A currency peg refers to the practice of indexing one currency against another. This is a macroeconomic strategy that seeks to simplify international trade and reduce inflation of the pegged currency. It essentially fixes the rate of one currency against a major currency – typically the United States dollar. To maintain the pegged local rate, the Central Bank trades its own currency for the currency to which it is pegged. To do this, the Central Bank has to have large reserves of the foreign currency in order to control the local money supply.
Usually a pegged currency has a “dirty float”, since no currency is wholly fixed or floating. For example, the Trinidad and Tobago dollar is pegged against the US dollar 6 : 1. This means that the rate most financial institutions use to purchase the US dollar is six TT dollars to one US dollar. The buying price remains fixed, but the selling price fluctuates by a few percentage points (ranging between 6.2 and 6.4). This is because the private sector is allowed to buy and sell US on the Forex market as well.
The implications of this move on the foreign exchange market are as follows:
a) There is a major trader of the foreign currency (Central Bank) in the local currency market
b) The exchange rate with the currency pair is fixed
However, the overall impact is limited on the vast Forex market for the following reasons:
a) There is high liquidity in the Forex market
b) No one trader can influence Forex prices
c) Countries with pegged currencies do not have a major currency
While the pegged currency barely makes a dent in the overall scheme of things, once the country does not have a closed capital account (this prevents private trading of the indexed currency), fixed currency trading is a valuable niche strategy.
Foreign exchange traders usually do not trade pegged currencies, although this might be because one side of the pair is not a major currency (US : TT) for example. However, the private sector of the country with the pegged currency can benefit from trading the indexed currency (US) because it is a low-risk, high-reward strategy.
Forex traders use a combination of technical analysis (analysis of price movements using graphical analysis) and fundamental analysis (macroeconomic indicators and government fiscal policy). Fixed currency trading mitigates the role and importance of technical analysis – rendering it meaningless. Trading a pegged currency suggests that a trader should pay closer attention to the fundamentals of the economy, hence fundamental analysis.
Both major strategies surrounding fixed currency trades rely heavily on fundamental analysis. Scalpers normally enter against the trade, knowing that the price would likely fall back down to the pegged rate. The long-term strategy involves speculating on an economy in crisis, hoping that the position of the peg might change altogether.
Perhaps pegged currency trading is not very popular among Forex traders because it involves fundamental analysis of unfamiliar economies and trading unfamiliar currencies as well. Even so, currency pegs provide a chance for opportunistic traders versed in fundamental analysis to trade with a low-risk, high-profit strategy in both the short and long term.