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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. This 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 may refer to the process of purchasing or selling a large quantity of a security in order to affect its price. This may be done by a government seeking to stabilize the price of the security or underlying asset. However, it may also be performed by companies or individuals as an unethical attempt to drive price in one direction or another for the benefit/profit of option writers.

 

Managing Market Volatility

One of the primary goals of currency pegging is to help decrease volatility in the market. During periods of economic or political upheaval, the exchange rates of some currencies can be drastically affected. A peg can help to stabilize a currency’s value.

When pegging currency value, countries aren’t limited to only using other currencies. A peg to a commodity such as gold is another option. Commodities with relatively stable prices make them a good stabilizer for a currency that may be experiencing excessive volatility.

 

Relation to the U.S. Dollar

Because the U.S. dollar is the lead reserve currency, many nations choose to peg their currency exchange rate to it. The primary reason for this 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/or international trade, the U.S. dollar connection 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 maintaining competitive pricing of goods. However, China uses a fixed exchange rate in order to keep their currency value lower than the dollar. This makes 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. More broadly, it is a good way to cut down on market volatility worldwide.

 

Related Readings

CFI offers the global Financial Modeling & Valuation Analyst certification program, designed to help anyone become a world-class financial analyst. The following resources will be helpful in furthering your financial education:

  • Capital Controls
  • Currency Risk
  • Economic Exposure
  • Trade-Weighted Exchange Rate

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