> How does the XSLT know the exact location of the files that you are  
> listing. Do they need to be located in the same directory?

They file contents are taken to be relaive URI based at the file, like
an href=... in html.So you can put <file>../../foo/bar.xml</file>
or <file>http://somewhere/files/file.xml</file> or whatever you want.

David