Trading a fixed currency is one of the low risk high reward ways of
profiting in the forex market. Although it is not that popular among
traders, a seasoned trader with good analytical skills can pocket very
large profits with this method in short time provided that he is
patient and only takes those opportunities which suit his expectations.
What is a pegged currency?
A pegged currency is a monetary unit the value of which is fixed to
that of another. By choosing this path, the central bank of the pegging
nation is abandoning monetary independence. Since any difference
between the interest rates of the pegged currency and the controlling
currency would be exploited by arbitrageurs distorting the exchange
rate, the pegging central bank has no choice but to mirror the monetary
policies of the other.
Pegged currencies are maintained by central banks at a fixed rate.
In many cases, pegs are introduced following political or economic
turmoil, and the rate is usually determined by historical factors.
However, unless the capital account is closed (which means that the
private sector cannot exchange currencies and buy and sell assets
internationally), there will be small fluctuations around the aimed
fixed rate as declared by the central bank. Traders of pegged
currencies profit from these fluctuations by betting, in most cases,
that the peg will hold.
Why does a nation maintain a fixed currency regime?
In most cases the purpose is controlling inflation. Since government
traditions in emerging markets are weak, political incentives for
inflating the money supply strong, and the independence of monetary
authorities is limited, or non-existent, inflation can become rampant
and uncontrollable by the traditional method of raising the interest
rates. As the public expects prices to go up, and press for higher
wages in return, firms raise prices, and a feedback loop based on the
psychological attitude of market participants can last indefinitely,
doing massive harm to the economic health of a nation.
Usually, the government which created the inflationary phase is
unwilling to solve the problem, and as it gets replaced at elections,
the new government is handed over a situation which demands radical
solutions. One of these radical solutions is the currency peg that
we’re discussing in this article; by instituting it, the government is
making a clear, irreversible, and reliable commitment to keeping any
growth of money supply beyond that of the controlling central bank
limited by the actual inflow of foreign currency into the nation
through external activities. In other words, the printing presses of
the pegging nation will be used only as often as that of the
controlling nation which is often a developed world country with a
credible and well-established policy.
Sometimes central banks and governments introduce pegs in
preparation for a monetary union. Since the currency of the pegging
nation will be abolished in time, it is beneficial to allow the public
to get used to the new unit of value by maintaining a peg, while the
new regulations and institutions are being built. The ERM (European
Exchange Rate Mechanism) which preceded the launch of the Euro, or the
present Danish peg, are examples of this kind of regime.
It is also possible that a peg be maintained for purely political
reasons, with only limited economic justifications. In the case of the
Gulf Arab States, and their much publicized, and criticized dollar
pegs, the main benefit is the political and military support of the
U.S. These nations have a sufficiently favorable current account
position to build up considerable forex reserves, and as they are not
exporters, they do not need to maintain a low exchange rate to help
their trade income. Although the dollar peg is useful for controlling
inflation sometimes, at other times the monetary policy of the U.S. can
be highly inflationary, negating this benefit. But as the Gulf States
mainly seek the political benefits of maintaining their pegs, this
issue is mostly ignored by them.
Pegs can also be introduced temporarily in response to currency
crises, without any relationship to inflation. Usually such regimes are
removed in time. HK and Malaysia, for example, both introduced a fixed
currency regime in response to the massive speculative attack during
the Asian crisis of 1998.
Advantages and Disadvantages
Just as the rationale justifying a currency peg differs from case to
case, the benefits and shortcomings of pegged currencies will be
different in different scenarios. But there are two obvious features
that are present in every case: the loss of independence by the pegging
central bank, and the stability and credibility granted to the currency
by the adoption of the new regime.
The advantages of the peg lie in its clarity and predictability. Its
disadvantage, on the other hand, is its inflexibility in adapting to
economic events. Unless government authorities have the wisdom to
gradually readjust or remove the peg if conditions require as much,
pegs which cannot be maintained can lead to currency crises involving
large devaluations. There are other, more complex problems caused by
exporter pegs, but this is out of the scope of this article.
Trading Fixed Currencies
Trading a fixed currency requires a good understanding of
fundamental factors. Technical analysis is not very useful, because
fluctuations of the rate lack continuity, liquidity is low, and there’s
not enough data to feed to the indicators in order to generate timely
and meaningful signals. Also, the actors that take part in the trading
of the fixed currency are usually large players with big pockets whose
choices are less sensitive to technical methods and strategies.
There are two ways of trading pegged currencies. One strategy
involves exploiting routine short term fluctuations which may have all
kinds of causes. These fluctuations are more frequent, but they always
return to the official value of the peg, and can easily be exploited
for profits. In this case, the trader will bet that the peg will hold,
will enter a position in accordance, and will await, indefinitely, that
intervention, or ordinary market dynamics bring the quote to where it
is expected to be. The other strategy requires the identification of
crisis-prone economies, and opening of positions that require that the
peg be tested severely, or even be broken. This is a long-term method
where profitable economic configurations are rarer. However, as
demonstrated by George Soros’ bet against the British peg, such
strategies can sometimes be extremely profitable and successful if
built on solid fundamentals.
In both methods, a good understanding of fundamentals is a must. The
trader must always keep an eye on currency in- and outflows, balance of
payments statistics, and more importantly, on the official statements
of government and monetary authorities. If the statements are backed by
a healthy surplus and a credible intervention policy, the peg can be
traded with confidence on a short term basis. If the central bank lacks
the reserves to intervene to maintain the fixed regime, or if the
government is unsure about the ultimate direction of economic policy,
one must be careful about the size and scope of one’s positions while
trading the peg.
For a reasonably knowledgeable trader, trading pegs can be lucrative
and relatively simple and easy. But it is wrong to think of this
trading strategy as being risk-free. While the small profits made in
short term trading can be very lucrative, if we’re trading blindly,
with eyes closed to fundamentals, a collapsing peg can wipe out the
gains of weeks or months in a few hours or days. So although this
strategy is safer, the necessity of diligent study and careful analysis
is by no means diminished.
There are fewer pegged currencies this decade, in comparison to the
last. This is partly because floating currency regimes are more popular
these days, and partly because the abundance of global liquidity during
the past years ensured that crises were less frequent, and the need to
introduce pegs was absent. We can expect that the popularity of the peg
will come back after 2009, although this is far from being certain.
The Saudi Riyal has been pegged to the dollar for decades. It’s
currently maintained around 3.75 USD per SAR (riyal). Since Saudi
Central Bank sits on top of sizable currency reserves, and as Saudi
Arabia is an oil exporter, the possibility that the SAR peg will be
abandoned due to external pressure and financial market turmoil is
minimal. Throughout 2008, there was speculation that Saudi Arabia would
abandon the peg in response to rampant inflation caused by the
depreciating U.S. dollar, but the rumors were proven wrong repeatedly
by the adamant denials of the Saudi authorities. As of this day (July
2009) there are no announced plans to drop the peg any time soon.
Saudi Arabia is a member of the Gulf Cooperation Council, which aims
at greater political cooperation and eventual monetary union.
Traders can exploit short term fluctuations in the value of the
Riyal by opening an account with a broker which offers low spreads for
this pair. Since the fluctuations which we hope to exploit are small
and frequent, the size of the spread charged by the broker will have a
direct impact on the profitability and frequency of our trades.
The Danish Krone is part of the ERM II, which determines the
relationship of EU member’s nations which do not use the Euro, with the
Euro system. It is expected that the Krone will be abolished sooner or
later, as Denmark chooses the path of closer integration with the
European financial system. Plans are in place for a referendum in 2011.
The Krone is one of the safest pegged currencies in the world for
currency traders. The Danish Central Bank is very predictable, and it
will regularly intervene if the EUR/DKK moves to far away from the
central point of 2.25 percent band at 7.46. In addition, the European
Central Bank has a commitment to provide unlimited liquidity if the
Danish authorities have difficulty in maintaining the peg, which makes
it almost impregnable against any kind of speculative attack in the
It is easy to trade the Krone. All we need to do is keeping an eye
on large aberrations from the central rate, and betting that the peg
will hold. Small sums gained over time may form significant amounts.
Hong Kong Dollar
The Hong Kong dollar’s peg is maintained by the Monetary Authority
of Hong Kong. Until 2007, the HKD was pegged strictly at 7.80 per USD,
but after the events of that year, the depreciation of the dollar,
appreciation of the Chinese Yuan, and the resultant high inflation, the
HKD is floating in a band of 7.75-85. The Hong Kong authorities are
committed to intervening when the band is in danger of breaking to
either side, and they have the reserves and financial power to do so.
Trading this currency involves similar methods. We need to make sure
that we’re up-to-date with government policies, and especially with the
decisions of the People’s Bank of China, as this institution has the
greatest impact on the choices made by the Hong Kong authorities.
Trading pegged currencies is a valid, safe, and lucrative method for
which the needle of the compass is the fundamental situation of the
economy. It is possible to profit greatly from the fluctuations of a
fixed currency, but the trader must be aware of the current account
situation and central bank reserves in order to avoid being caught in
the midst of a shock which can create losses with the speed of
lightning. Fortunately, such scenarios develop very slowly, and there
is almost always a way to be aware of them before currency collapses