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, indeed, differences in the size of economies explain a large fraction of the cross-sectional variation in currency returns. The data also support additional implications of the model: the introduction of a currency union lowers interest rates in participating countries, and stocks in the nontraded sector of larger economies pay lower expected returns. © 2013 the American Finance Association.