Country Size, Currency Unions, and International Asset Returns

  • Author(s): TAREK A. HASSAN
  • Published: Nov 12, 2013
  • Pages: 2269-2308
  • DOI: 10.1111/jofi.12081

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, indeed, differences in the size of economies explain a large fraction of the cross‐sectional variation in currency returns. The data also support additional implications of the model: the introduction of a currency union lowers interest rates in participating countries, and stocks in the nontraded sector of larger economies pay lower expected returns.

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