DP8991 Country Size, Currency Unions, and International Asset Returns
|Author(s):||Tarek Alexander Hassan|
|Publication Date:||May 2012|
|Keyword(s):||carry trade, country size, currency unions, International return differentials, market segmentation, uncovered interest parity|
|Programme Areas:||International Macroeconomics, Financial Economics, International Trade and Regional Economics|
|Link to this Page:||cepr.org/active/publications/discussion_papers/dp.php?dpno=8991|
Differences in real interest rates across developed economies are puzzlingly large and persistent. I propose a simple explanation: Bonds issued in the currencies of larger economies are expensive because they insure against shocks that affect a larger fraction of the world economy. I show that differences in the size of economies indeed explain a large fraction of the cross-sectional variation in currency returns. The data also support a number of additional implications of the model: The introduction of a currency union lowers interest rates in participating countries and stocks in the non-traded sector of larger economies pay lower expected returns.