Pegging explained: What it is and how it works

Currency pegging occurs when a government or central bank artificially raises or lowers the value of its currency in relation to the value of another asset rather than letting it continue trading on the market.

The act of connecting or linking a currency's exchange rate to the currency of another country is referred to as pegging.

Fixed-rate pegging usually involves predetermined ratios, which is why it's called that.

Pegs are frequently used to create currency stability by tying it to another currency that is already stable.

Many countries use the U.S dollar as a currency peg because it is the world's reserve currency. Since the dollar is the world's reserve currency, pegging to it is widespread.

Prior to options expiration, pegging can also refer to the act of price manipulation of an underlying asset, such as a commodity.

Pegging is a price manipulation technique employed by options traders as the expiration date approaches.

As the expiration date draws closer, writers (options shorts) are most usually connected with the process of pushing up or down the price of the underlying asset in an options contract.

This is because they have a financial motive to guarantee that the option contract expires out of the money (OTM), preventing the buyer from exercising the option.

How currency pegging works

Currency risk makes financial management challenging for businesses. Most countries peg their exchange rates to that of the United States, which has a strong and stable economy, in order to reduce currency risk.

Countries frequently choose a stable currency to peg their currencies to. This helps in keeping their currencies stable while maintaining competitiveness in the export market for their goods and services.

Pegged currencies have fixed exchange rates. The fixed-rate for a single US dollar, for example, is 3.67 United Arab Emirates dirham (AED).

The central bank of a country buys and sells its currency on the open market in order to keep the pegged ratio that is believed to ensure optimal stability.

When a country's currency value fluctuates a lot, it makes it much more difficult for international enterprises to function and make money.

It's helpful to understand the mechanism underlying pegged currency in order to describe it. Supply and demand determine the value of a free-floating currency in relation to other currencies.

When traders try to buy more of a currency than is accessible, the price of that currency rises.

If political and economic circumstances, for example, cause uncertainty in a currency, traders may attempt to sell it in greater volume than the market requires, leading the price to fall.

Currency pegging works similarly, however instead of allowing market forces to determine supply and demand, the country's central bank manipulates the market by purchasing and selling its own currency to maintain a target value.

Advantages of Pegging

Pegged currencies can help enhance commerce and real earnings, especially when currency movements are minor and there are no long-term changes.

Individuals, organizations, and governments are free to reap the full benefits of specialization and exchange without the danger of currency fluctuations or tariffs. Everyone will be able to spend more time doing what they do best, according to the concept of comparative advantage.

Rather than wasting time and money hedging foreign exchange risk with derivatives, farmers can use pegged exchange rates to just produce food as best they can. Likewise, technology companies might concentrate their efforts on developing better computers.

Both countries' retailers can look out for the most cost-effective producers. Long-term investment in the other country is easier with pegged exchange rates.

Currency pegs prevent shifting exchange rates from affecting supply chains and altering the value of assets.

To prevent rising demands or supply, central banks with a currency peg must track supply and demand and control cash flow. These increases might cause a currency's pegged price to deviate.

To counteract excessive buying or selling of its currency, these governments must maintain huge foreign exchange reserves. Currency pegs have an impact on forex trading since they reduce volatility.

Disadvantages of Pegging

When a country's currency is fixed at low exchange rates, it faces a unique set of issues.

Domestic consumers are unable to purchase foreign items due to a lack of purchasing power.

Assume the Chinese yuan is overvalued in relation to the U.S dollar. Consumers in China will have to spend more on foreign food and oil, reducing their consumption and living standards.

Farmers in the United States and Middle Eastern oil producers, on the other hand, who would sell them more commodities, make less profit.

Trade tensions naturally arise between the country with the undervalued currency and the rest of the globe as a result of this circumstance.

If a currency is pegged at an excessively high rate, other complications arise. Over time, a country may be unable to secure the peg.

Domestic customers will purchase too many imports and use more than they can generate because governments set rates too high.

The government will have to spend foreign exchange reserves to secure the peg as a result of these chronic trade deficits, which will put downward pressure on the domestic currency. The government's reserves will be depleted at some point, and the peg will fall apart.

When a currency peg fails, imports become more expensive for the country that set the peg excessively high.

As a result, inflation will grow, and the country may face difficulties repaying its obligations. The exporters of the other country will lose markets, and investors will lose money on foreign assets that are no longer worth as much in local currency.

Pegging to the dollar

If a country pegs its currency to the dollar, it establishes a fixed exchange rate. The country's central bank keeps track of the currency's value.

The value of the dollar changes since it is based on a variable rate. This means that the value of the pegged currency grows and falls in tandem with the value of the dollar.

The dollar is the world's reserve currency, and it is relatively strong in the international market, this is why countries peg their currencies to the dollar.

As a result, transactions and international trade are frequently conducted in U.S dollars. This contributes to the stability of a country's pegged currency.

Currencies Pegged to the Dollar

The following are some of the most well-known countries with currencies tied to the dollar, along with their exchange rates:

• Cuba convertible peso (CUC): 1.000

• Panama Balboa (PAB): 1.000

• Saudi Arabia riyal (SAR): 3.75

• United Arab Emirates dirham (AED): 3.673

• Hong Kong dollar (HKD): 7.76

Pegging of Options

A call option buyer pays a premium in exchange for the right to purchase the stock which is the underlying security at a specific strike price.

Meanwhile, if the buyer chooses to exercise the option contract, the writer of that call option obtains the premium and is compelled to sell the shares, exposing themselves to the resulting unlimited risk potential.

For instance, if an investor purchases a $40 call option, they will be able to purchase a particular stock at the $40 strike price by May 31. The premium has already been paid from the buyer, and the writer would prefer to see the option expire at a stock price that is less than $50.

The buyer expects the price of the stock to trade at a higher price than the strike price and the premium paid per share. It would only make sense for the buyer to exercise the option at this point.

If the price is very near to the strike plus premium per share level right before the option's expiry date, the buyer, and particularly the call writer will have an incentive to purchase and sell the underlying stock. Pegging is the name for this activity.

Likewise, the inverse is true.

If the buyer of a put option chooses to exercise the option contract, the buyer pays a premium in exchange for the right to sell the stock at the predefined strike price, while the writer of the put option acquires the premium and is required to buy the stock, exposing themselves to the resulting unlimited risk potential.