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This paper establishes the link of microstructure and macroeconomic factors with the time-varying conditional correlation of foreign exchange and excess equity returns. By using the proposed DCC model with exogenous variables, capital flows and interest rate differentials are shown to be significant determinants of this correlation which is inclusive of the short-run variation of both asset returns. The results also provide evidence of the dynamic behavior of global investors as they seek parity in equity returns between home and foreign markets to reduce exchange rate risks.

What Drives the Dynamic Conditional Correlation of Foreign Exchange and Equity Returns?