Country Size, Currency Unions, and International Asset Returns

Author(s): Tarek Hassan

CEPR Discussion Paper Number 8991
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Programme Area(s): Financial Economics (FE), International Macroeconomics (IM), International Trade and Regional Economics (IT)

Date of Publication:

Keyword(s): carry trade, country size, currency unions, International return differentials, market segmentation, uncovered interest parity

JEL(s): F3, G0

Abstract: 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.

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