On the occasion of the 65th birthday of Governor Klaus Liebscher and in recognition of his commitment to Austria’s participation in European monetary union and to the cause of European integration, the Oesterreichische Nationalbank (OeNB) established a “Klaus Liebscher Award”. It will be offered annually as of 2005 for up to two excellent scientific papers on European monetary union and European integration issues. The authors must be less than 35 years old and be citizens from EU member or EU candidate countries. The “Klaus Liebscher Award” is worth EUR 10,000 each. The winning papers of the fifth Award 2009 were written by Tarek A. Hassan and by Anton Korinek. Tarek A. Hassan’s paper is presented in this Working Paper, while Anton Korinek’s contribution is contained in Working Paper 155. The fact that economies differ in size has important implications for international asset returns. In this paper Tarek A. Hassan solves 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 nontraded 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. The author tests the predictions of the model for a panel of OECD countries and shows 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.