Modelling Eur/Usd Exchange Rate

Chapter 1

INTRODUCTION

1.1 Background of the Study

Exchange rates are quoted as foreign currency per unit of domestic currency or domestic currency per unit of foreign currency (Krugman & Obstfeld, 2005). Our study focuses on two major world currencies; the US Dollar and the Euro. The basis of our choice is due to the fact that both the US Dollar and the Euro posses the highest composition of foreign exchange reserves and therefore, both currencies are commonly used worldwide. We had chosen the US Dollar as it is currently the leading international currency and thus, acclaiming the status of the World currency. Consequently, the Euro is chosen also as it is a major competitor of the US Dollar as proven by Chinn and Frankel (2008) in which the Euro could overtake the dollar as early as 2015.

We have selected from 1999-2013 as our research timeframe, depicting a 14 years research period.

Figure 1: The 10-year EUR/USD Exchange Rate from 2003 to 2013

Source: Google Finance

The performance of the EUR/USD exchange rate is clearly reflected in Figure 1. From 2003 leading up to the financial crisis of 2008, the EUR/USD exchange rate generally shows an upward trend. Then, the EUR/USD exchange rate recorded an all time high in early in 2008. In late 2008 however, a sharp drop in the exchange rate is recorded. From 2009 till 2013, alternating upwards and downwards trend in exchange rate has been recorded.

With the movement of the EUR/USD exchange rate being as such, the world economy is simultaneously affected by it. Be it in a positive or a negative manner. A major impact that the exchange rate movement has on the world economy is its involvement in international trade.

Figure 2: The 12-year World International Trade (Exports) from 2000 to 2012

Source: CPB Netherlands Bureau for Economic Policy Analysis

World trade volume (based on exports) is clearly reflected in Figure 2. It is shown that there is a significant increase in the world trade volume from...