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Country Size, Currency Unions, and International Asset Returns

  • TAREK A. HASSAN

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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File URL: http://hdl.handle.net/10.1111/jofi.2013.68.issue-6
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Article provided by American Finance Association in its journal Journal of Finance.

Volume (Year): 68 (2013)
Issue (Month): 6 (December)
Pages: 2269-2308

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Handle: RePEc:bla:jfinan:v:68:y:2013:i:6:p:2269-2308
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