How strong are the causal relationships between Islamic stock markets and conventional financial systems? Evidence from linear and nonlinear tests

Past studies suggest that the Islamic Â…nance system is only weakly linked or even de- coupled from conventional markets. If this statement is true, then this system may provide a cushion against potential losses resulting from probable future Â…nancial crises. In this article, we make use of heteroscedasticity-robust linear Granger causality and nonlinear Granger causality tests to examine the links between the Islamic and global conventional stock markets, and between the Islamic stock market and several global economic and Â…nancial shocks. Our Â…ndings reveal evidence of signiÂ…cant linear and nonlinear causality between the Islamic and conventional stock markets but more strongly from the Islamic stock market to the other markets. They also show potent causality between the Islamic stock market and Â…nancial and risk factors. This evidence leads to the rejection of the hy- pothesis of decoupling of the Islamic market from their conventional counterparts, thereby reduces the portfolio beneÂ…ts from diversiÂ…cation with Sharia-based markets. A striking result shows a connection between the Islamic stock market and interest rates and interest- bearing securities, which is inconsistent with the Sharia rules. The results also suggest that modeling Islamic stock markets should be done within a nonlinear VAR system and not through a regression equation.