Portfolio Diversification Across Islamic Vs. Conventional Banks: The Role of Macroeconomic Fundamentals in Stock Volatility

Abstract

Purpose: This study aims to investigate the effect of macroeconomic
factors on the stock return volatility and volatility dynamics on
comparative bases for Islamic vs. Conventional Banks.
Methodology: The stock returns volatility of all the Pakistani listed
banks from Islamic and Conventional sectors is considered for the period
from Jan 1, 2010, to Dec 31, 2021. A time-series model GARCH(1,1) is
applied for the relationship between stock returns volatility along with its
various dynamics and economic fundamentals.
Findings: All the macroeconomic factors prove their significance in
finding the stock return volatility in both Islamic and Conventional
banking systems. The market return shows a negative association with
stock return volatility in both Islamic and Conventional Banks. For most
of the Conventional and Islamic banks, the risk-free rate shows positive
and negative effects, respectively. Finally, the exchange rate and oil prices
show a negative impact on both Islamic and Conventional banks. The
volatility shocks are quite persistent. Both the ARCH and GARCH effects
play their role in generating conditional future stock return volatility.
Moreover, the overall volatility process is mean-reverting; nonetheless,
the speed of mean reversion varies across both sectors.
Significance: To the best of the authors’ knowledge, this is the first study
of its kind that compares the Conventional and Islamic banks’ stock
volatility with regard to the economic fundamentals in Pakistan.
Practical Implication: The results designate that there are significant
dissimilarities (even carrying opposing or negative correlation) in both
sectors; hence, the investors may diversify their investments and form their
liquidity positions in both sectors to attain the maximum advantages from
the market and bank’s specific factors.