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Religiosity, neglected risk and asset returns: theory and evidence from Islamic finance industry

Azmat, Saad
Ali, Haiqa
Azad, A. S. M. Sohel
Hassan, M. Kabir
Working Paper
This paper studies the sociological influence of religion on the risk and return in the financial markets with particular context of Islamic finance, a rapidly emerging and expanding financial industry. The paper builds a theoretical model to show how intermediaries serve their customers’ religious needs by creating innovative Islamic financial instruments. The customer's emphasis on religiosity exposes the industry to a theological risk, which can increase the financial fragility of the system. In our model, the theological risk emerges as a neglected component, which can be realized in the event of a bad news challenging the religious legitimacy of (Islamic) finance structures. To corroborate our theoretical findings, we present two sets of results. First, using stock prices data for 104 Islamic bond (Sukuk) issuers, we show that Sukuk issuers experienced a significant decline in their stock prices, following multiple formal and informal announcements in 2008, which challenged the religious legitimacy of Islamic bond structures. Second, using data from 1360 newly issued Malaysian Sukuk from 2006 to 2016, we find that following the regulatory changes the Sukuk margins have increased significantly. This suggests that there may be a significant difference between what Islamic and conventional customers may be willing to pay for Sukuk, exposing the industry to a unique form of religious risk.
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