ECON 40364-Investigating International Portfolio Diversification Opportunities for the Asian Islamic Stock Market Investors

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1 INTRODUCTION The economic integration of international stock markets has become especially relevant over the last two decades. The substantial development of technology and the increased flow of c... apital between countries are the main factors for this globalization process. Thus, understanding the linkages between different financial markets is of great importance for portfolio managers and financial institutions. Volatility, as measured by the standard deviation or variance of returns, is often used as a crude measure of the total risk of financial assets (Brooks, 2002). Hence, when referring to international equity markets integration, researchers not only investigate the return causality linkages, but also measure volatility spillover effects. Information about volatility spillover effects is very useful for the application of value at risk and hedging strategies. Recently, with the role of the emerging markets becoming more important, economists not only focus on developed countries, for example, United States, the United Kingdom, and Japan, but also pay great attention to the emerging markets. For example, in the equity markets, the extent of the linkages of the emerging stock market exchanges with developed stock market exchanges has important implications for both the developing and the developed countries’ investors. If the emerging market stock exchange is only weakly integrated with the developed market, it has the implication that there would be portfolio diversification possibilities for developed countries’ investors through including the emerging market stocks in their portfolio as this diversification should reduce risk, and vice versa. On the contrary, if the emerging stock markets were fully integrated with the developed stock markets, there would not be any portfolio diversification benefit for either developed and/or emerging countries’ investors. Several researches such as Kumar and Mukhopadhyay (2002) and Wong, Agarwal, and Du (2005) support the notion that there is a correlation between the various markets globally. Furthermore, Yang (2005) inspected the international stock exchange correlations between Japan and the Asian Four Tigers (Hong Kong, Singapore, South Korea, and Taiwan) and found that stock exchange correlations vary widely over time and volatilities seem to be contagious across the markets. The importance of these studies was also confirmed by Levy and Sarnat (1970), in which they have shown how the correlations between developed and developing countries provide a paramount risk-reduction benefit. More recently, the focus of the studies of these topics shifted to the contagion effect of financial crisis. For example, Lucia and Bernadette’s (2010) analysis show the evidence that the global financial crisis in 2007–2009 has been affecting differently the world economic regions. In the same year, Charles, Pop, and Darne (2011) discovered that during the crisis, both Islamic and conventional indices were affected to the same degree by variance changes. However, in terms of portfolio diversification, 3 Achsani, Effendi, and Abidin (2007), in general, find that the interdependence of the Islamic stock markets tends to be asymmetric across a wide geographical area. While there are strong correlations between the Islamic stock indices of Indonesia and Malaysia, the US and Canada, and Japan and Asia Pacific, this is not exactly the case across the region. [Show More]

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