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This paper extends the studies on the relative importance of country and industry effects in explaining cross-sectional stock return variations by exploring the fundamental sources of the country effects. The standard dummy variable decomposition method is applied to data from 13 emerging stock markets (ESMs) from 1984 to 2004 to generate pure country effects. The findings show that the change in the exchange rate and inflation rate together can explain about 55% of the pure country effects, whereas banking and stock market development contribute much less: about 2.8%. The regressions also find evidence to support that argument that the legal origin of the market does matter to stock returns.
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