Overview and Pros and Cons

What Is Pegging?

The term pegging refers to the practice of attaching or tying a currency’s exchange rate to another country’s currency. Pegging often involves preset ratios, which is why it’s called a fixed rate. Pegs are often put in place to provide stability to a nation’s currency by linking it to an already stable currency.

The U.S. dollar is often used as a currency peg by many nations, as it is the world’s reserve currency. Pegging can also refer to the practice of manipulating the price of an underlying asset, such as a commodity, prior to option expiry.

Understanding Pegging

Wide currency fluctuations can be quite detrimental to international business transactions, which is why many countries maintain a currency peg. Doing so allows them to keep their currencies relatively stable against that of another country.

Pegging to the U.S. dollar is common. As noted above, that’s because the dollar is the world’s reserve currency. In Europe, the Swiss franc was pegged to the euro for the better part of the four-year period between 2011 and 2015, though this was done more so to curb the strength of the franc from a persistent inflow of capital.

Pegging is also a price manipulation strategy used sometimes by options traders as expiration approaches. Writers (options shorts) are most commonly associated with the practice of driving up or down the price of the underlying security in an options contract as the expiry date approaches. That’s because they have a monetary incentive to ensure that the option expires out of the money (OTM) so the buyer does not exercise the option contract.

Currency Pegging

Currency risk makes it difficult for companies to manage their finances. To minimize currency risk, many countries peg an exchange rate to that of the United States, which has a large and stable economy. But how does it work?

Countries often choose to peg their currencies to a stable one. This allows them to keep their currencies stable while allowing their products and services to remain competitive in the export market. Exchange rates between pegged currencies are fixed. For instance, the fixed rate for a single U.S. dollar is 3.67 United Arab Emirates dirham (AED).

A country’s central bank goes into the open market to buy and sell its currency in order to maintain the pegged ratio that has been deemed to provide optimal stability. If a country’s currency value experiences large fluctuations, it becomes even more difficult for foreign companies to operate and generate a profit.

For example, if a U.S. company operates in Brazil, the firm has to convert U.S. dollars into Brazilian reals (BRL) to fund the business. If the value of Brazil’s currency changes dramatically compared to the dollar, the U.S. company may incur a loss when it converts back into U.S. dollars.

Advantages and Disadvantages of Pegging

There are some benefits and drawbacks when it comes to pegging. We’ve highlighted some of the key pros and cons below.

Advantages

Pegged currencies can expand trade and boost real incomes, particularly when currency fluctuations are relatively low and show no long-term changes. Individuals, businesses, and nations are free to benefit fully from specialization and exchange without any of the associated exchange rate risk and tariffs. According to the theory of comparative advantage, everyone will be able to spend more time doing what they do best.

Farmers can use pegged exchange rates to simply produce food as best they can, rather than spending time and money hedging foreign exchange risk with derivatives. Similarly, technology firms can focus on building better computers.

Perhaps most importantly, retailers in both countries can source from the most efficient producers. Pegged exchange rates make more long-term investments possible in the other country. With a currency peg, fluctuating exchange rates are not constantly disrupting supply chains and changing the value of investments.

Central banks with a currency peg must monitor supply and demand and manage cash flow to avoid spikes in demand or supply. These spikes can cause a currency to stray from its pegged price. That means these authorities need to hold large foreign exchange reserves to counter excessive buying or selling of its currency. Currency pegs affect forex trading by artificially stemming volatility.

Disadvantages

Countries experience a particular set of problems when a currency is pegged at low exchange rates. Domestic consumers are deprived of the purchasing power to buy foreign goods. Suppose the Chinese yuan is pegged too low against the U.S. dollar. Chinese consumers will have to pay more for imported food and oil, lowering their consumption and standard of living. But U.S. farmers and Middle East oil producers who would sell them more goods lose business. This situation naturally creates trade tensions between the country with an undervalued currency and the rest of the world.

More problems emerge when a currency is pegged at an overly high rate. A country may be unable to defend the peg over time. Since governments set rates too high, domestic consumers will buy too many imports and consume more than they can produce. These chronic trade deficits will create downward pressure on the home currency, and the government will have to spend foreign exchange reserves to defend the peg. The government’s reserves will eventually be exhausted, and the peg will collapse.

When a currency peg collapses, the country that set the peg too high will suddenly find imports more expensive. That means inflation will rise, and the nation may also have difficulty paying its debts. The other country will find its exporters losing markets, and its investors losing money on foreign assets that are no longer worth as much in domestic currency.

Why Peg to the Dollar?

When a country pegs its currency to the dollar, it fixes the exchange at a set, predetermined rate. The value of the currency is maintained by the country’s central bank. Since the dollar’s value is on a floating rate, it fluctuates. This means that the pegged currency’s value rises and drops with the dollar.

Countries that peg their currency to the dollar do so because the U.S. dollar is the world’s reserve currency and is relatively strong in the international market. As such, transactions and any international trade that takes place often happens in U.S. dollars. This helps keep a country’s pegged currency stable.

Some countries peg to the dollar because it helps keep their currencies and, therefore, their exports priced competitively. Others do so because they are reliant on trade, such as Singapore and Malaysia.

Currencies Pegged to the Dollar

As noted above, the U.S. dollar is a popular currency that other countries use to peg their own currencies. Countries that choose to do so often have different reasons that are based on their own economies. Here are some of the most notable countries whose currencies are pegged to the greenback along with their rates:

• Belize dollar (BZ$): 2.00
• Cuba convertible peso (CUC): 1.000
• Hong Kong dollar (HKD): 7.76
• Panama balboa (PAB): 1.000
• Saudi Arabia riyal (SAR): 3.75
• United Arab Emirates dirham (AED): 3.673

Options Pegging

The buyer of a call option pays a premium to obtain the right to buy the stock (underlying security) at a specified strike price. The writer of that call option, meanwhile, receives the premium and is obligated to sell the stock, and expose themselves to the resulting infinite risk potential, if the buyer chooses to exercise the option contract.

For example, an investor buys a $50 call option, which gives them the right to buy XYZ stock at the strike price of $50 by June 30. The writer has already collected the premium from the buyer and would ideally like to see the option expire worthless (stock price less than $50 at expiry).

The buyer wants the price of XYZ to rise above the strike price plus the premium paid per share. Only at this level would it make sense for the buyer to exercise the option. If the price is very close to the strike plus premium per share level just before the option’s expiry date then the buyer and especially the writer of the call would have an incentive to be active in buying and selling the underlying stock, respectively. This activity is known as pegging

The converse holds true as well. The buyer of a put option pays a premium to obtain the right to sell the stock at the specified strike price, while the writer of that put option receives the premium and is obligated to buy the stock, and expose themselves to the resulting infinite risk potential, if the buyer chooses to exercise the option contract.

A lesser-used definition of pegging occurs mainly in futures markets and entails a commodity exchange linking daily trading limits to the previous day’s settlement price so as to control price fluctuations.

Example of Options Pegging

An investor buys a put option on XYZ stock with a strike price of $45 that expires on July 31 and pays the required premium. The writer receives the premium and the waiting game begins.

The writer wants the price of the underlying stock to remain above $45 minus the premium paid per share, while the buyer wants to see it below that level. Again, if the price of XYZ stock is very close to this level, then both would be actively selling and buying to try to influence XYZ’s price to where it would benefit them.

While this concept of pegging could apply to both, it is used predominantly by sellers as they have a bit more incentive to not see the option contract exercised.