This paper presents a theoretical model to explain the third country effect on bilateral exchange rate. The conventional trade theories suggest that the bilateral exchange rate in a free-floating regime is determined by the demand and supply of the two currencies concerned. It implies that all the credit items in the balance of payment forming the supply side and all the debit items in the balance of payment forming the demand side would determine the bilateral equilibrium exchange rate. The

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... ditional two country trade models are based on the implied assumption that the key variables such as exports, imports, FDIs, and net transfers between the two countries are key determinants of the foreign exchange rate between the two currencies concerned.