Working Paper: CEPR ID: DP8991
Authors: Tarek Hassan
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: carry trade; country size; currency unions; international return differentials; market segmentation; uncovered interest parity
JEL Codes: F3; G0
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| differences in the size of economies (F40) | currency returns (F31) |
| larger economies (P19) | higher bond prices (G12) |
| introduction of a currency union (F36) | lower interest rates (E43) |
| size of the economy (E20) | expected returns in the nontraded sector (G19) |