Oil Shocks Greasing the Wheels of Islamic Stocks: An Explorative Forecasting Analysis

This paper examines the relationship between Islamic finance and oil shocks by decomposing oil price into demand, supply, and risk shocks. This paper’s distinguishing feature lies in assessing the forecasting prowess of —in-and-out-of-sample—oil shocks on Islamic finance. Using pooled data from the Dow Jones regional Islamic finance indices across regions (Emerging economies, Europe, Asia-Pacific, and the world), our results reveal that the three variants of shocks are significant determinants of Islamic finance returns. We also show that the shocks can forecast stock returns, though this forecasting ability is weak for the European market. Accounting for the influence of some macroeconomic fundamentals improves the forecasting prowess of the model and allows for successful robustness checks. The policy implication of the result is that investors and related shareholders in the Islamic financial markets should necessarily consider the divergent activities in the oil market while making portfolio design decisions. We are also of the view that future studies could consider replicating the analytical construct and hypothesis of this paper on a country-level and probably at the sectoral level.