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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. Gourinchas, Pierre-Olivier & Rey, Hélène, 2013. "External Adjustment, Global Imbalances and Valuation Effects," CEPR Discussion Papers 9566, C.E.P.R. Discussion Papers.
  2. Matteo Maggiori, 2012. "Financial Intermediation, International Risk Sharing, and Reserve Currencies," 2012 Meeting Papers 146, Society for Economic Dynamics.
  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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