The title of our project is factors affecting international equity return. The purpose of our study is about the equity markets and equity returns. This concept paper examines the functioning of the equity market and equity return from conventional and Islamic perspective. In general for first decade of 21′ century, Islamic financing shown tremendous increase. Besides, global volume has reached to US $ 1,041 billion by the end of 2009. This study also conducted to understand about how the international equity return can be affected. The findings of the study are included the Mudharabah perspective, risk and return of islamic equity fund. In conclusion, the variety of international equity benchmark was presented. Equity return were also found that it is more sensitive to own-currency exchange rate changes.
Keywords : Equity return, equity market, macroecononmics, employment rate, Islamic financing, Risk, Return, Mudharabah deposits.
International equity markets are included how ownership in publicity owned corporations traded throughout the global. It is also included the primary sale of new common stock by corporations to initial investors from outside the country and also how previously issued common stock is traded between investors in the secondary markets. Besides that, it is important to know where is the major national equity markets are located, information about their relative sizes, and the opportunities for trading and ownership.
Equity return can be defined as the profitability gained by the company generate from the money that have been invested by shareholders. There will be important implications for many of the financial economics. Besides that, if the stock returns display long-term dependence, they will exhibit significant auto correlation that are widely separated in time. On past returns, it have been stated that the presence of long memory in asset returns will be contrast with the market efficiency and the future assets return are unpredictable. According to Mandelbrot (1971), observes that in the presence of long memory, the arrival of new market information cannot be fully arbitraged away and martingale models of asset prices cannot be obtained from arbitrage.
Factors affecting international equity return
Economic factors affect corporate profits, which influence stock prices and equity returns. Revenues depend on consumer and business spending, which vary with interest rates, employment and global economic conditions. Operating and non-operating expenses depend on interest rates, labor wage rates and commodity prices. Economic growth and low inflation usually mean positive equity returns, while recessions and high interest rates mean flat or negative returns. According to Solnik (1984), the factors affecting international equity return is the effect of exchange rate changes, interest rate differentials, the level of domestic interest rate, and changes in domestic inflation expectations. All of the macroeconomic variables used in these studies will be classified into four groups variables related to employment rate, interest rate, exchange rate, monetary policy and oil price.
1. Employment rate
Employment rates affect interest rates because jobs determine non-refundable income. When people do not have jobs, they are likely to spend only on the essentials. They are unlikely to spend on big-ticket items, such as cars and travel. While the consumer staples sector would fare well in such an economic recession, the stock returns of other sectors would suffer. When unemployment levels are low and more people have jobs, demand would pick up for both essential and non-essential goods, which would lead to positive equity returns. According to Sing, Mehta, and Varsha (2011) who studies relationship between macroeconomic factor and equity return in Taiwan, They found that employment rate was insignificant, whereas gross domestic product was significant.
In general time-series studies, employment rate is not common compared to the industrial production index. The industrial production index can be a better alternative for economic conditions in general. However, in specific areas such as the real estate sector, the industrial production index is not a good candidate for the cyclical factor in that case, employment level will be used instead (Brooks & Tsolacos, 1999).
In event studies concerning macroeconomic news announcements, the announcement about employment level has a significant effect on stock returns rather than the industrial production index or gross domestic product. Boyd, Jagannathan, and Hu (2005) have studied the effect of unemployment announcements on stock prices. They found that the announcement of rising unemployment can significantly affect the stock market. Flannery and Protopapadakis (2002) found that employment announcements can affect the conditional volatility of the stock market, whereas the announcement of gross national product and industrial production are insignificant.
2. Interest rate
Studies on interest rate and stock returns were occupied in financial research before the popularity of the macroeconomic model. The capability to borrow money is a driving force of the economy. Interest rates determine the cost of borrowing and can therefore have a major impact on equity returns. If interest rates rise, it becomes unattractive to borrow and equities are likely to drop, followed by the overall economy. Declining interest rates are a positive sign for equity returns, although if interest rates decline too far it shows lack of economic demand and can lead to deflation. Lack of demand and deflation has a negative effect on equity returns.
The U.S. Federal Reserve sets short-term interest rates, which affect loans, mortgage and credit cards. The Fed lowers rates to shoot economic growth and raises rates to control inflation. Rising rates mean higher borrowing costs, which mean lower disposable income for individuals and less investment flexibility for businesses. This could lead to lower revenues and profit margins, which would reduce equity returns. Conversely, lower interest rates could mean more consumer and business spending, which would improve margins and equity returns. According to Park and Choi (2011), in addition to commercial bank stock returns, insurer stock returns are also significantly affected by interest rate .
Other variables related to interest rate are term spread and default spread. Term spread, which represents the term structure variable in many researches, is the difference between the yields on long-term and short-term government securities. Chen, Ross, and Roll (1986) have suggested that this variable is the measurement of unanticipated returns on long-term bonds. Czaja and Scholz (2007) used the term structure model to examine the relationship between interest rate change and stock returns. They conclude that the negative impact of the slope of term structure or term spread on stock returns varies among industries. The automobile and utilities industries, which are industries that depend on large initial capital investment and long-term financing, are more sensitive to the term spread.
The default spread is the difference between yields on risky corporate bonds and yields on government bonds. Chen, Ross, and Roll (1986) have measured this default spread according to the difference between yields on low-grade bonds and government bonds. This variable measures the risk aversion level. They also show evidence of a positive relationship between this default spread (risk premium) and stock returns.
3. Exchange rate
Exchange rate is one of the most important factors in this group especially for the countries that depend to a great extent on international trading activities. According to Adler and Simon (1986), they found that changes in exchanges rates generally explained a larger portion of the variability of foreign bond indexes than foreign equity indexes, but that some foreign equity markets were more exposed to exchange rate changes than it would likely be beneficial to hedge such as protect foreign stock investment against exchange rate uncertainty. Mohammed et al. (2009) used foreign exchange reserve and foreign exchange rate together with other macroeconomic variables to study stock returns in Pakistan. They found that both foreign exchange reserve and foreign exchange rate were more significant compared to other macroeconomic variables.
The existence of a relationship between stock prices and exchange rate has received considerable attention. Early studies (Aggarwal, 1981; Soenen and Hennigar, 1988) in this area considered only the correlation between the two variables-exchange rates and stock returns. Theory explained that a change in the exchange rates would affect a firm’s foreign operation and overall profits which would, in turn, affect its stock prices, depending on the multinational characteristics of the firm.
4. Monetary policy
However, some studies have focused on specific areas of macroeconomic variables. The most popular area is monetary policy. However, some studies focusing on monetary policy will use the central bank’s key policy rate instead. Patelis (1997) for example examined the role of monetary policy in predicting stock returns. Prather and Bertin (1999) have studied stock returns predictability regarding the Federal Reserve announcement of discount rate change. Some studies concerning monetary policy use the level of money supplies. Chen (2007) for example used money supply (M2) growth rate and change in the Federal fund rate to study how monetary policy variables affect stock return.
Economists generally posit that restrictive (accommodative) monetary policy leads to lower (higher) stock prices. For example, some researchers argue that changes in monetary policy influence forecasts of market-determined interest rates, the equity cost of capital, and expectations of corporate profitability (Waud, 1970). With respect to the longer-run, Jensen and Johnson (1995) examine monthly and quarterly performance and find that expected stock returns are significantly greater during expansive monetary periods.
5. Oil prices
Some studied focus on oil price which is a critical asset in both the production and consumption process. It is also a proxy for cost-push inflation. Faff and Brailsford (1999) have shown evidence for Australian equity return sensitivities in relation to oil price changes. These sensitivities vary across industries, such as with the negative effects of the oil and gas industry but negative effects regarding the paper, packaging and transportation industries. Kilian and Park (2009) have studied the effect of oil price shock on stock returns by separating oil price shocks into demand shocks and supply shocks. They found that only oil demand shocks have a significant impact on stock returns. Fedorova and Pankratov (2010) used Brent oil price to examine the influence of macroeconomic factors on stock returns in Russia. The results reveal that the Brent oil prices are the macroeconomic factor that most affects stock returns.
Risk and return of Islamic equity fund
According to Zahir and Hassan (2001) Islamic finance is a closed financial system with the aim of fulfilling the teaching of the Quran and Sunnah as oppose to earning maximum returns on financial assets. There are five (5) main principles that have to be follow which are prohibition of interest (riba),excessive uncertainty (gharar), speculation (maysir), risk and return sharing and prohibition of investing in ‘unethical’ industries ( Shanmugan and Zahari, 2009 ). Investing in mutual fund is allowed since they adhere to the five (5) main principles. There are some leniency that have been applied since principle of not receiving or paying any interest is too restrictive for most otherwise eligible company. The following financial criteria firm must adhere in order to beclassified as halal (permissible according to Islamic law) :
‘ Total debt divided by the trailing 12-month average market capitalization has to be less than 33%
‘ Cash plus interest-bearing securities divided by the trailing 12-month average market capitalization has to be less than 33%
‘ Accounts receivable divided by the trailing 12-month average market capitalization has to be less than 33%
According to Derigs and Marzban (2008), the 1/3 rules most probably based on hadith (saying of the Prophet Muhammad PBUH) that one shouldnot donate more than a third of his wealth to charity.
Muslims can invest in the stock market via so-called Islamic equity funds (IEFs). It is the investment vehicles that allow people who lack the knowledge, skill, or time to manage their own wealth to prosper from the return of international equity markets. According to Abdullah et al. (2007), when taking risk into account, during the bear market, the IEFs perform better than conventional fund, while during bull market it is resulted opposite to bear market. Most IEFS are standard open’ended mutual fund, offering medium to long-term growth based on capital appreciation rather than dividend comes.
IEFs are still not at their full potential as numerous caveats obstruct futher growth such as :
‘ The lack of standardization and limited risk management instrument
‘ The lack of liquidity and slow innovation
‘ The ppor awareness among potential clients
‘ Exposed to specific risk that normally not borne by conventional fund
‘ Limited in diversification potential
‘ No real agreement regarding financial criteria used to screen halal stock
IEFs are rather special type of investment vehicles. They have to pass a number of ethical and fiancial criteria before being halal. On average IEFs substancially underperform both their Islamic and conventional benchmarks. Globally invested IEFs have the worst performance , while locally is slightly better even before considering management fees. The downside risk as a potential explanation for the inferior performance resulted IEFs do not posses any significant downside risk.
IEFs posses some specific risk that are usually not present in conventional investment. These risk include changing sharia (islamic) rules, the lack of sufficient track record, high exposure to companies that might be sub-optimally leverage and low working capital.
THE RETURNS ON MUDHARABAH DEPOSIT AND ON EQUITY IN ISLAMIC BANKS
The Return on Mudharabah Deposit (ROMD)
Mudharabah is a contract endorsed by Shar??’ah, whereby one party, the Rabbul-mal or financier, provides the capital, while the other party, the Mudharib, provides the entrepreneurship and effort to run the business. Profits of the business are shared by the two parties according to a predetermined profit-sharing ratio. Losses are to be borne by the financier if they are not due to the Mudharib negligence. Unlike the contract of sale, Mudharabah is not binding, that is any party may terminate the Mudharabah agreement. The Mudharib has the entire responsibility for running the business; hence the financier is not allowed to interfere.
Under the two-tier Mudharabah Islamic banks act as Mudharib for the depositors and at the same time as Rabbulmal for the investors or businessmen. Any profit will be shared between the three parties according to the ratios that have been agreed, whereas loss will be born by the capital. (Siddiqi, 2000)
Given the lawfulness of Mudharabah from a Shari’ah perspective, the Board sees no delaying to the bank’s purchasing goods on the international market with funds gathered from other Islamic banks and financial institutions in partnership, and then it is assuming responsibility of managing the operation as a Mudharabah in which it also participates as an investor, regardless of whether it is dealing are accepted on a short or a long-term basis, or choose to sale of trust, such as Murabahah, or an ordinary bargained sale.
However, using finance theories, Mudharabah financing has serious result problems, lacks the bonding effect of debt financing and can influence perverse incentives. Furthermore, within risk-return ideas, he shows that for a ‘borrower’ faced with the alternative of using Mudharabah, debt or equity financing, Mudharabah would be the best. On the other hand, for a financier faced with the same three alternatives, Mudharabah financing would be the worst. These factors could explain the decline of Mudharabah as financing vehicle by Islamic banks. (Bacha, 1997)
Comparison of Returns on MudhaRabah Deposit and On Equity
According to Rosly and Zaini (2008), they compared ROMD and ROE for six Malaysian Islamic Banks in 2005 which found that ROE was higher than ROMD. This is because it is exhibit behaviour similar to that of conventional-fixed deposit. Fixed deposit also used local interest rate as the benchmark to determine the return rate.
While Sundarajan (2005) study the relationship among the returns on investment accounts, the return on bank deposits which is in the banking system, the return on assets (ROA) and equity and the level of risks. Based on their research, there are validate ‘smoothing’ of return on investment account despite wide differences in risk and hence very little risk sharing with investment. It is related to their research which is based on some Islamic banks have established two types of reserve namely the profit equalization reserve (PER) and the investment risk reserve (IRR). These two reserves could be the contributing factors why returns on Mudharabah deposits are always lower than equity.
Based on analysis of ROMD and ROE from selected Islamic banks, ROMD the standard deviation is 2.24 while for ROE, it is 15.45. If we know that standard deviation is a measure of riskiness, since it determines the variability of the return, the results for ROE are theoretically consistent in a risk-return framework. The ROEs in the sample tend to be at least two times higher than the ROMD, even though the risk is similar in many respects. ROA affects more significantly the ROE than the ROMD. Such a difference is explained by the fact that equity holders benefit from the leverage effect while the depositors do not. It is resulted to the raise serious issues about the fairness of the profit distribution policies adopted by Islamic banks. It is clear that the current practice is hardly justifiable within the Islamic economics framework which is completely concerned about wealth circulation and equitable distribution of profit.
Islamic banks should use other concept, than Mudharabah, which accommodates the risk-return profile of conventional banks deposits, if they are interested to follow conventional banks. However, we are of the view that the launch of a product that reflects the characteristics of Mudharabah in terms of risk and return would enable Islamic banks to tap a niche market which is lacking in the conventional system. It is submit that there exist depositors who would be happy to bear the same risk as equity holders provided that they are rewarded accordingly.
From the study, it was conclude that the international equity return was affected by many factors. In Mudharabah perspective it shows that the ROE tend to be at least two times higher than the ROMD. In most of the investigated cases the ROMD are more correlated to the corresponding conventional interest rate than to ROE. The regression analysis suggests that the return on assets affects more significantly the ROE than the ROMD. The summary statistics of the ROMD and the ROE is used to make a comparison between them with a sample of nine Islamic banks, from seven countries, over the last five years. Regression analysis is also undertaken to unveil the variables affecting the behaviour of ROMD and ROE at Kuwait Finance House. The Operating and non-operating expenses depend on interest rates, labor wage rates and commodity prices. Investing in mutual fund is allowed since they adhere to the five (5) main principles. There are five (5) main principles that have to be follow which are prohibition of interest (riba),excessive uncertainty (gharar), speculation (maysir), risk and return sharing and prohibition of investing in ‘unethical’ industries ( Shanmugan and Zahari, 2009 ). The comparison shows that islamic equity return is less profitable than conventional.
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