DCC-Garch Models Using Islamic Market and European Market Indices

Abstract

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The last financial crisis (2007-2008) raises the question of how European stock shocks are distributed and transmitted from developed stock markets to Islamic stock markets. More precisely, the problem related to Islamic finance or any other alternative finance is, whether the shocks to the volatilities in the asset returns constitute substitute or complement in terms of risks strategies. A good understanding of volatilities of asset returns is necessary to analyze and forecast domestic and international investors’ portfolios. The cornerstone of the current paper is the analysis of the dynamic correlations between the European conventional financial indices (as a proxy for global
benchmark) and Islamic indices. We have chosen European markets since most of the works on this topic have focused on the US market. We have used the Dynamic Conditional Correlations approach to detect any shifts in correlations between the different indices over a recent period (from 07/31/2007 to 08/25/2017). The period includes the most severe financial turbulences (2007-2011) in Europe. Two types of distribution have been tested namely Gaussian distributions versus t-distributions. The paper finds that European and Islamic indices are highly correlated. This point may be useful for the policymakers because of the contagion risk. The results are robust across
different distributions and the model associated with t-distribution is more relevant.