Currency Peg in Forex

Definition

A currency peg is an exchange-rate policy in which a country attempts to keep the value of its currency fixed, or within a narrow range, relative to another currency or reference value.

It is also commonly associated with a fixed exchange rate.

How Does a Currency Peg Work?

Many currencies are allowed to move freely according to market supply and demand.

A pegged currency works differently.

Its monetary authorities choose a reference value and attempt to keep the exchange rate close to that level.

The reference may be:

another major currency,

a group or basket of currencies,

or another agreed monetary reference.

Why Would a Country Peg Its Currency?

One reason is stability.

Large exchange-rate movements can create uncertainty for businesses involved in international trade.

Keeping the currency relatively stable against an important trading currency can make it easier for businesses to estimate future costs and revenues.

Does a Peg Mean the Price Never Moves?

Not always.

Some currency arrangements maintain a very tight fixed value, while others allow the currency to move within an approved range.

A peg can also come under pressure when market conditions strongly push a currency away from its intended value.

Currency Peg vs. Floating Currency

With a currency peg, authorities aim to maintain a particular exchange relationship.

With a floating exchange rate, the currency's value is allowed to respond more freely to market supply and demand.

Key Takeaway

A currency peg is a policy designed to keep a currency's exchange rate linked to another currency or reference value.

Its main purpose is usually greater exchange-rate stability.