**COMPARISON OF ISLAMIC AND CONVENTIONAL BANK STOCKS BY VALUE-AT-RISK METHOD**

**NURSULTAN ABDRASHEV****LOMONOSOV MOSCOW STATE UNIVERSITY, FACULTY OF ECONOMICS**

*Abstract.* This article is focused on comparison of Islamic and conventional bank stock volatility by VaR (Value-At-Risk) risk assessment method. The performed analysis has shown that factors affecting stock values for different financial models are very similar, and that including stocks of both Islamic and conventional banks in an investor’s portfolio gives no significant benefits in terms of diversification.

*Keywords:* Islamic finance, Islamic banking, market risk, portfolio risk, volatility

JEL Classification: F33, G21, C22, C53

ABDRASHEV, NURSULTAN (2015) "COMPARISON OF ISLAMIC AND CONVENTIONAL BANK STOCKS BY VALUE-AT-RISK METHOD". Journal of Russian Review (ISSN 2313-1578), VOL. 2(3), 50-57.

**1. Introduction**

The major principle of conventional financing is ‘the higher the investment risk, the higher the returns’. However, the relationship between risk and asset returns in Islamic financial institutions, which are an alternative type of stock market investors, still needs to be studied.

The purpose of the work is to find out if Islamic bank stocks are less susceptible to financial crises. For this purpose, a comparison of volatility for Islamic and conventional bank stocks is performed using VaR (Value-At-Risk) method of risk assessment.

Ideally, an Islamic financial institution’s stock value should be less fluctuating and less susceptible to influence of microeconomic factors. Therefore, these stocks are to be less risky and more immune to financial crises. Accordingly, they can bring some benefits if used for investment portfolio diversification purposes.

That said, it remains unclear if all financial instruments of companies that position themselves as Islamic really comply with Sharia principles. Here the assumption is that they do comply with these principles.

In the course of the study, the following hypotheses were to be verified.

- A portfolio consisting only of Islamic bank stocks will have much lower volatility (lower VaR values);
- Including stocks of both Islamic and conventional banks in a portfolio will give significant benefits for the investor in terms of diversification;
- Correlation between returns on Islamic and conventional bank stocks would be negative in most cases due to differences in the factors affecting stock prices for the two dissimilar financial models

The study covers a broad time frame including both pre-crisis and post-crisis periods - 2007 to 2014.

**2. Literature review**

In economic literature, there are few works discussing stocks of Islamic financial institutions. Derigs and Marzban (2009) made a comparison of portfolios consisting of Islamic and conventional assets (stocks) from an asset structure perspective. They concluded that, by developing a portfolio strategy based on market capitalization, a portfolio consisting of Sharia-compliant assets can be as profitable as a portfolio consisting of conventional assets.

Guyot (2012), based on his analysis of The Dow Jones Islamic Market Index (DJIMI), says that in comparison the DJIMI^{1} is more susceptible with the regular Dow-Jones index, to such macroeconomic factors as mortgage crisis. Also, the author maintains that the Islamic index has no co-integration (relationship) with other indices and is therefore reliable from long-term portfolio diversification perspective. Additionally, Derbel, Bouraoui and Dammak concluded in their study (2011) that the Islamic financial model can reduce crisis influence, and that this influence is less evident in countries which use Islamic financing methods.

*(1) The Dow Jones Islamic Market Index (DJIMI) is a basic index of Islamic companies’ capitalization. It makes part of the group of global Dow-Jones indices, which are calculated based on company stocks from 34 countries of the world. The purpose of DJIMI is to establish a clear standard of measuring global stock market indicators according to the existing methodology of calculating DJ indices and to Islamic investment guidelines established by Sharia supervisory board (Musaev, Magomedova - - Special regulations of Islamic financial institutions, 2015. http://rifc.su/?p=840) )*

Herwany and Febrian (2013) conducted a portfolio analysis of Islamic and conventional stocks on Indonesian stock exchange. They reported high volatility of a portfolio consisting of Islamic stocks and its strong dependence on changes of macroeconomic indicators. In another study (Yusop, 2008), the author used the Kuala Lumpur Syariah Index (KLSI) and concluded that beta of Islamic company stocks is positive and below 1, which means that investment risk for Islamic stocks on Kuala Lumpur stock exchange is lower than the market risk. Selim (2008) made a similar conclusion.

From this review of empirical studies, we can see that the studies were based mainly on the Islamic index rather than on individual stock prices. Along with that, the analysis of prices for Islamic financial institutions within a portfolio structure makes it possible to obtain more information and allow for volatility. Also, Cakir and Raei (2007) used portfolio analysis to compare sukuk and conventional bonds. To conduct an analysis by VaR assessment method, hypothetical portfolios were built, which consisted of sukuk and conventional bonds from different countries. The results were in sukuk’s favour; when included in a portfolio of conventional bonds, sukuk gave the investor diversification benefits due to significant decrease in the portfolio’s VaR value. We shall apply a similar methodology in this work.

**3. Methodology**

The VaR method will be used to analyze a portfolio consisting of Islamic and conventional bank stocks, in order to find out if this kind of diversification provides any benefits.

For the analysis, we shall take six hypothetical portfolios of Islamic and conventional bank stocks. The banks of the following countries were selected: Bahrain, UAE, Jordan, Kuwait and Qatar. The country selection was partly determined by restricted amount of available data. Countries where numerous Islamic financial institutions operate without any obvious restrictions that is, Islamic countries, were selected intentionally. Islamic and conventional banks were selected based on comparability of their market capitalization. In the frame of the study, data on stock prices for these banks for the period of 2007-2014 were used. All the data were taken from the finanz.ru service.

The first portfolio will contain only Islamic bank stocks. In the second portfolio, one Islamic bank will be replaced with a conventional one. In the next portfolio, two banks will be replaced, and so on. As a result, the fifth portfolio will contain stocks of one Islamic and four conventional banks. The sixth portfolio will consist of conventional bank stocks only. VaR of each portfolio will be calculated. Based on the results, conclusions will be made. The table below represents banks selected for the study:

**Table 1. List of banks selected for the study**

¹ | Islamic bank | Conventional Bank | Country |

1 | Al Baraka Banking Group | Al Salam Bank - Bahrain | Bahrain |

2 | Dubai Islamic Bank | Commercial bank of Dubai | UAE |

3 | Jordan Islamic Bank | Jordan Ahli Bank | Jordan |

4 | Kuwait Finance House | Gulf Bank | Kuwait |

5 | Qatar Islamic Bank | Commercial Bank of Qatar | Qatar |

There are different methods to calculate a portfolio’s VaR value. In this work, we shall use the one where individual VaR values for portfolio assets are calculated first, then the total portfolio VaR is determined (Nikiforova, 2010). The method uses the formula:

where

V – a column matrix of VaR values for each share,

V’- transpose of a column matrix of VaR values for each share, i.e. a row matrix,

p- n õ n correlation matrix (n – the number of assets in a portfolio).

To calculate the VaR risk measure for each asset, a method of simulation on history (‘delta normal method’) will be applied. Among all methods of VaR calculation, this is the most popular one. The simulation will be made in Excel.

Let’s consider an example of VaR calculation for one of the selected Islamic bank stocks - Qatar Islamic Bank. First of all, prices for the period under discussion are to be loaded. According to Bank of International Settlements’ guidelines, minimum 250 price data are to be used for VaR calculation. We have daily stock prices for 8 years (in average, 2000 prices per bank).

The next step is to calculate daily returns for the company’s shares. They can be derived as the natural logarithm of the previous day close to the current day close ratio.

Then, we have to calculate the mathematical expectation and standard deviation values. These are the major parameters of the returns distribution. The mathematical expectation is calculated as an average of all daily returns on shares. For Qatar Islamic Bank shares, the average annualized return for the period under discussion was 3.31%. The standard deviation of return on stock for the bank was 1.95%.

The next step is to determine the normal distribution quantile. In statistics, quantile is the value of the Gaussian distribution function with the defined parameters (mathematical expectation and standard deviation). That is, at these parameters, the function must not exceed the derived value with the defined probability. In our analysis, a 99% probability level will be used. For the bank under discussion, the quantile was 4.56%.

Then, the future stock value at the defined returns distribution parameters is forecasted. To this end, the following formula is applied:

where

q – quantile of the stock return distribution,

Pt – stock price at the moment t,

Pt+1 – minimum stock value in the next time period t at the defined quantile level.

To determine forecasted values of the future stock price some periods in advance, the modification of the above formula is used:

where

q – quantile of the stock return distribution,

Pt – stock price at the moment t,

Pt+1 – minimum stock value in the next time period t at the defined quantile level.

n – forecast depth, for which a probable minimum stock value is determined.

For Qatar Islamic Bank, Pt+1 value was 97.54 Qatar reals. This means that, with a probability of 99%, the stock value on the next forecasted day will be 97.54 Qatar reals minimum. The stock value on the last day (Dec. 31, 2014) was 103.1 Qatar reals.

Then, the VaR value itself for the bank is calculated a certain number of days in advance. To calculate a relative VaR value (for the analysis in this work, relative VaR values will be used, because the downloaded data on stock prices are in different currencies), we have to calculate the natural logarithm of the stock price forecasted some days in advance to the stock price on the last day ratio (Dec. 31, 2014). That said, VaRt+1 for the bank under examination was 4.76%; this means, with a probability of 99%, the stock price on the next forecasted day will be lower by 4.67% maximum than the previous day price. However, for the purposes of the analysis, as the available data cover a large time frame, we shall use a 5-day period (i.e. we’ll analyze in what lower limits a stock price will be in 5 days with a probability of 99%). This time frame is also more representative (the selected countries have different working days, which results in different trade operations; so one day would be insufficient for correct forecasting) and more often used in studies. For Qatar Islamic Bank, the VaRt+5 value was 10.77%. Using this methodology, VaRt+5 values for all banks under consideration were determined.

**Table 2. VaR values for Islamic banks**

Banks | VaRt+5 | |

1 | Al Baraka Banking Group | 0.1717 |

2 | Dubai Islamic Bank | 0.1448 |

3 | Jordan Islamic Bank | 0.0889 |

4 | Kuwait Finance House | 0.1285 |

5 | Qatar Islamic Bank | 0.1076 |

**Table 3. VaR values for conventional banks**

Banks | VaRt+5 | |

1 | Al Salam Bank - Bahrain | 0.2167 |

2 | Commercial bank of Dubai | 0.1211 |

3 | Jordan Ahli Bank | 0.1821 |

4 | Gulf Bank | 0.2880 |

5 | Commercial Bank of Qatar | 0.0834 |

We can see that individual Islamic banks do not outgo their conventional ‘rivals’ on this criterion very much, with the exception of Kuwait banks - the Islamic bank’s VaRt+5 is 12.85%, while that of the conventional one is 28.8%.

**4. Calculation**

We make calculations according to the analysis methodology.

**Portfolio 1:****Table 4. Correlation matrix of daily returns for portfolio 1 stocks:**

Al Baraka Banking Group | Dubai Islamic Bank | Jordan Islamic Bank | Kuwait Finance House | Qatar Islamic Bank | |

Al Baraka Banking Group | 1 | 0.91 | 0.87 | 0.49 | 0.37 |

Dubai Islamic Bank | 0.91 | 1 | 0.82 | 0.54 | 0.42 |

Jordan Islamic Bank | 0.87 | 0.82 | 1 | 0.76 | 0.60 |

Kuwait Finance House | 0.49 | 0.54 | 0.76 | 1 | 0.69 |

Qatar Islamic Bank | 0.37 | 0.42 | 0.60 | 0.69 | 1 |

For this portfolio consisting of Islamic banks only, VaRt+5 is 8.31%. This means that, with the probability of 99%, an investor holding a portfolio that consists of these bank stocks in equal proportion can lose in 5 days maximum 8.31% of the current portfolio value.

Then, to verify the suggested hypotheses, we replace one Islamic bank after another with conventional ones. The order is determined by the level of correlation between an Islamic and conventional bank of the country (from lower to higher correlation levels).

The correlation of daily returns for Islamic and conventional bank stock prices is presented below by country.

Table 5. The correlation of returns for Islamic and conventional bank stocks

Al Baraka Banking Group | Dubai Islamic Bank | Jordan Islamic Bank | Gulf Bank | Qatar Islamic Bank | |

Al Baraka Banking Group | 1 | 0,91 | 0,87 | 0,25 | 0,37 |

Dubai Islamic Bank | 0,91 | 1 | 0,82 | 0,25 | 0,42 |

Jordan Islamic Bank | 0,87 | 0,82 | 1 | 0,20 | 0,60 |

Gulf Bank | 0,25 | 0,25 | 0,20 | 1 | 0,41 |

Qatar Islamic Bank | 0,37 | 0,42 | 0,60 | 0,41 | 1 |

**Portfolio 2:****Table 6. Correlation matrix of daily returns for portfolio 2 stocks:**

VaRt+5 = 8.45%. We can see that this portfolio’s VaR is 0.14% higher as compared to the previous one, ie, the replacement of an Islamic bank by a conventional one so far has caused losses.

**Portfolio 3:****Table 7. Correlation matrix of daily returns for portfolio 3 stocks:**

Al Salam Bank - Bahrain | Dubai Islamic Bank | Jordan Islamic Bank | Gulf Bank | Qatar Islamic Bank | |

A lSalamBank - Bahrain | 1 | 0,66 | 0,33 | 0,12 | -0,07 |

Dubai Islamic Bank | 0,66 | 1 | 0,82 | 0,25 | 0,42 |

Jordan Islamic Bank | 0,33 | 0,82 | 1 | 0,20 | 0,60 |

Gulf Bank | 0,12 | 0,25 | 0,20 | 1 | 0,41 |

Qatar Islamic Bank | -0,07 | 0,42 | 0,60 | 0,41 | 1 |

VaRt+5 = 8.00%. In this case, after replacement of two Islamic banks by conventional ones, VaR is slightly lower; it declined by 0.31%.

Portfolio 4:**Table 8. Correlation matrix of daily returns for portfolio 4 stocks:**

A lSalam Bank - Bahrain | Dubai Islamic Bank | Jordan Ahli Bank | Gulf Bank | Qatar Islamic Bank | |

Al Salam Bank - Bahrain | 1 | 0,66 | 0,53 | 0,12 | -0,07 |

Dubai Islamic Bank | 0,66 | 1 | 0,82 | 0,25 | 0,42 |

Jordan Ahli Bank | 0,53 | 0,82 | 1 | 0,63 | 0,68 |

Gulf Bank | 0,12 | 0,25 | 0,63 | 1 | 0,41 |

VaRt+5 = 8.32%, which is practically identical to the original portfolio which consisted of Islamic banks only.

**Portfolio 5:****Table 9. Correlation matrix of daily returns for portfolio 5 stocks:**

Al Salam Bank - Bahrain | Dubai Islamic Bank | Jordan Ahli Bank | Gulf Bank | Commercial Bank of Qatar | |

Al Salam Bank - Bahrain | 1 | 0,66 | 0,53 | 0,12 | -0,20 |

Dubai Islamic Bank | 0,66 | 1 | 0,82 | 0,25 | 0,45 |

Jordan Ahli Bank | 0,53 | 0,82 | 1 | 0,63 | 0,63 |

Gulf Bank | 0,12 | 0,25 | 0,63 | 1 | 0,66 |

Commercial Bank of Qatar | -0,20 | 0,45 | 0,63 | 0,66 | 1 |

VaRt+5 = 7.95%. The risk decreased.

**Portfolio 6.****Table 10. Correlation matrix of daily returns for portfolio 6 stocks:**

Al Salam Bank - Bahrain | Commercial bank of Dubai | Jordan Ahli Bank | Gulf Bank | Commercial Bank of Qatar | |

Al Salam Bank - Bahrain | 1 | 0,60 | 0,53 | 0,12 | -0,20 |

Commercial bank of Dubai | 0,60 | 1 | 0,84 | 0,29 | 0,56 |

Jordan Ahli Bank | 0,53 | 0,84 | 1 | 0,63 | 0,63 |

Gulf Bank | 0,12 | 0,29 | 0,63 | 1 | 0,66 |

Commercial Bank of Qatar | -0,20 | 0,56 | 0,63 | 0,66 | 1 |

VaRt+5 = 8.23%. The risk increased.

5. Conclusion

It was found that VaR values for both the portfolio consisting of only Islamic bank stocks and the portfolio consisting of only conventional bank stocks are practically equal (for conventional banks, the value was even slightly better – by 0.08%). This means that the first hypothesis has to be rejected: the statement, ‘A portfolio consisting of only Islamic bank stocks will have much lower volatility’ was not corroborated.

We assumed that the investment diversification could bring significant benefits; however, from the portfolio analysis we can conclude that no significant benefits were achieved. For all portfolios consisting of both Islamic and conventional bank stocks, the VaR value did not deviate more than by 0.5% from VaR of the original portfolio, which consisted of Islamic bank stocks only, and from VaR of the portfolio, which consisted of conventional bank stocks only. Thus, the second hypothesis also has to be rejected: the statement, ‘Including stocks of both Islamic and conventional banks in a portfolio will give significant benefits for the investor in terms of diversification’ was not corroborated.

In practice, all signs of correlation matrices of the portfolios under examination, which included both Islamic and conventional banks, are positive. This means that factors, which affected stock prices of both Islamic and conventional banks of the selected countries, were much alike. That said, the third hypothesis also has to be rejected: the statement, ‘Correlation between returns of Islamic and conventional bank stocks will be negative in most cases due to differences in factors affecting stock prices for the two dissimilar financial models’ was not corroborated.

The objective of the research – to find out if Islamic bank stocks are less susceptible to financial crises – is achieved. The major conclusion of the study can be formulated as follows: the popular opinion that Islamic financial institutions are less susceptible to financial crises than conventional ones can not be corroborated.

The final results were certainly affected by the selection of countries, whose banks were included in the portfolios. While these countries are formally Islamic, they are far from leading positions in the rating of compliance with Islamic economic principles: Kuwait holds position No, 42, Bahrain – 61, UAE – 64, Jordan – 74 and Qatar – 112 . It is worth noting that our study was limited by ten banks only, due to data availability. However, probably the major factor was infrastructural imperfection of Islamic stock exchanges as well as the fact that they allow speculations with financial assets, which is confirmed by Bekkin and Yandiev (2010). This fact apparently levels the originally high immunity of Islamic financial assets to financial crises.

**6. References**

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