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Country Size, Currency Unions, and International Asset Returns

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  • Tarek A. Hassan

    ()
    (Harvard University, Department of Economics; Postal Address: Littauer Center G4, 1875 Cambridge Street, Cambridge MA 02138, USA,)

Abstract

The fact that economies differ in size has important implications for international asset returns. I solve for the spread on international bonds and stocks in an endowment economy with complete asset markets and non-traded goods. The model predicts that larger countries have lower real interest rates because their bonds provide insurance against shocks that affect a larger fraction of the world economy. Larger countries' bonds must therefore pay lower excess returns in equilibrium and uncovered interest parity fails. By a similar logic, stocks in the non-traded sector of larger countries also tend to pay lower excess returns. If asset markets are segmented, the introduction of a currency union lowers real interest rates and expected returns on stocks in the non-traded sector of participating countries. I test the predictions of the model for a panel of OECD countries and show that they are strongly supported by the data: Investors earn lower excess returns on bonds and stocks in the non-traded sector of larger countries. Similarly, excess returns on EMU member countries'bonds and stocks in the non-traded sector fell after European monetary integration.

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Bibliographic Info

Paper provided by Oesterreichische Nationalbank (Austrian Central Bank) in its series Working Papers with number 154.

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Length: 69
Date of creation: 14 May 2009
Date of revision:
Handle: RePEc:onb:oenbwp:154

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Keywords: International return differentials; country size; currency unions; uncovered interest parity; market segmentation.;

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References

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Cited by:
  1. Matteo Maggiori, 2012. "Financial Intermediation, International Risk Sharing, and Reserve Currencies," 2012 Meeting Papers 146, Society for Economic Dynamics.
  2. Gourinchas, Pierre-Olivier & Rey, Hélène, 2013. "External Adjustment, Global Imbalances and Valuation Effects," CEPR Discussion Papers 9566, C.E.P.R. Discussion Papers.
  3. Ian Martin, 2011. "The Forward Premium Puzzle in a Two-Country World," NBER Working Papers 17564, National Bureau of Economic Research, Inc.
  4. Pierre-Olivier Gourinchas & Helene Rey & Nicolas Govillot, 2010. "Exorbitant Privilege and Exorbitant Duty," IMES Discussion Paper Series 10-E-20, Institute for Monetary and Economic Studies, Bank of Japan.
  5. Gorea, Denis & Radev, Deyan, 2014. "The euro area sovereign debt crisis: Can contagion spread from the periphery to the core?," International Review of Economics & Finance, Elsevier, vol. 30(C), pages 78-100.

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