Country Size, Currency Unions, and International Asset Returns

Abstract

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.

Keywords: International return differentials, country size, currency unions, uncovered interest parity, market segmentation

JEL Classification: F3, G0