What is Pegging?

Pegging is controlling a country's currency rate by tying it to another country's currency or steering an asset's price prior to option expiration. 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 stabler, currency. It can also refer to the practice of manipulating the price of an underlying asset, like a commodity, prior to option expiry.

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What is Pegging?

Understanding Pegging

Many countries use pegging 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.

Pegging is also a strategy deployed by buyers and writers (sellers) of call and put options. Writers are most commonly associated with this practice of driving up or down the price of the underlying security as the option nears expiry. The reason is that they have a monetary incentive to ensure that the buyer does not exercise the option contract.

A less known 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.

Key Takeaways

  • Pegging is controlling a country's currency rate by tying it to another country's currency or steering an asset's price prior to option expiration.
  • 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 a strategy deployed by buyers and writers (sellers) of call and put options.

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 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.

Options Pegging

The buyer of a call option pays a premium to obtain the right to buy the stock (underlying security) at the specified strike price while the writer of that call option 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 the underlying stock at the strike price of $50, on XYZ stock that expires on 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 and the seller would be theoretically exposed to infinite risk from continued potential rise of XYZ stock. 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 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.

For example, an investor buys a put option on XYZ stock with a strike price of $45 that expires on July 31st and pays 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 if below that level. Again, if the price of XYZ stock is very close to this level, then both would be active (selling and buying) in trying 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.