In Finance, what is Pegging?

Pegging is a practice which is used to increase market stability by fixing values relative to assets of stable value. A classic example is currency pegging, in which the value of a nation's currency is pegged to the value of another currency which is viewed as reliable and highly stable. Different nations take different stances on this practice and how heavily regulators can intervene in the market. It can also be influenced by trade agreements, treaties, and similar contracts which may be made between nations.

The reason pegging is practiced is to decrease market volatility, which can be a concern during periods of economic or political uncertainty. In addition to pegging currency values to other currencies such as the Euro, nations can also peg to commodities like gold. These commodities tend to have relatively stable and secure prices which make them a safe choice of commodity to peg the value of a national currency to, especially if a nation has reserves of the commodity which can be used to influence the movement of the market.

Some degree of market intervention is practiced around the world The goal is to keep market growth steady by promoting economic activity without putting nations into a bubble. Economic bubbles can result in collapse later because of inflated values which vanish when the bubble pops. Thus, regulators have to walk a fine line between intervening too much and being too hands off. Worldwide, many nations belong to groups of countries which cooperate economically and thus have an interest in retaining members with stable economies.

There can be times at which pegging can backfire. Even stable currencies can sometimes behave unpredictably. By harnessing fortunes and futures to the value of one nation's currency, a nation will find itself taken along for a ride if the other country experiences financial instability. Making the decision to unpeg currency values can be catastrophic because inflation may quickly drive them out of control.

The term “pegging” can be used in another sense in the world of finance. When someone holds a derivative, someone else may make a large purchase to push the market in a particular direction and this can be known as pegging. This is done with the goal of making exercise of the derivative unfavorable so that the person or institution which wrote the derivative retains the premium paid for it without being disadvantaged by the decision to exercise it.