Pegging

By 
AKHILESH GANTI

 
 
Updated Jun 11, 2021
What Is Pegging?
Pegging is controlling a country's currency rate by tying it to another country's
currency. A country's central bank, at times, will engage in open market
operations to stabilize its currency by pegging, or fixing, it to another country's
presumably more stable currency.

Pegging can also refer to the practice of manipulating the price of an underlying
asset, such as a commodity, prior to option expiry.

KEY TAKEAWAYS

 Pegging is a way of controlling a country's currency rate by tying it to

another country's currency.
 Many countries stabilize their currencies by pegging them to the U.S.
dollar, which is globally considered to be the most stable currency.
 Pegging is also an illegal strategy deployed by some buyers and writers
(sellers) of call and put options to manipulate its price.
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What is Pegging?

Understanding Pegging
Many countries maintain a currency peg to keep their currencies stable relative
to another country. Wide currency fluctuations can be quite detrimental to
international business transactions. Pegging to the U.S. dollar is common. In
Europe, the Swiss franc was pegged to the euro for much of 2011-2015, though
this was done more so to curb the strength of the Swiss Franc from a persistent
inflow of capital.1

Pegging is also a price manipulation strategy used sometimes by options traders

as expiration approaches. Writers (options shorts) are most commonly
associated with this practice of driving up or down the price of the underlying
security as the option nears expiry. 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
A country's central bank will go 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, foreign companies

have a more difficult time operating and generating a profit. If a U.S. company
operates in Brazil, for example, the firm has to convert U.S. dollars into Brazilian
reals 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.

This form of currency risk makes it difficult for a company to manage its finances.
To minimize currency risk, many countries peg an exchange rate to that of the
United States, which has a large and stable economy.

More than 66 countries have pegged their currencies to the U.S. dollar,
according to AvaTrade.2
Advantages of Pegged Exchange Rates
Pegged currencies can expand trade and boost real incomes, particularly when
currency fluctuations are relatively low and show no long-term changes. Without
exchange rate risk and tariffs, individuals, businesses, and nations are free to
benefit fully from specialization and exchange. According to the theory
of comparative advantage, everyone will be able to spend more time doing what
they do best.

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

Perhaps most importantly, retailers in both countries will be able to 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.

Disadvantages of Pegged Currencies

The central bank of a country 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 the
central bank will 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.

Countries will experience a particular set of problems when a currency is pegged

at an overly low exchange rate. On the one hand, domestic consumers will be
deprived of the purchasing power to buy foreign goods. Suppose that 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. On the other hand, the U.S. farmers and Middle East oil
producers who would have sold them more goods lose business. This situation
naturally creates trade tensions between the country with an undervalued
currency and the rest of the world.

Another set of problems emerges when a currency is pegged at an overly high

rate. A country may be unable to defend the peg over time. Since the
government set the rate 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. Major currency peg
breakdowns include the Argentine peso to the U.S. dollar in 2002, the British
pound to the German mark in 1992, and arguably the U.S. dollar to gold in 1971.
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 30th. 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 31st 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.