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Each fundamental risk indicator includes different variables.
The author applies his risk scoring system to 24 developed markets and 33 emerging markets. Mr. Karolyi also gives his readers the emerging and developed medians so that they get a better perspective of how each of the 57 markets performs compared to both medians. The author convincingly shows that emerging market risk indicators have significantly stronger correlations with each other than those among developed markets.
Mr. Karolyi subsequently tests the validity of his risk scoring system by assessing how the six different fundamental risk indicators can explain the “home-bias” and “foreign-bias.” The “home-bias” refers to the propensity to disproportionately invest in securities at home, say the U.S. The “foreign-bias” covers the inclination of investors to disproportionately invest in securities that are familiar or proximate, say Canada and Mexico. The author’s risk scoring system better explains the holdings of global institutional investors than the foreign investor holdings of US residents.
Mr. Karolyi further tests the validity of his risk scoring system by looking at the impact of the U.S. Federal Reserve’s decision to taper its securities purchase program a.k.a. “quantitative easing” on US residents’ exit from emerging markets in 2013. Operational inefficiency, corporate opacity, the limits to legal protections, and political instability played a statistically significant role in the portfolio net flows of US residents across merging markets during that year.
To his credit, Mr. Karolyi repeatedly acknowledges the weaknesses of the approach that he takes. As a side note, appendixes A to E include a useful overview of the key data sources used to build the author’s risk scoring system.