FOREX-Dollar rises, set to close its best year since 2005

* Dollar rises; euro set for first yearly drop since 2005

* Yen seen as standout among majors in 2008

* Pound has worst year vs dollar since end of gold standard (Recasts, adds comments, changes byline and dateline, previous LONDON)

By Vivianne Rodrigues

NEW YORK, Dec 31 (Reuters) - The U.S. dollar rose on Wednesday and was headed for its first yearly gain against the euro since 2005 as the worst financial crisis in 80 years led investors to take refuge in the greenback.

The dollar was on track to end 2008 higher against most major currencies as a financial meltdown prompted investors to sell stocks, commodities and other risky assets and park the money in the relative safety of the U.S. currency.

The yen was the other top performer this year, boosted as investors unwound trades financed by borrowing the Japanese currency at low interest rates.

Liquidity was thin as traders closed their books on a year that saw bank failures and partial bank nationalizations around the globe, sparked by the collapse of a U.S. housing bubble.

Central banks had fought aggressively to shore up their economies, with the Federal Reserve and the Bank of Japan cutting rates virtually to zero.

"In forex, the year could be summed up in two words: risk aversion," said Dustin Reid, director for FX strategy at RBS Global Banking & Markets in Chicago. "And the yen and the dollar were at the receiving end of that global flight to safety."

In morning trading in New York, the euro EUR= was en route to posting a 4.3 percent fall against the dollar this year -- its first annual drop since 2005 -- while the U.S. currency is seen gaining roughly 5 percent against a basket of currencies .DXY.

The euro was last down 1 percent to $1.3956 after trading at above $1.60 in July.

"The volatility in euro/dollar in 2008 was simply spectacular," said Reid. "At the height of risk aversion a couple of months ago, the entire world rushed to buy dollars. But as the Fed reacted by bringing rates to zero, the dollar's luster has been gradually coming off."

YEN GAINS; POUND TUMBLES

Despite its rally against higher-yielding currencies such as sterling and the Australian and New Zealand dollars, the U.S. dollar has tumbled more than 18 percent against the yen, while the euro was 22 percent lower.

The yen was last up 0.5 percent at 90.76 JPY= after trading as high as 87.15 to the dollar earlier this month,