Third-country effects on the exchange rate

Predictive regressions for bilateral exchange rates are typically run on variables from the associated bilateral pairs of countries. These regressions characteristically have low explanatory power, which leaves room for an omitted variables interpretation. We test whether these omitted variables are from third-countries. When third-country macro factors are added to bilateral exchange rate regressions, they enter significantly and increase the adjusted R2. A three-country exchange rate model illustrates potential channels for third-country spillovers to affect the bilateral rate.