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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.

Suggested Citation

  • Tarek A. Hassan, 2009. "Country Size, Currency Unions, and International Asset Returns," Working Papers 154, Oesterreichische Nationalbank (Austrian Central Bank).
  • Handle: RePEc:onb:oenbwp:154
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    References listed on IDEAS

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    Cited by:

    1. Ian Martin, 2011. "The Forward Premium Puzzle in a Two-Country World," NBER Working Papers 17564, National Bureau of Economic Research, Inc.
    2. 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.

    More about this item

    Keywords

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

    JEL classification:

    • F3 - International Economics - - International Finance
    • G0 - Financial Economics - - General

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