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Country Size, Currency Unions, and International Asset Returns

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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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 8991.

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Date of creation: May 2012
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Handle: RePEc:cpr:ceprdp:8991
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