DEFINITION of a currency peg
A currency peg is a governmental policy of secure the exchange rate of its currency to that of another currency. Or occasionally to the gold price.
WHAT IT IS IN ESSENCE
Sometimes it is called a fixed exchange rate, or pegging.
Maintaining a currency peg requires a central bank to monitor supply and demand, releasing or restricting cash flow.
That’s in order to ensure that there are no unexpected events in demand or supply. The actual value of currency no longer reflects the pegged price that it is trading at. So problems arise for central banks who have to work against excessive buying or selling of their currency. By holding huge volumes of foreign currency.
Currency pegs can play a big part in forex trading by keeping volatility,
The central bank can realize this by buying or selling its own currency in the market against the other currency or basket of currencies.
This buying and selling can take place continuously. But also there is the limitation to certain moments of the day. As the linkage is made public most market participants take the rate as a given reducing the need for the central bank to intervene.
The central bank can also utilize short-term money market instruments or derivatives to stabilize the exchange rate in terms of the peg.
HOW TO USE
However one should be aware that this pegging to the currency of another country implies a loss of autonomy concerning monetary developments. And of course, the risks of depletion of its currency reserves.
As a result, there is the risk that a certain fixed exchange rate level cannot be maintained indefinitely. So the exchange rate or inflationary shocks could be the result. And consequently, the financial sector could lose trust in the monetary policies of the monetary authorities.
The objective of this kind of exchange rate policy is frequently to contribute to stable prices in international trading with one or more partner countries.
This is conducive to lower price risks, increased trade, and even integration of neighboring economies.
Furthermore, if the partner country is carrying out a low inflation policy that policy is more or less duplicated. However, the country with a strong currency always remains leading.