Exotics, pegs and other risque’ sounding FX stuff (mini-lesson time!)

   One of you wrote in asking me this:

   Thanks for the review of the exotics. I’ve got a question for you: I’ve heard some of these currencies (the HKD, anyway, I believe) being referred to as “pegged” to the US Dollar. I’d appreciate it if you could talk about what this means, and how it might affect trading. I’ve no plans to trade exotics yet, I’m just curious.

 So summed up, what is a currency peg and how does it affect me harvesting vast sums of pips?

 

  Is it just me or is there all sorts of odd-ball stuff like this we hear in the FX world and wonder what it means? Well, let’s roll our sleeves up for a longer than usual post and do another little mini-lesson, more economic in nature, since this requires some explaining.

• What it is: OK, a pegged currency (AKA “fixed exchange rate”) derives its value from something else: usually another currency or a basket of them, or something else that’s fixed like gold. So the currency’s value rises and falls according to that other thing. For example, many currencies are pegged to the dollar, meaning they rise and fall in value as the dollar does.

  I can think of a couple reasons off-hand why they do this.

1. One is that the currency which is pegged to something else (like the dollar) represents a small economy. Imagine the harmful effects to that economy if the currency was free floating (not pegged) and somebody manipulated if by buying/selling tons of it, or if a certain element of the economy affected the currency in an unbalanced way.
2. Some currencies peg to others (again, like the dollar) because they export heavily to the one they peg to and want to be able to continue selling to that country because it is vital to their economy. China does this – imagine the effect on China (which heavily exports, its lifeblood is manufacturing) if the dollar halved in value, and so Americans could only afford half as much goods from China, without a peg.

• And so this affects me (a trader) …. how, exactly? Well, there’s been lots of talk lately about people abandoning their peg to the dollar because its been dropping in value. If there is a trend in unpegging, of course that will hurt whatever is being unpegged to. Like the buck. It’s been a vicious snowball effect: the dollar goes down, for whatever reason, and then it goes down more because some other governments start saying “whoah, that’s making our currency go down too much, too!”, they dump/threaten to dumb billions of USD, which causes the USD to fall further, making people more antsy yet, etc. etc. you get the picture.

   Soooo, pegs only affect our trades if they are being changed and we’re trading those currencies. News items that such-and-such government is unpegging from the buck with cause a spike down in the buck that day, and contribute the overall trend of dollar selling (for example), and any news of who may be the beneficiary (“forget that crummy dollar, we’re putting more money in the euro now!”) will bump up that other currency.

 

  Think of it all this way: peg-stuff is macroeconomic-stuff, and affects currencies accordingly: more over time than on an hour-by-hour basis. And usually this long-term trend will be reflected on the chart: thus, the glory of technical analysis … simply follow the chart!