Nontraded Sector Growth Risks and Economic Sizes in International Asset Pricing

Abstract

Output fluctuations in nontraded sectors are a primary country-specific risk factor because nontraded outputs are consumed domestically. While nontraded sector growth risks are mostly non-diversifiable, they can be partially mitigated by international trades in other sectors. The mitigation decreases with the host country's size because a larger economy needs to execute a proportionally larger trade to substitute for losses in its nontraded consumption. In interest rate markets, fluctuations in the growth of industries with higher nontradability feed greater risk to the economy and lower interest rates. In currency markets, these fluctuations generate large currency premia and explain why known funding and investment currencies are associated
with economies of both small and large sizes.

Keywords: Nontraded output risk, Exchange rate, Currency carry trade, Interest rate

JEL Classification: F3, F31, F4, G0, G12, G15