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Pegging

The act of linking the exchange rate of one currency to another

What is Pegging?

In finance, pegging refers to two different actions. 1) A peg is the act of linking the exchange rate of one currency to another. For most countries, the general practice is to peg the exchange rate of their currency to that of the U.S. dollar. However, some countries peg to currency baskets. It means that a currency’s exchange rate is pegged to a group of other currencies’ exchange rates.

 

Pegging theme - how to use a peg

 

2) Pegging also refers to the process of purchasing a large quantity of a security in order to drive up its price. For investors writing put options, or for those that hold short positions, pegging becomes useful when the expiration date of the option is near, and it seems that the put option is going to be exercised, which leaves the writer with either no profit or a loss. The primary goal is to prevent this from happening, letting the writer profit from the premium.

 

Managing Market Volatility

One of the primary goals of currency pegging is to help decrease volatility in the market. During periods of economic upheaval or concerns in the political setting, the global market and the exchange rates of currencies can be drastically affected. A peg helps to stabilize currency values and fluctuation in asset trading and prices.

When pegging currency value, countries don’t need to peg only to other currency values; a peg to commodities – such as gold – is another option. Commodities with relatively secure prices make them a good stabilizer for the currency of a country that may be experiencing volatility – or the potential for fluctuation.

 

Pegging to the U.S. Dollar

Because the U.S. dollar takes the lead when it comes to a worldwide reserve currency, many nations choose to peg their currency exchange rate to it. The primary reason for the move is because the majority of the world’s financial transactions and international trade occurs in U.S. dollars. For countries that rely heavily on their financial sector and international trade, pegging to the U.S. dollar makes sound financial sense.

For countries that export a lot to the United States, such as China, pegging to the U.S. dollar is key to help maintain a competitive price on goods. However, China uses a fixed exchange rate in order to keep their currency value lower than the dollar. It means that they make their exports to the U.S. cheaper, giving them a comparative price advantage on their goods.

Currency pegs are an excellent way for countries to maintain the exchange rate of their currencies and, more broadly, is a good way to cut down on market volatility worldwide.

 

Related Readings

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