The rapid development of the Eurodollar market, which can be defined as US
dollars deposited in banks outside the US, was a major mechanism for
speeding up Forex trading. Similarly, Euro markets are those where currencies
are deposited outside their country of origin. The Eurodollar market came
into being in the 1950s as a result of the Soviet Union depositing US dollars
earned from oil revenue outside the US, in fear of having these assets frozen
by US regulators. This gave rise to a vast offshore pool of dollars outside the
control of US authorities. The US government reacted by imposing laws to
restrict dollar lending to foreigners. Euro markets were particularly attractive
because they had far fewer regulations and offered higher yields. From the
late 1980s onwards, US companies began to borrow offshore, finding Euro
markets an advantageous place for holding excess liquidity, providing shortterm
loans and financing imports and exports.
London was and remains the principal offshore market. In the 1980s, it
became the key center in the Eurodollar market, when British banks began
lending dollars as an alternative to pounds in order to maintain their leading
position in global finance. London's convenient geographical location
(operating during Asian and American markets) is also instrumental in
preserving its dominance in the Euro market.
Euro-Dollar currency exchange
The euro to US dollar exchange rate is the price at which the world demand
for US dollars equals the world supply of euros. Regardless of geographical
origin, a rise in the world demand for euros leads to an appreciation of the
euro.
Factors affecting the Euro to US dollar exchange rate
Four factors are identified as fundamental determinants of the real euro to US
dollar exchange rate:
• The international real interest rate differential between the Federal
Reserve and European Central Bank
• Relative prices in the traded and non-traded goods sectors
• The real oil price
• The relative fiscal position of the US and Euro zone
The nominal bilateral US dollar to euro exchange is the exchange rate that
attracts the most attention. Notwithstanding the comparative importance of
bilateral trade links with the US, trade with the UK is, to some extent, more
important for the euro.
The following chart illustrates the EUR/USD exchange rate over time, from
the inauguration of the euro, until mid 2006. Note that each line (the
EUR/USD, USD/EUR) is a “mirror” image of the other, since both are
reciprocal to one another. This chart is illustrates the steady (general) decline
of the USD (in terms of euro) from the beginning of 2002 until the end of
2004.
In the long run, the correlation between the bilateral US dollar to euro
exchange rate, and different measures of the effective exchange rate of
Euroland, has been rather high, especially when one looks at the effective
real exchange rate. As inflation is at very similar levels in the US and the Euro
area, there is no need to adjust the US dollar to euro rate for inflation
differentials. However, because the Euro zone also trades intensively with
countries that have relatively high inflation rates (e.g. some countries in
Central and Eastern Europe, Turkey, etc.), it is more important to downplay
nominal exchange rate measures by looking at relative price and cost
developments.
