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
JEL(s): F3, G0
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.