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What is 'Pegging'

Pegging is a central bank's open market operations meant to stabilize its country's currency to that of another country by fixing its exchange rate. This term also refers to the practice of an investor buying large amounts of an underlying commodity or security close to the expiration date of a derivative held by that investor. This is done to encourage a favorable move in market price of the underlying security or commodity which may increase the value of the derivative.

BREAKING DOWN 'Pegging'

Many countries use pegging to keep their currencies stable relative to another country. Pegging to the U.S. dollar is common. In Europe, the Swiss franc was pegged to the euro for much of 2011-2015.

Pegging is also a strategy deployed by owners of call options on common stock and by sellers of put options. A call option buyer pays for the right to buy a stock at a specific strike price for a set period of time. Assume, for example, an investor buys a $50 call for XYZ stock that expires on June 30th. If the value of XYZ stock increases above $50 per share, the option position becomes more valuable. When the call option owner buys shares of XYZ stock close to the June expiration date, both the common stock price and the value of the option increase in value.

Factoring in Put Options

A put option allows the owner to sell a stock at a specific strike price. An investor who sells, or writes, a put option receives an amount of money from the put option buyer called a premium. The put option seller is obligated to buy the stock from the options buyer at the strike price if the buyer chooses to exercise the option before the expiration date.

As an example, assume an investor sells a $50 put on XYZ common stock that expires on June 30th and receives a $100 premium. Option sellers want the option to expire worthless and not be exercised by the option buyer. If the stock price increases in price above $50 per share, the option buyer lets the option expire worthless and sells the stock in the market. If the option seller buys the underlying security close to the expiration date, the stock may increase in price therefore causing the option to expire worthless.

How Currencies Are Pegged

Central Banks will go into the open market to buy and sell its currency in order to maintain its pegged ratio. If a country’s currency value has 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.

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