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We separately identify domestic and external sources of exchange
rate fluctuations in a large sample of small open economies. We find that external shocks lead to large and predictable deviations from UIP, while domestic shocks do not. In addition, external
shocks are linked to fluctuations in global risk aversion and U.S.
macroeconomic aggregates. We present a small open economy
model that rationalizes these facts. In the model, global risk aversion shocks drive exchange rate
fluctuations, and a country's net external position governs their transmission. We provide evidence
that a country's response to external shocks indeed depends on its external position.
