research digest

excerpted from Capital Ideas

Why Large Countries Have Low Interest Rates

If you poll Wall Street traders or economics students, you will likely hear that the carry trade between currencies makes money because high-interest-rate currencies appreciate faster than low-rate ones. In a carry trade, an investor purchases a higher-yielding currency and sells a lower-yielding one.

hassanBut research by Tarek Alexander Hassan, associate professor of finance and economics, suggests there's more to this explanation. Such a trade is profitable because there's a permanent interest-rate difference between countries, he says, not due to predictability in exchange rates. Hassan's findings were published last year in the Journal of Finance, "Country Size, Currency Unions, and International Asset Returns," and in a working paper, "Forward and Spot Exchange Rates in a Multi-Currency World."

The differences in real interest rates across developed economies remain curiously large and persistent. Canadian consumers, for example, will always have to pay more to borrow than US consumers.

Hassan proposes that is because bonds are essentially a form of insurance that is country specific. Bonds issued in the currencies of larger economies are comparatively expensive simply because they insure against shocks that affect a larger portion of the global economy. If you buy a US dollar denominated bond, that's insurance on the $17 trillion US economy.

If you buy a bond denominated in Australian dollars, it's insurance on that far smaller economy. However, if something goes wrong in a large economy like the United States or Japan, it's far more likely to affect the rest of the world than a crisis in a country such as Australia or Egypt. As a result, the currencies of large economies tend to gain value when times are bad. Bonds issued in the currencies of larger countries are thus more expensive and hence offered at chronically lower interest rates.–Roben Farzad

Photo by Dan Dry

Last Updated 4/23/14