particularly
during the financial crisis. This better performance of Islamic equities is attributed to the shariah screening criteria and the good
governance and disclosure mechanisms. Based on risk-adjusted returns, Al-Zoubi and Maghyereh (2007); Shamsudin (2014) and
Merdad et al. (2015a, 2015b) conclude that Islamic stock indices outperform their conventional counterparts. In contrast, Albaity and
Mudor (2012); El-Khamlichi et al. (2014) and Sensoy (2016) find that both Islamic and conventional indices have the same level of
(in)efficiency and there is no significant difference in the level of systematic risk between the two markets. Al-Khazali et al. (2016)
2
find the same result during periods of general downturns. By examining the multifractality and dynamic weak-form efficiency of
stock markets in GCC, Mensi et al. (2018) show that efficiency is sensitive to time horizons and varies with the timeframe. Islamic
stock indices are more efficient in the long term than in the short term. This result is supported by Al-Khazali and Mirzaei (2017), who
conclude that the Dow Jones Islamic indices has become more efficient over time.
The third strand examines the return and volatility-based linkages between Islamic equity markets and their conventional
counterparts (e.g., Hakim and Rashidian, 2002; Dania and Malhotra, 2013; Krasicka and Nowak, 2012; Hassan et al., 2005; Hoepner
et al., 2011; Girard and Kabir, 2008; Forte and Miglietta, 2007). The fourth strand extends the third by focusing on dynamic co-
movements between Islamic and conventional markets during turbulent periods (e.g., Nazlioglu et al., 2015; Ajmi et al., 2014; Hkiri
et al., 2017; Hammoudeh et al., 2016; Aloui et al., 2015; Kassab, 2013; Majdoub and Mansour, 2014; Miniaoui et al., 2015;
Kenourgios et al., 2016; Arshad and Rizvi, 2013; Rizvi, 2015; Dewandaru et al., 2014; Akhtar et al., 2013; Hammoudeh et al., 2014).
To some extent, our study belongs to the last two strands assessing dynamic linkages and contagion between shariah-compliant
stocks. Recent studies (e.g., Rizvi and Arshad, 2014; Majdoub and Mansour, 2014; Hammoudeh et al., 2014; Dewandaru et al., 2014;
Ajmi et al., 2014; Yilmaz et al., 2015; Rizvi et al., 2015; Mensi et al., 2015, 2017a; Nagayev et al., 2016) investigate the dynamic
correlations between Islamic equities, conventional counterparts and commodities. Their conclusions are mixed depending on the
country sample and the econometric methodology. Other studies turn their attention to the interactions and volatilities between
Islamic equities and their conventional counterparts. For instance, Dewandaru et al. (2014) offer evidence of contagion and inter-
dependence between Islamic and conventional markets. Rizvi et al. (2015) and Yilmaz et al. (2015) demonstrate that there is
significant integration of the Islamic sectors and global markets. Sclip et al. (2016) examined volatility behavior and co-movements
between Sukuk, U.S. and EU stock markets. Their results lend support to high correlation and volatility linkages between Sukuk and
regional stock indexes during the financial crisis.
Using various GARCH family models, Mensi et al. (2017a) analyze the time-varying cross-market linkages between ten Dow Jones
Islamic and global conventional stock sectors. The results suggest significant time-varying linkages between the sectoral Islamic and
conventional indexes. More importantly, there is evidence of effective hedging strategies by incorporating conventional stock sector
indexes in well-diversified portfolios of Islamic sector stocks. These findings are consistent with those of Rahim and Masih (2016) and
Dewandaru et al. (2017).
Nazlioglu et al. (2015) explore the volatility spillover between Dow Jones Islamic stocks and three conventional stock markets,
namely the U.S., European and Asian markets, before, during and after the 2008 crisis period. The volatility spillover test confirms
that there is volatility/risk transfer between the Islamic equity markets and the three major global conventional equity markets. This
implies mutual risk transmission between the Islamic and conventional stock markets and is indicative of contagion effects. Kassab
(2013) investigates the persistence of volatility in Islamic (DJIM) and conventional (SP 500 index) markets and finds that the
volatility persistence of both markets is highly significant. However, it is shown that the DJIM index is less volatile than the con-
ventional index and less risky in crisis periods. Similarly, Saiti et al. (2014) suggest that Islamic financial stocks reduce risk when
added to a set of fixed income securities, especially during market downturns.
Other studies analyze the dynamic correlations among Islamic equities and different types of commodities. Khan and Masih
(2014) and Nagayev et al. (2016) explore the extent to which the commodities market co-moves with the Islamic equities market.
Khan and Masih (2014) and Khan et al. (2015) find that the correlation between the Dow Jones Islamic return and some commodities
evolves through time, and gold has a safe-haven role, which helps decrease the risk management of portfolios with diversification in
times of declining equity prices. Using MGARCH-DCC and Wavelet Coherence analyses, Nagayev et al. (2016) analyze the potential
co-movements and synchronization between Islamic and commodities returns, showing evidence of highly volatile and time-varying
dependencies between the Islamic equity index and the five-clustered commodities. The results are in line with those of Mensi et al.
(2017b) underlining the existence of dynamic volatility spillovers between commodities (precious metals, oil) and the aggregate Dow
Jones Islamic Index and its associated ten stock sectors.
Some studies support the decoupling hypothesis of Islamic equity markets from conventional equity markets and examine only the
dynamic correlations between Islamic equities intended for faith-based investors (Umar, 2017). However, few studies examine the
interactions and volatility between Islamic equities. For instance, Kabir et al. (2013) investigate the issue of integration for five
Islamic equity markets (Dow Jones Islamic equity indices of the Asia-Pacific, Kuwait, Europe, United Kingdom and United States).
The authors show that the five markets are integrated, with the Eurozone Islamic equity market as the most dominant market and the
U.K. Islamic equity market as the follower. Moreover, the permanent and transitory components of all these Islamic markets tend to
move together.
Dewandaru et al. (2013) examine the extent to which volatility in the GCC Islamic stock markets is sensitive to the volatility in
other Islamic markets (Asia Pacific, Eurozone and ASEAN). The authors show that the subprime crisis generated both long-term and
short-term shocks to volatility in all Islamic equity indices, and the GCC Islamic equity index was the most susceptible with the shocks
mostly transmitted via fundamental linkages. However, there is evidence of weak stock market integration between the GCC equity
market and other markets.
Using dynamic conditional correlation and dynamic equicorrelation, Yilmaz et al. (2015) investigate the interactions between the
ten major sectors of Islamic equity markets. The authors provide evidence of strong dependence of Islamic equity prices on firm
fundamentals and real economic factors as well as integration in the financial system (shocks and contagion). Moreover, there is no
support for the decoupling hypothesis of Islamic equity markets from the conventional financial system, because the exclusion of
conventional equities from the asset menu of faith-based investors results in substantial welfare losses (Hammoudeh et al., 2014;
Umar, 2017).
Previous studies focused on the extent of co-movements of Islamic and conventional equity markets but did not investigate the
3
importance of common shocks and common transmission mechanisms in contributing to Islamic equity market business fluctuations.
The present paper attempts to fill this research gap by examining how common shocks and common transmission mechanisms
contribute to Islamic stock market return co-movements, their spillover mechanisms and global risk factor determinants of the
former. The rationale for this study is that most faith-based investors seek to maximize wealth by investing in various Islamic markets
(Umar, 2017). Thus, it is important to explore integration across Islamic stock markets and diversification opportunity issues.
The econometric methodology will be based on, first, the common trends and common cycles model to examine whether Islamic
stock markets’ co-movements are the result of existing common trends, common cycles or both. In addition, following Centoni and
Cubadda (2003) and Centoni et al. (2007), we decompose each market permanent (transitory) shock into domestic and foreign
components, under short- and long-run co-movement restrictions. Thus, for each market, we identify four shocks that contribute to its
business fluctuations. In so doing, we obtain an accurate measure of the role of domestic and foreign shocks in the extent of spillover
effects on Islamic stock market returns.
Second, we use the Diebold and Yilmaz (2012) approach to measure time-varying return and volatility spillovers across Islamic
stock markets and a set of influential financial and macroeconomic factors. Recently, numerous studies used Diebold and Yilmaz’s
(2012) approach to examine the return and volatility spillovers across Islamic and conventional equity markets (e.g., Shahzad et al.,
2017; Mensi et al., 2017b; Majdoub and Mansour, 2017; Hkiri et al., 2017). The set of macroeconomic and financial factors include
the stock market implied volatility index (VIX), the U.S. equity market-related uncertainty index, the changes in U.S. 10-year
Treasury bond yields and the international crude oil price. The VIX variable constitutes a measure of financial risk and has been used
as an indicator of market volatility and investor’s risk aversion (Neifar, 2016; Shahzad et al., 2017). In addition, Baker et al. (2015)
introduce the U.S. equity market-related uncertainty index to account for economic uncertainty in the U.S. equity market. The index
is a weighted average of three sub-indices, namely the number of news articles related to the term economic uncertainty index, the
federal tax expirations index and the economic forecaster disagreement index. The index has been widely employed to assess the
sensitivity of stock markets to economic uncertainty (e.g. Ajmi et al., 2015; Wu et al., 2016; Shahzad et al., 2017). Further, we use the
changes in U.S. 10-year Treasury bond yields to capture the effects of long-term world interests on stock market volatility. Indeed,
numerous studies have proven either a positive or a negative relationship between movements in interest rates and stock market
volatilities (e.g. Fama and French, 1993; Campell and Ammer, 1993; Campell, 1987; Elton et al., 2001; Gebhardta et al., 2005; Ferrer
et al., 2006). Lastly, some studies (e.g. Hamilton, 1983, 2003; Arouri et al., 2011; Naifar and Al Dohaiman, 2016) report a strong
connection between changes in oil price and stock market movements. Thus, we include the WTI crude oil price as a proxy of the
international crude oil price, which captures the impact of economic instability and uncertainty on Islamic equity market volatilities.
3. Econometric methodology
The econometric methodology involves three steps. First, we use the common trends and common cycles model to decompose the
permanent and transitory shocks into domestic and foreign components. Second, we examine the directional (net) return and vo-
latility spillovers across Islamic equity markets using DY’s (2012) approach.
3.1. Measuring the effects of foreign and domestic transitory/permanent shocks
We use the decomposition framework proposed by Centoni et al. (2007) to return the effects of foreign and domestic transitory/
permanent shocks. This decomposition involves the following steps:
1 The 2-step approach of Vahid and Engel (1993) is applied to test for common features. First, the cointegration rank r is de-
termined applying the Johansen (1988, 1991) techniques and the cointegrating vectors β are estimated using the maximum
likelihood (ML) method. Second, conditional on r and β obtained in the first step, the ML approach is used again to determine s
(number of cofeature vectors) and estimate the cofeature matrix δ .
2 A Vector Autoregressive (VAR) model is estimated under common trends and serial correlation common feature (SCCF) re-
strictions.
3 Following Centoni and Cubadda (2003), it is possible to perform, first, a permanent-transitory decomposition of the shocks.
Second, each permanent (transitory) shock is decomposed into domestic and foreign components to return their respective
contributions in stock market return fluctuations.
3.2. Measuring the time-varying return and volatility spillover indices
We apply Diebold and Yilmaz’s (2012) method to evaluate the time-varying returns and volatility spillover across Dow Jones
regional Islamic indices. The use of this approach has the advantage of computing the total, directional and net spillover indices based
on forecast error variance decomposition (FEVD) in the framework of the Vector Auto-Regression (VAR) model. The total spillover
index measures the contribution of return (volatility) spillover shocks of return (volatility) across all regional markets to the total
forecast error variance. In addition, two directional spillover indices are computed: a measure of the contribution of spillovers from
one market to all other markets and a measure of the reverse direction spillovers of all other markets to one market. The net spillover
index for one market is defined as the difference between total spillovers transmitted to one market from all other markets and those
transmitted from that market to all other markets.
4
Table 1
Descriptive statistics of Islamic daily returns and global risk variables.
Min. Mean Max. S.Dev Skewness Kurtosis J.B ARCH(12) Q(12)
Islamic Dow Jones stock returns

UK −0.0949 0.000120 0.12248 0.01272 −0.1972 9.56 1666.2 138 42.39
CA −0.1339 0.000152 0.11308 0.01601 −0.7927 10.94 2224.4 210.12 78.9
JP −0.1247 0.000129 0.12346 0.01212 −0.6315 11.34 2372.0 93.78 99.89
EU −0.0971 0.000165 0.12049 0.01206 −0.0808 10.9 2164.9 141.81 53.34
US −0.1213 0.000265 0.12125 0.01115 −0.0447 16.81 5150.0 80.9 122.21
ASP −0.0919 0.000122 0.14444 0.01163 −0.0412 13.32 3234.0 57.59 92.8
GCC −0.0688 0.000094 0.07442 0.0078 −0.7562 16.27 4865.3 69.38 91.54
Global risk variables
OIL −0.1519 0.0002 0.1641 0.0237 −0.01823 4.378 3308.8 77.9 32.6
UCT 1.2000 4.4196 6.3743 0.6475 −0.25985 0.384 72.05 403.3 103.4
VIX 2.2127 2.8668 4.3927 0.3792 0.92197 0.691 669.24 120.98 361.4
DGC-10 −0.51 −0.0006 0.24 0.0574 −0.0627 2.955 1509.6 24.585 17.44
Notes: Daily returns are the difference of logarithm of Islamic Dow Jones markets indices. VIX is the logarithm of VIX. OIL is changes in the WTI oil
spot price, UCT is the logarithm of the U.S. equity market-related uncertainty index and DGC-10 is changes in the US 10-year Treasury bond yield.
Min., Max. and S.Dev represent minimum, maximum and standard deviation, respectively. J-B is the statistic of the Jarque-Bera test for normality.
ARCH(12) and Q(12) refer to Engle’s LM test for ARCH effects and the Ljung-Box Q-test statistics for autocorrelation in the residuals, respectively,
computed with 12 lags. The asterisks ***, ** and ⁎ indicate statistical significance at the 1%, 5% and 10% level, respectively.
4. Data and preliminary analysis
Seven regional Dow Jones Islamic equity indices (DJIM) were selected for empirical examination, namely the daily DJIM Asia-
Pacific ex-Japan index (ASP), DJIM Canada index (CA), DJIM Europe index (EU), DJIM GCC index (GCC), DJIM Japan index (JP),
DJIM U.K. index (UK) and DJIM U.S. index (US) for the period April 14, 2003 to November 28, 2018. The data were retrieved from
the Datastream database. All daily Dow Jones Islamic market indices were transformed into natural logarithms.
In addition, we include some macroeconomic and financial determinants of return and volatility spillovers, namely the Chicago
Board Options Exchange (CBOE) volatility index (VIX), the U.S. 10-year Treasury yield (DGC), the U.S. equity market-related un-
certainty index (UCT) and the WTI oil spot price (OIL). The data were retrieved from FRED ECONOMIC DATA, Federal Reserve Bank
of ST-LOUIS.
Table 1 provides the basic statistics of the data. The results indicate that the DJIM-CA is the most volatile index and the DJIM-GCC
the least volatile one. All Dow Jones Islamic market indices are negatively skewed time series. In addition, all Dow Jones Islamic
market indices exhibit high values of Kurtosis, which suggests there are sharp peaks in these markets. The Jarque-Bera (J-B) statistics
reject the null hypothesis of normal distribution. Further, the Lagrange multiplier test (ARCH-LM) of Engle (1982) indicates the
existence of an ARCH effect for all the time series. The Ljung-Box test statistics (at lag 20, Q(20)) supports the hypothesis of auto-
correlation for the series.
Fig. 1 depicts the time movements of the DJIM indices as well as the macroeconomic and financial variables. The figure de-
monstrates that the movements of the variables exhibit strong variability and evidence of structural changes in the data. Therefore, a
unit root test with structural breaks is required to establish the integration order of the data. We apply the Augmented Dicky-Fuller
(ADF) unit root test examining the null hypothesis of a unit root against mean stationarity and trend stationarity (without structural
breaks), and Lee and Strazicich’s (2003, LS hereinafter) unit root test with two structural breaks. The LS unit root test allows for
breaks under both the null and alternative hypotheses. The results of the two tests are displayed in Table 2, suggesting that both tests
reject the unit root hypothesis. Moreover, the LS test indicates that the two structural break dates are 8/15/2007 and 6/16/2010 for
the DJIM UK, EU, US, CA, VIX and DGC, while they are 8/15/2007 and 11/14/2013 for the DJIM JP, ASP, GCC and OIL. The
estimated dates correspond to the periods of the GFC and EDC crises. Therefore, we spill according to the break dates 8/15/2007 and
11/14/2013 (Fig. 2).1
5. Empirical results
5.1. Common trends and common cycle tests
We investigate the existence of short- and long-run co-movements of the seven Dow Jones Islamic market indices for the period
from 4/14/2003 to 11/28/2018. The results of the cointegration and SCCF tests for the full period are presented in Table 3. These
results indicate that the seven DJIM share five common trends and six common cycles, and provide support for the existence of both
short- and long-run financial integration in Islamic stock markets. Thus, it is more likely that Islamic stock markets are characterized
by similar systematic risk factors.
In addition, the presence of cointegration and common cycles implies that seven Islamic stock markets are driven by both cycles
1
We choose the break date 11/14/2013 so that the sub-period includes both the GFC and EDC crises.
5
Fig. 1. Time trajectories of Islamic Dow Jones stock indices.
Table 2
Results of the standard ADF and LS unit root tests.
ADF LS
TB1 TB2 T-Stat Critical Values
1% 5% 10%
Islamic Dow Jones stock returns

UK −8.98* 2007-8-15* 2013-11-14* −8.98* −5.085 −4.576 −4.301
US −7.23* 2007-8-15* 2013-11-14 −7.41* −5.085 −4.576 −4.301
Europe −8.38* 2007-8-15* 2013-11-14* −8.58* −5.085 −4.773 −4.535
Canada −8.37* 2006-6-16* 2010-6-16* −8.38* −5.183 −4.576 −4.301
Japan −6.45* 2007-8-15* 2013-11-14* −8.35* −5.183 −4.773 −4.535
Asia-Pacific −8.11* 2007-8-15* 2013-11-14* −7.45* −5.099 −4.716 −4.481
GCC −8.13* 2006-6-16 2010-6-16 −8.62* −5.183 −4.773 −4.535
Global risk variables
DOIL −5.95* 2006-6-16 2013-11-14* −5.86* −5.183 −4.773 −4.535
LUCT −6.03* 2006-7-15* 2010-6-18* −5.06* −5.085 −4.576 −4.301
LVIX −8.31* 2007-8-15 2010-6-18* −8.89* −5.240 −4.578 −4.278
DGC-10 −6.55* 2007-8-15 2010-6-18* −5.93* −5.240 −4.578 −4.278
Notes: ADF denotes the statistics of the standard Augmented Dickey-Fuller unit root test. TB1 and TB2 refer to the first and second trend break point,
respectively, determined endogenously in the LS unit root test. T-Stat represents the student-statistic of the LS unit root test. CVs are the Monte Carlo
critical values of the LS unit root test. * denotes the level of significance at 5%.
(transitory shocks) and permanent shocks. Hence, it is important to measure the effects of the common shocks and common
transmission mechanisms as well as the contributions of their domestic and foreign components in generating Islamic stock market
business cycles.
5.2. The effects of foreign and domestic transitory/permanent shocks
Once the number of common trends and common cycles is identified, we apply the methodology of Centoni et al. (2007) to
evaluate the importance of foreign and domestic permanent/transitory (PT) shocks in explaining the short- and long-run movements
of the seven Dow Jones Islamic market indices.
Table 4 provides the results of the contributions of foreign and domestic PT shocks over the business cycle for the period from 2/
25/2002 to 11/28/2018. First, we observe that all Islamic stock market indices, except the GCC market index, are more sensitive to
domestic than to foreign shocks. In particular, domestic shocks account for more than 90% of the DJIM CA fluctuations, while they
explain more than 70% of the DJIM JP and ASP fluctuations. In addition, the transitory shocks are the main components explaining
6
Fig. 2. Time trajectories of macroeconomic and financial variables.
Table 3
Cointegration and SCCF tests.
Cointegration test SCCF test
Null hypothesis Trace statistics P-value Null hypothesis LR statistics P-value

r=0 205.2 0.000 * s≥1 49.46 0.15
r≤1 120.6 0.000 * s≥2 117.20 0.01
r≤2 69.1 0.055 s≥3 219.28 0.00
r≤3 38.0 0.304 s≥4 365.76 0.00
r≤4 21.2 0.354 s≥5 550.37 0.00
r≤5 7.1 0.577 s≥6 831.25 0.00
r≤6 0.6 0.426 s=7 1164.83 0.00
Notes: For the cointegration test, the values are the Johansen’s trace statistics. For the SCCF test, we reject the null hypothesis if the p-value is less
than 0.05. * denotes significance at the 5% level.
Table 4
Measures of the business cycle effects of foreign-domestic PT shocks for the period 4/14/2003 to 11/28/2018.
U.K. U.S. EU CA JP ASP GCC
Domestic-Permanent 39.9% 49.8% 30.2% 26.4% 35.3% 27.4% 37.0%

Domestic-Transitory 24.2% 13.7% 23.1% 65.8% 38.3% 49.8% 12.2%
Total Domestic 64.1% 63.5% 53.3% 92.2% 73.6% 77.2% 49.2%
Foreign-Permanent 26.7% 19.8% 31.3% 2.7% 9.0% 6.7% 30.5%
Foreign-Transitory 9.2% 16.7% 15.4% 5.1% 17.4% 16.1% 20.3%
Total Foreign 35.9% 36.5% 46.7% 7.8% 26.4% 22.8% 50.8%
Total Permanent 66.6% 69.6% 61.5% 29.1% 44.3% 34.1% 67.5%
Total Transitory 33.4% 30.4% 38.5% 70.9% 55.7% 65.9% 32.5%
the DJIM JP and ASP stock market variations over the business cycle, with a proportion of 71% for the DJIM CA. If we assume that
the transitory shocks represent the effects of aggregate demand shocks (such as monetary policy, fiscal policy, inflation, interest rate
variations) on stock markets, it appears that these regional stock markets are more sensitive to aggregate demand shocks over the
business cycle. Thus, monetary policies are more important in explaining Islamic stock price movements in the DJIM CA, JP and ASP.
Second, the results indicate that the DJIM U.S., U.K., EU and GCC are more sensitive to foreign shocks than the DJIM CA, JP and
ASP. A higher contribution of foreign shocks is observed for the DJIM GCC with 50.7%. Moreover, the analysis of the importance of
transitory vs. permanent components of foreign shocks outlines the dominance of permanent shocks in explaining the fluctuations of
DJIM U.S., U.K., EU and GCC. Thus, the more sensitive the market is to external shocks, the more important is the permanent
component (Centoni et al., 2007).
7
Overall, our results suggest that the domestic/foreign and transitory/permanent distinction is important to characterize markets
that are more sensitive to domestic/foreign and transitory/permanent shocks. The findings also provide evidence for the importance
of transitory shocks in explaining market fluctuations when the markets are more sensitive to domestic shocks, while permanent
shocks are the dominant component when the markets are more sensitive to external shocks. Nonetheless, the P-T decompositions
only allow us to detect the nature of shocks and their contribution in explaining business cycle fluctuations of Islamic stock markets.
The approach does not allow us to investigate the extent of spillover mechanisms of these shocks. Thus, we follow DY (2012) to
investigate return and volatility spillovers across Islamic stock markets.
5.3. Return and volatility spillover effects
Following Shahzad et al. (2017), we use the threshold generalized autoregressive conditional heteroscedasticity (TGARCH) model
with a skewed-t distribution2 to estimate the conditional volatility of Islamic equity returns. Fig. 3 displays the time paths of the
estimated conditional variances of the Islamic equity returns. The estimated conditional variances are time-varying over the sample
period. We can observe that the different estimated conditional variances exhibit similar patterns with major peaks observed in the
period 2007–2008, which corresponds to the GFC crisis period. However, the GCC conditional volatility is more unstable than the
volatility of other returns. Thus, the high volatility of Islamic equity returns during the GCF period suggests that Islamic equity
returns are affected via contagion effects through the interactions of Islamic stock markets with their conventional counterparts.
Table 5 presents the total static return and volatility spillover indices for a forecast horizon of 10 days. The empirical results show
that the return spillovers are slightly higher than the volatility spillovers. In fact, we found that the total return spillovers index
records 45.6%, while 42.1% of the forecast error variance comes from volatility spillovers. The analysis of the column Contribution to
others including own of the return spillovers index suggests that the U.S. (138.6%), EU (128.4%), U.K. (126.1%) and JP (121.6%) stock
markets have the highest values of spillovers, implying that the U.S, EU and U.K. are the most influential markets. The lowest value of
return spillovers was detected for the GCC market (48%). In addition, we observe that the GCC market is the most sensitive to
external shocks (75.61% of shocks coming from other markets), while the DJIM CA (3.74%) and JP (1.74%) are the least sensitive to
foreign shocks. The results of return spillovers are in line with those of the P-T decompositions, suggesting that the DJIM U.S., U.K.,
EU and GCC are the most sensitive to foreign shocks.
The full sample total volatility spillovers index attained the value 42.1%, where most directional spillovers come from the U.S.
(132.4%), U.K. (104.42%), EU (115.7%), JP (111.9%) and DGC (108.9%), suggesting that these markets and the DGC variable are the
main sources of volatility spillovers to the other markets and macroeconomic variables. On the other hand, the directional spillover
index for the full sample period indicates that the U.S. and U.K. markets strongly affect the GCC market and to some extent the ASP
markets and the VIX. The GCC region (-51.9%) is the highest net recipient compared to the Asia Pacific region (-18.4%), while the
UCT (-1%), Oil (-1%) and CA (-3.5%) remain neutral. In addition, we observe that the GCC is the most sensitive to external volatility
shocks, with volatility shocks coming from others at about 75.81%.
Diebold and Yilmaz (2009, 2012) report that the directional spillover indices do not provide a clear picture of the time-varying
movements of spillovers. Accordingly, we examine the dynamic return and volatility spillovers over the full sample period by es-
timating the return and volatility spillovers using a rolling window. Fig. 4 displays the total return and volatility spillover using 200-
day rolling samples and shows that there are significant return and volatility spillover fluctuations (absence of trend). Indeed, we
identify several cycles in the movements of the total directional return and volatility spillovers index. The first phase corresponds to
the sub-period from 4/14/2003 to 8/18/2007, the second phase from 8/19/2007 to 11/16/2013 and the third from 11/17/2013 to
the end of the sample. During the first phase, we observe a steady path for the return spillovers during the period 5/12/2006 to 8/12/
2007, but a higher magnitude of volatility spillovers, which reach 50% from 2005 as a response to the movements of some financial
and economic factors such as higher volatility of the US 10-year Treasury bond yield.
The second phase corresponds to the GFC and EDC crises periods. The cyclical movements and the magnitude of return and
volatility spillovers are similar. Both return and volatility spillovers experienced a significant increase. Some peaks exist for both
return and volatility spillovers, especially in 2008 with the collapse of Lehman Brothers, which reached a record high of 60% for both
return and volatility spillovers. Another peak in return spillovers occurred at the end of 2010 with a high of 65% due to the
intensification of the European sovereign debt crisis and the establishment of joint programs by the European Union and the IMF to
support members in difficulties. An additional peak in volatility spillovers is observed in 2012 at a higher magnitude, caused by a
correction in the U.S. stock market as a result of economic uncertainty (Shahzad et al., 2017).
Regarding the third phase, return and volatility spillovers fluctuated around a stable trend of 40% and 50% during the period
2013–2015, respectively. The return and volatility spillover indices jumped up again in 2017 and remained stable until the end of the
sample. Therefore, the highest positive and unstable values of the return spillovers during the crisis period demonstrate that the GFC
and EDC crises increased the return spillovers across Islamic stock markets and show the presence of contagion phenomena via
financial turbulences observed during this period. In addition, we observe that there are persistent return and volatility spillovers
during the pre- and post-crisis periods.
These changes in spillovers suggest that the Islamic stock markets were affected differently by the 2008–2009 financial crisis and
the 2010–2012 European sovereign debt crisis, and the latter was the more contagious. These findings are in line with those of
Dewandaru et al. (2013), who find that the subprime crises in the U.S. generated both short- and long-run shocks to the volatility of
2
The rationale underlying the use of the TGARCH model is its ability to account for asymmetric effects of conditional variance.
8
Fig. 3. Time path of the estimated conditional variances of Islamic equity returns.
all Islamic equity indices. Reversal funds in dealing with greater uncertainty during this period and the move of capital towards more
stable market assets may be factors explaining the increase of spillover indices. In addition, the increase of the spillover index may be
explained by a fundamental-based contagion between all Islamic equity markets (Dewandaru et al., 2017).
Overall, the time-varying dynamics of the directional return and volatility spillover return suggest that there are some phases of
intensification of spillovers indicative of financial contagion, and other phases of low spillovers providing support for interregional
Islamic portfolio diversification. In addition, most Islamic stock markets are sensitive to interregional shocks. Thus, investors should
account for these features of regional Islamic stock markets.
The next step in our empirical analysis is to identify the net receivers and transmitters of return and volatility spillovers for the
seven studied markets and the set of major global risk factors. Fig. 5 depicts the time-varying dynamics of the net return spillover
index for each Islamic equity market. The figure suggests that the DJIM U.S, the DJIM U.K, the DJIM Europe and the DJIM Japan
indices are the greatest net return transmitters of shocks to other markets, while global risk factors and the remaining Islamic stock
markets are identified as net return receivers of shocks. Thus, the Islamic stock market returns are less affected by global risk factors.
Moreover, we can observe that the DJIM U.S index is the dominant net transmitter of return spillovers to other Islamic stock markets,
especially in the sub-period 8/19/2007 to 11/16/2013. These results are in line with Shahzad et al. (2017) confirming the prominent
role of the DJIM U.S index in the transmission of return spillovers to other markets. The size of the effects of DJIM U.K., DJIM Europe
and DJIM Japan on the other markets remains stable over the three sub-periods. Additionally, the Canadian, Asia-Pacific and GCC
Islamic stock markets exhibit negative net directional return spillovers over the whole sample period, demonstrating that these
markets are net receivers of return spillovers. Specifically, the GCC Islamic stock market is identified as the greatest net receiver of
return spillovers, especially from 2010 to the end of the sample. Even if the direct impact of the subprime crisis was limited in GCC
countries, the shocks were transmitted mainly by a higher overall trade integration of the GCC with the rest of the world. The
Canadian market is mainly identified as a net receiver of return spillovers, especially during the period 2009-2012. Its limited impact
on the other markets and its low sensitivity to external shocks explain the low impact of return and volatility spillovers on the
Canadian market. High linkages to other markets characterize the Asia-Pacific market, which is a net receiver of shocks, mainly from
U.S. and European markets. The Asia-Pacific net return spillover index is negative from the beginning of the sample until the second
quarter of 2015. Notably, we detect high spillovers during the global financial and European sovereign debt crises due to the extent of
economic openness and export-based orientation of these countries.
In contrast, the low influence of global risk factors, namely the stock market implied volatility index (VIX), the U.S. equity market-
related uncertainty index, changes in U.S. 10-year Treasury bond yields and the international crude oil price, is a more surprising
result. In particular, the VIX is identified as the most important receiver of return spillovers among other global risk variables,
suggesting a limited impact of global risk factors on Islamic stock market return movements. Therefore, we can conclude that the
Islamic stock returns are less sensitive to global risk factors, and there are interregional return spillovers confirming the results of the
9
Table 5
Directional and net spillover indices.
Returns
UK US EU CA JP ASP GCC VIX UCT DGC OIL From Others

UK 36.6 14.0 27.6 3.6 10.4 3.6 4.1 0.0 0.0 0.1 0.0 63.4
US 13.3 36.5 16.5 2.5 26.1 2.5 2.3 0.0 0.0 0.1 0.2 63.5
EU 26.6 16.8 35.3 3.7 9.9 3.6 4.0 0.0 0.0 0.1 0.0 64.7
CA 8.7 7.3 8.6 34.4 5.9 31.2 3.5 0.0 0.0 0.3 0.0 65.6
JP 11.0 30.0 10.7 2.1 42.2 2.0 1.7 0.1 0.0 0.1 0.2 57.8
ASP 9.3 8.1 9.1 30.2 6.3 33.3 3.3 0.0 0.0 0.3 0.0 66.7
GCC 15.4 20.3 15.8 3.4 16.9 3.5 24.1 0.1 0.0 0.4 0.0 75.9
VIX 0.9 0.5 0.9 0.7 0.3 0.8 1.3 86.7 0.5 4.7 2.5 13.3
UCT 0.1 0.0 0.1 0.1 0.0 0.1 0.3 2.8 96.2 0.2 0.1 3.8
DGC 3.3 3.5 2.9 1.4 2.3 1.8 2.7 0.0 0.0 81.9 0.1 18.1
OIL 1.0 1.6 0.9 0.3 1.2 0.3 0.7 0.1 0.2 2.0 91.7 8.3
Contribution to others 89.6 102.2 93.1 47.9 79.4 49.4 23.9 3.2 0.9 8.3 3.2 501.2
Contribution including 126.1 138.6 128.4 82.3 121.6 82.7 48.0 89.9 97.2 90.3 94.9 Spillover Index = 45.6%
own
Net spillover 26.1 38.6 28.4 −17.7 21.6 −17.3 −52 −10.1 −2.8 −9.7 −5.1
Volatility
UK US EU CA JP ASP GCC VIX UCT DGC OIL From Others
UK 43.1 11.2 28.0 2.6 7.5 1.6 4.5 0.9 0.1 0.3 0.3 56.86
US 8.9 40.8 9.5 4.1 28.9 3.3 3.6 0.2 0.4 0.1 0.2 59.16
EU 30.4 12.2 42.4 3.0 5.4 2.1 2.8 0.9 0.1 0.4 0.3 57.60
CA 6.7 5.7 7.0 40.0 4.5 31.7 3.0 0.4 0.5 0.1 0.3 59.96
JP 6.5 33.8 4.5 4.1 43.7 3.0 3.5 0.1 0.5 0.1 0.2 56.29
ASP 6.5 5.9 7.0 36.8 4.4 35.6 2.3 0.4 0.5 0.2 0.3 64.37
GCC 16.3 20.6 13.5 4.3 16.1 3.2 24.2 0.7 0.4 0.2 0.5 75.81
VIX 3.8 1.1 3.1 1.1 1.0 0.8 3.0 78.1 0.8 5.6 1.5 21.88
UCT 0.6 0.3 0.3 0.1 0.1 0.0 0.4 2.3 95.4 0.3 0.1 4.64
DGC 0.1 0.4 0.0 0.1 0.2 0.1 0.1 0.0 0.0 98.9 0.1 1.11
OIL 0.2 0.1 0.3 0.1 0.1 0.1 0.7 0.1 0.3 2.9 95.1 4.92
Contribution to others 79.9 91.5 73.3 56.4 68.2 46.0 23.9 5.9 3.7 10.0 3.9 462.59
Contribution including 123.0 132.4 115.7 96.5 111.9 81.6 48.1 84.0 99.0 108.9 99.0 Spillover
own index = 42.1%
Net spillover 23.0 32.4 15.7 −3.5 11.9 −18.4 −51.9 −16.0 −1.0 8.9 −1.0
P-T decompositions outlining the importance of domestic shocks over foreign shocks on the business fluctuations of Islamic stock
markets.
Fig. 6 displays a network diagram of the net pairwise return spillovers among the seven Islamic stock markets and the four global
risk variables. The results confirm the prominent role of the DJIM U.S., the DJIM U.K., the DJIM Europe and the DJIM Japan markets
as the main net transmitters of return spillovers to the other markets. Additionally, we can observe that there is an increase in net
return spillovers over the sub-period 8/19/2007 to 11/16/2013. The Dow Jones GCC Islamic index is mostly affected by the Islamic
Dow Jones U.S, U.K., Europe and Japan return spillovers. The VIX appears as the greatest receiver of return spillovers during the third
sub-period (11/17/2013 to the end of the sample). In particular, the net return spillovers to the VIX reach roughly 40% more
transmitted from Islamic equity markets than other global risk factors. This finding is not consistent with those of Hammoudeh et al.
(2014) and Wahyudi and Sani (2014), which report evidence of negative dependence between Islamic stock market returns and the
VIX.
Fig. 5 shows the time-varying dynamics of the net volatility spillover index for each Islamic equity market. It is worth noting that
all markets and global risk variables exhibit an important variability in net volatility spillovers. Again, the DJIM U.S, U.K., Europe,
Japan indices and, to a lesser extent, the changes in U.S. 10-year Treasury bond yields appear as the greatest transmitters of volatility
spillovers. In contrast, the DJIM GCC and Asia-Pacific Dow indices and, to a lesser degree, the DJIM Canada index, are net receivers of
volatility spillovers. Also, the VIX, the U.S. equity market-related uncertainty index, and the international crude oil price are iden-
tified as net receivers of volatility spillovers from the other Islamic stock markets and changes in U.S. 10-year Treasury bond yields.
More importantly, the VIX is mostly influenced by the changes in U.S. 10-year Treasury bond yields. This result demonstrates the high
influence of U.S. monetary policy on the movements of the VIX, which measures the level of investor’s risk aversion.
Fig. 7 displays a network diagram of the net pairwise volatility spillovers among the seven Islamic stock markets and the four
global risk variables. The results confirm the prominent role of the US, UK, Europe and Japan Islamic stock markets as the main net
transmitters of volatility spillovers to the other markets. It is worth noting that the volatility spillovers increase sharply during the
GFC and EDC periods (the volatility spillover index reached 46.6% in the sub-period 8/19/2007 to 11/16/2013). On the other hand,
the changes in the U.S. 10-year Treasury bond yields emerge, to some extent, as a net transmitter of volatility spillovers mainly on the
VIX variable, while its influence on Islamic stock markets is limited. However, this finding is in line with Shamsuddin (2014), who
provides evidence of low dependence between the DJIM index and changes in the U.S. 10-year Treasury bond yields.
Overall, the analysis of return and volatility spillovers across the seven Dow Jones Islamic indices and the four global risk factors
reveals the intensification of total spillovers during the GFC and EDC periods, suggesting the existence of inter-regional contagion
10
Fig. 4. 200-day rolling windows estimation of total returns and volatility spillover indices of Islamic Dow Jones indices.
phenomena. In addition, the results reveal the weak linkages between the Dow Jones Islamic indices and global risk factors, sup-
porting the decoupling hypothesis of the Islamic equity markets from contagion risks.
5.4. Sensitivity analysis of return and volatility spillover indices
In this subsection, we assess the sensitivity of the estimated return and volatility spillover indices to the choice of forecast
horizons and the size of the rolling window. Figs. 8.A.1 and B.1 display the total return and volatility spillover indices for different
forecast horizons varying from 10 to 40 days. The figures show that both return and volatility spillover indices follow similar patterns
for different forecast horizons. Thus, the total estimated return and volatility spillover indices are not sensitive to the choice of
forecast horizon. Similarly, Figs. 8.A.2 and B.2 provide support to the insensitivity of the total estimated return and volatility
spillover indices to the size of the rolling window.
6. Conclusions
In this paper, we shed light on the sources of common shocks affecting the Dow Jones Islamic stock markets, namely the Asia-
Pacific, U.S., European, U.K, Japan, Canada and GCC markets, as well as return and volatility spillovers across these markets and a set
of global risk factors. We used daily data from 4/14/2003 to 11/23/2018, notably covering the global financial and European debt
crises. First, we performed decompositions of permanent and transitory shocks into their respective domestic and foreign components
to measure their contribution to the movements of the seven Islamic Dow Jones market indices (Centoni et al., 2007). Second, we
applied the Diebold and Yilmaz (2009, 2012) approach to track the time variance and magnitude of return and volatility spillovers
across the seven Islamic markets and global risk factors.
The results demonstrate that the full sample decompositions of the transitory and permanent shocks into their domestic and
foreign components reveal that the DJIM CA, JP and ASP are the most sensitive to domestic shocks as compared to the DJIM U.S, U.K,
EU and GCC. In addition, the results provide evidence of the importance of transitory shocks in explaining market fluctuations when
the markets are more sensitive to domestic shocks, while permanent shocks are the dominant components when the markets are more
sensitive to external shocks. Thus, the dominant effect of domestic shocks on Islamic stock markets is evident, but some markets are
relatively more sensitive to external shocks and their permanent components than others. The findings provide reliable information
on the reactions of Islamic stock markets to domestic and foreign shocks and likely have important implications for faith-based
investors as we characterize geographically which markets are more sensitive to transitory or permanent shocks or both, and the
extent of their domestic and foreign components in explaining variations of Dow Jones Islamic stock indices.
Moreover, we investigate the time-varying mechanisms of the propagation of return and volatility spillovers across the seven Dow
11
Fig. 5. Entire sample net return and volatility spillover indices.
Jones Islamic markets and major global risk factors including the stock market implied volatility index (VIX), the U.S. equity market-
related uncertainty index, changes in U.S. 10-year Treasury bond yields and the international crude oil price. The empirical results
indicate that return and volatility spillovers exhibit similar patterns and provide evidence of significant inter-market connectedness of
Islamic stock markets, especially during the recent global financial and European debt crises. The Dow Jones U.S. Islamic market is
identified as the main transmitter of both return and volatility spillovers across Islamic stock markets and global risk factors. On the
other hand, the Asia-Pacific and GCC Islamic stock markets appear as the greatest receivers of return and volatility spillovers. The
Canadian Islamic stock market is least affected by external shocks.
The intensity of return and volatility spillovers increased during the crisis period, which calls into question the stability and
resilience of Islamic stock markets against the global finance and the European debt crises. Thus, Islamic stock markets appear to be
vulnerable to financial crises, which confirms the findings of some previous studies such as Hkiri et al. (2017) and Shahzad et al.
(2017). In contrast, we find that Islamic equity markets are less sensitive to global risk shocks, supporting the evidence that Islamic
securities are more resilient to common risk shocks. This finding is not consistent with those of Hammoudeh et al. (2014), who report
a significant dependence between Islamic equity markets and a set of global macroeconomic and financial risk variables (the WTI oil
prices, the VIX volatility index, the EMU 10-year government bond benchmark and the U.S. 10-year Treasury note constant maturity
rate).
Overall, our findings help faith-based investors assess the extent of permanent/transitory shocks on Islamic stock markets as well
as the transmission mechanisms of their domestic and foreign components. Besides, the presence of contagion effects among the
seven Dow Jones Islamic stock markets included in the study doesn’t provide possible diversification benefits for faith-based in-
vestors. More importantly, the return and volatility spillovers from the oil market to Islamic stock markets are weak, demonstrating
the importance of the oil market as a refuge against financial shocks that hit Islamic stock markets.
Despite the contributions of this paper to the Islamic finance literature there are some avenues to improve our understanding of
Islamic stock market linkages. It would be worthwhile to examine the effects of Islamic market-specific global risk factors on its
12
Fig. 6. Network diagrams of the 55 net pairwise directional return spillovers.

Notes: This figure depicts the network diagrams of the 42 pairs of directional return spillovers among the seven Islamic stock markets. The color of
the node indicates whether the market is a net transmitter (red) or receiver (green) market, while the size of the node detects the magnitude of
transmission (reception) of return spillovers. The size of the edges reflects the spillovers magnitudes. Full sample (period 14/4/2013-11/23/2018),
subperiod1 (14/4/2003-8/14/2007), subperiod2 (8/15/2007-11/18/2013) and subperiod3 (11/20/2013-11/23/2018). The index is the average of
the total return spillovers across Islamic stock markets.
return and volatility spillover dynamics. In addition, a possible extension would be to estimate the spillover indicators of Diebold and
Yilamz (2012) under short- and long-run co-movement restrictions (i.e. the Generalized VAR approach with these co-movement
restrictions).
Acknowledgements
The first author acknowledges the support provided by the Deanship of Academic Research at Imam Mohammad Ibn Saud Islamic
University, Riyadh, Saudi Arabia under the Grant number: 371121 for the year 1438H.
The authors would like to thank the Co-Editor Ali Kutan and the two anonyms reviewers for their constructive comments and
suggestions that have improved our manuscript.
Appendix A. Measures of the effects of domestic and foreign permanent/ transitory shocks
The usual approach used to estimate models with common trends and common cycles is based on finite order VAR models. So,
consider an n n -dimensional integrated I(1) process {Xt } {Xt} generated by a VAR (p) model in levels:
Π(L) Xt = εt (1)
p
where (L) = In − Πi
∑i = 1 Li ,
L is the lag operator and εt is a multivariate Gaussian white noise process εt ∼ N (0, Ω) . Since the AR
p−1
operator Π (L) can be re-expressed as Π (L) = Π (1) + (1 − L) Γ (L) with Γ (L) = In − ∑ j = 1 Γj L j , the VAR (p) can be written as a
vector error correction model (VECM) (see, e.g., Engle and Granger, 1987; Johansen, 1988, 1991):
Γ (L) ΔXt = αβ′ Xt − 1 + εt (2)

where β is the n × r matrix of the cointegration vectors and α is the nxr matrix of adjustment coefficients that are the factor loadings
in the VECM. The presence of r cointegration relations among n variables of {Xt } {Xt} {Xt} implies that there are k = n − r common
trends.
Vahid and Engle (1993) have shown that the VECM representation in (2) may be refined by considering the presence of short-run
13
Fig. 7. Network diagrams of pairwise directional volatility spillovers.

Notes: This figure depicts the network diagrams of the 42 pairs of directional return spillovers among the seven Islamic stock markets. The color of
the node indicates whether the market is a net transmitter (purple) or receiver (red) market, while the size of the node detects the magnitude of
transmission (reception) of return spillovers. The size of the edges reflects the spillovers magnitudes. Full sample (period 14/4/2013-11/23/2018),
subperiod1 (14/4/2003-8/14/2007), subperiod2 (8/15/2007-11/18/2013) and subperiod3 (11/20/2013-11/23/2018). The index is the average of
the total volatility spillovers across Islamic stock markets.
co-movements between the variables in {Xt } {Xt} , which imposes the serial correlation common feature (SCCF) restrictions. There-
fore, the elements of ΔXt ΔXt share SCCF if there is a linear combination of them that represents an innovation with respect to
information available prior to period t t (i.e. that removes the serial correlation pattern in ΔXt ).
According to Vahid and Engle (1993), SCCF holds for the VECM in (2) if there is a nxs (nxs) matrix δ of rank s such that the
∼
following two conditions are jointly satisfied: δ ′ Γi = 0 and δ ′α = 0 δ′Γ (1) = − β′α β′ = 0sxn . In addition, Centoni et al. (2007) showed
that the VECM in (2) with SCCF restrictions can be written as a common factor representation:
ΔXt = δ⊥ Φ Wt − 1 + εt ≡ δ⊥ Ft − 1 + εt (3)
′
where Φ is the (n − s ) x (n (p − 1) + r ) full rank matrix, Wt − 1 = (X′ t − 1 β, ΔX′ t − 1, ⋯, ΔX t − p + 1 ) ′ and δ⊥ is the (n − s ) xs matrix of rank
(n − s ) such that δ ′δ⊥ = 0 .
Usually, the 2-step approach of Vahid and Engel (1993) is applied to estimate and test for common features in the above common
factor representation (equation (3)). First, the cointegration rank r is determined applying the Johansen (1988, 1991) techniques and
the cointegrating vectors β are estimated using the maximum likelihood (ML) method. Second, conditional on r and β obtained in the
first step, the ML approach is used again to determine s and estimate the cofeature matrix δ . Hecq et al. (2000, 2002, 2006) show that
the ML inference is equivalent to solve the canonical correlation program CanCor (ΔXt , Wt − 1 \Dt ) , which denotes the partial ca-
nonical correlations between ΔXt and Wt − 1 conditional on the vector of deterministic terms Dt . The likelihood ratio (LR) test statistics
for the null hypothesis that the dimension of the cofeature space is at least s are given by:
s
LR = − T ∑ ln(1 − λˆl )
l=1 (4)
where the λ̂l are the s smallest squared canonical correlations between ΔXt and Wt − 1, T is the number of observations. The LR
statistic is asymptotically distributed as chi-square with s (n (p − 1) + r ) − s (n − s ) degrees of freedom.
Once the number of cointegrating and cofeature vectors is determined, Hecq et al. (2006) and Cubadda (2007) propose a Fully
Information Maximum Likelihood (FIML) approach for the estimation of the VECM model in (3) under common features restrictions.
14
Fig. 8. Sensitivity analysis.
15
Measuring the effects of foreign and domestic transitory/permanent shocks
Conditional on the parameter estimates obtained from the VECM model under common trends and common cycles restrictions; it
is possible to attempt a permanent-transitory decomposition of the variables in the system. Following Centoni and Cubadda (2003),
we perform, first, the common permanent-transitory decomposition of the shocks as follows:
p ˆ εˆt
ût = αˆ⊥′ εˆt and u
ˆ tT = αˆ ′ Ω (5)
where ε̂t is the VECM residuals, and α̂ and α̂⊥ are the estimate and the orthonormal estimate of α, respectively.
Second, we use the decomposition framework proposed by Centoni et al. (2007) to return the effects of foreign and domestic
transitory/permanent shocks. This decomposition involves the following steps:
ˆ αˆ⊥)−1 u tp and εˆtT = αˆ (α′
ˆ αˆ⊥ (αˆ⊥′ Ω
1. Construct εˆtp = Ω ˆ αˆ )−1 u tT
P, D
ˆ ˆ Ω ˆ p T,D
2. Compute for = 1, ⋯, n , u jt (the permanent-domestic shock) as the fitted values of a regression of u t on ε̂ jtp and u jt (the
ˆ ˆ ˆ
T
transitory-domestic shock) as the fitted values of a regression of u t on ε̂tT . ˆ
P, F p P, D T,F
T
3. The permanent-foreign and the transitory-foreign shocks are computed respectively as u jt = u t − u jt and u jt =
T,D
ˆ ˆ ˆ ˆ
ˆ ˆ
u t − u jt for j = 1, ⋯, n .
P, F P, D T,D P, F P, D T,D
4. Compute Ω̂ j , Ω̂ j , and Ω̂ j respectively, as the sample covariance matrices of the vector series u jt , u jt , and u jt for
j = 1, ⋯, n .
ˆ ˆ ˆ
* *
′ *
ˆ αˆ⊥)−1, and T̂ * (z k ) = C * (z k ) αˆ (α′
*
ˆ
5. Construct Ĉ (z k ) = ( Γˆ (z k ) − αˆ βˆ z k )−1, P (z k ) = C (z k ) Ω
ˆ αˆ⊥ (αˆ⊥′ Ω
ˆ ˆ Ω ˆ
ˆ αˆ )−1, where
z k = exp(−iωk ) , and ωk = ω0 ( m−k
k ) + ω ( ) for k = 0, ⋯, m.
1
k
m
P, F P, D T ,D
6. The relative contributions of foreign-permanent ( Î j ), domestic-permanent ( Î j ), domestic-transitory ( Î j ) and foreign-
T ,F
transitory ( Î j ) shocks, for j = 1, ⋯, n , are computed as:
m m −1
P, D ⎡ *
ˆ Pj , D P * (z k−1 )′ ej ⎤ ⎡ ∑ e′j C * (z k ) Ω
ˆ C * (z k−1 )′ ej⎤
Î j (ω0, ω1) = ⎢ ∑ e′j P (z k ) Ω
⎣ k=0
ˆ ˆ ⎥⎢
⎦ ⎣ k=0
ˆ ˆ ⎥
⎦
m m −1
P, F ⎡ *
ˆ Pj , F P * (z k−1 )′ ej ⎤ ⎡ ∑ e′j C * (z k ) Ω
ˆ C * (z k−1 )′ ej⎤
Î j (ω0, ω1) = ⎢ ∑ e′j P (z k ) Ω
⎣ k=0
ˆ ˆ ⎥⎢
⎦ ⎣ k=0
ˆ ˆ ⎥
⎦
m m −1
T, D ⎡ *
ˆ Tj , D T * (z k−1 )′ ej ⎤ ⎡ ∑ e′j C * (z k ) Ω
ˆ C * (z k−1 )′ ej⎤
Î j (ω0, ω1) = ⎢ ∑ e′j T (z k ) Ω
⎣ k = 0
ˆ ˆ ⎥⎢
⎦⎣ k = 0
ˆ ˆ ⎥
⎦
Î jT ,F (ω0, ω1) = 1 − Î jP,D (ω0, ω1) − Î jP,F (ω0, ω1) − Î jT,D (ω0, ω1)
where ej is an n -vector with unity as its jth element and zeroes elsewhere, and (ω0, ω1) denotes the business cycle frequency.3
Appendix B. Measures of directional and net return/volatility spillovers
To implement the Diebold and Yilmaz (2012) approach, we assume that the n− returns of the Dow-Jones Islamic equity indices
follow a qth -order VAR:
q
Yt = ∑ aj Yt−j + ϑt
j=1 (6)
where aj are n × n autoregressive parameter matrices, and ϑt ∼ N (0, Σ) . As the VAR system is stationary, it possible to find an infinite
Moving Average (MA) representation given by:

Yt = ∑ θj ϑt−j
j=0 (7)
θj = a1 θj − 1 + a2 θj − 2 + ⋯+aq θj − q (8)
where θ0 = In , and θj = 0 for i < 0 . Based on the generalised variance decomposition introduced by Koop et al. (1996); Pesaran and
Shin (1998), and Diebold and Yilmaz (2012) propose the following H-step forecast error variance decomposition that is invariant to
variable ordering:
3 P, F P, D T ,D T ,F
The foreign-permanent ( Î j ), domestic-permanent ( Î j ), domestic-transitory ( Î j ) and foreign-transitory ( Î j ) shocks are the relative
measures of spectral mass at the business cycle frequency band (ω0 , ω1)
16
H −1
σ −jj1 ∑h = 0 (e′ i θh ej )2
ij (H ) = H −1
∑h = 0 (e′ i θh Σθ′ h ei )2 (9)
where σjj is the standard deviation of the j error term, and ei is the selection vector with one in its ith element and zero elsewhere. To
n
solve the problem that ∑ j = 1 Qij (H ) ≠ 1, each element of the variance decomposition matrix can be normalised by its row sum:
∼ ij (H )
ij (H ) = n
∑ j = 1 ij (H ) (10)
n ∼ n ∼
where ∑ j = 1 Qij (H ) = 1, and = n . The total spillover index is, therefore, defined as:
∑i, j = 1 Qij (H )
n ∼ n ∼
∑i, j = 1, i ≠ j ij (H ) ∑i, j = 1, i ≠ j ij (H )
TS (H ) = n ∼ × 100 = × 100
∑i, j = 1 ij (H ) n
(11)
The directional spillovers index from market i to all other markets j is given by:
n ∼ n ∼
∑ j = 1, i ≠ j ji (H ) ∑ j = 1, i ≠ j ji (H )
Di → j (H ) = n ∼ × 100 = × 100
∑i, j = 1 ij (H ) n
(12)
Similarly, the directional spillovers index from all other markets to market i is given by:
n ∼ n ∼
∑ j = 1, i ≠ j ij (H ) ∑ j = 1, i ≠ j ij (H )
Di ⟵ j (H ) = n ∼ × 100 = × 100
∑i, j = 1 ij (H ) n
(13)
The two directional spillover indices provide information on the magnitude of transmission channels of intra- and interregional
spillovers across markets. Then, it is possible to investigate whether a market is a net transmitter or net receiver of shocks by
computing the net spillovers index:
NSi (H ) = Di → j (H ) − Di ⟵ j (H ) (14)
Moreover, the Diebold and Yilmaz (2012) approach allows calculating the net pairwise spillovers between markets i and j defined
as the difference between the gross shocks transmitted from market i to market j and vice versa. Therefore, the net pairwise spillovers
is given by:
∼ ∼
⎡ ij (H ) ji (H ) ⎤
NPSij (H ) = ⎢ n ∼ − n ∼ ⎥
∑
⎣ k = 1 ik (H ) ∑ (H ) ⎦
k = 1 ik (15)
Appendix C. Supplementary data
Supplementary material related to this article can be found, in the online version, at doi:https://doi.org/10.1016/j.ecosys.2020.
100760.
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Economic Systems 44 (2020) 100760

Contents lists available at ScienceDirect

Common shocks, common transmission mechanisms and time-

3.1. Measuring the eﬀects of foreign and domestic transitory/permanent shocks

3.2. Measuring the time-varying return and volatility spillover indices

Islamic Dow Jones stock returns

4. Data and preliminary analysis

5.1. Common trends and common cycle tests

Fig. 1. Time trajectories of Islamic Dow Jones stock indices.

TB1 TB2 T-Stat Critical Values

Islamic Dow Jones stock returns

5.2. The eﬀects of foreign and domestic transitory/permanent shocks

Fig. 2. Time trajectories of macroeconomic and ﬁnancial variables.

Null hypothesis Trace statistics P-value Null hypothesis LR statistics P-value

Domestic-Permanent 39.9% 49.8% 30.2% 26.4% 35.3% 27.4% 37.0%

5.3. Return and volatility spillover eﬀects

UK US EU CA JP ASP GCC VIX UCT DGC OIL From Others

5.4. Sensitivity analysis of return and volatility spillover indices

Fig. 5. Entire sample net return and volatility spillover indices.

Fig. 6. Network diagrams of the 55 net pairwise directional return spillovers.

Γ (L) ΔXt = αβ′ Xt − 1 + εt (2)

Fig. 7. Network diagrams of pairwise directional volatility spillovers.

Fig. 8. Sensitivity analysis.

Measuring the eﬀects of foreign and domestic transitory/permanent shocks

Appendix B. Measures of directional and net return/volatility spillovers

Appendix C. Supplementary data

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