Global financial crisis can affect the financial industry very quickly throughout the world due to the mutual economic linkages between countries. For example, the global financial crisis that occurred in 2008, which resulted in a fall in world stock prices, including Islamic stocks. The financial crisis in 2008 began when Lehman Brothers Holdings Inc., which is one of the largest investment banks in the United States, declared bankruptcy and affected various sectors, especially the stock market around the world. At that time, the banking sector also experienced a crisis with restraint and carefully provided loans due to fears of inadequate funds. The Federal Reserve (The Fed) as the central bank in America must also reduce lending rates to 0% to stimulate a slowing economy and pour funds into the financial sector to stimulate sluggish transactions. It is because global financial shocks harm the financial industry, particularly the stock market.
The study was conducted to determine how global financial shocks affect the correlation between Indonesia and seven other selected countries (US, UK, Japan, Kuwait, Saudi Arabia, Malaysia, and Qatar) from December 2004 to December 2012. Unlike the previous one, this study used the wavelet method to find out the implications of financial shocks on the stock market, during shock periods and non-shock periods in a particular frequency. The advantage of wavelet is that this method can visualize the estimated wavelet correlation at different time scales. Therefore, the results of this study will be able to explore how the right portfolio diversification strategy by considering its effect on portfolio weight. Furthermore, the application of the wavelet method in this study is expected to make a vital contribution compared to using Pearson’s correlation in making investment decisions. With the assumption that the correlation between stocks will show dynamic behaviour that can be determined how long the relationship lasts and the wavelet method is considered to be more able to describe periods with different frequencies that cannot be expressed by autoregressive conditional heteroscedasticity (DCC-GARCH) and other conventional methods.
The results of this study indicate that the correlation between Islamic and conventional stock markets tends to be more volatile at different scales during before, during and after the crisis. Wavelets show a higher correlation during crisis periods, both in the short and long term. When there is a high correlation between stocks between countries, there is very little possible diversification in that market. Conversely, when the correlation tends to be low, diversification can be done. The results of the study show the strength of the Islamic financial system against global financial shocks that usually affect conventional financial systems. However, this does not mean that the Islamic financial system is free from the impact of global financial shocks, given its linkages with America, Japan and other markets. Several Islamic stock markets in these countries were also affected by the 2008 global crisis, but it can be concluded that Islamic stocks have performed better than conventional stocks.
The results of this study have significant implications for investors to optimize their stock allocation strategy or to diversify their global investments because changes in the correlation of the stock market at high and low-frequency scales will significantly affect investment portfolios at the international level.
Author: Siti Zulaikha