An asset is pegged when its value is directly tied to the value of another underlying asset. For example, the Bermudian dollar is pegged to the U.S. dollar such that one Bermudian dollar is worth one U.S. dollar. Despite being different currencies, they maintain the exact same value relative to one another.
A government will often peg its currency to stabilize the value and boost investor confidence. By tying the currency to that of a more stable currency, a country can artificially stabilize its own currency.
A pegged currency can reduce risk for foreign investors, encouraging foreign direct investment. By making an investment in a foreign country, an investor has exposure to that country’s currency, in addition to the inherent risk of the investment. If the currency is pegged to the investor’s local currency this risk is mitigated.
In order to peg a currency, a government ensures that it can be traded in for the underlying asset. For example, the Bermudian government has promised that anyone can trade in a Bermudian dollar for a U.S. dollar. This promise is only credible if the government maintains a significant reserve of the underlying currency.
If the promised exchange loses credibility then the peg may fail. When this happens the pegged currency will return to its inherent equilibrium value. This generally means it will lose a significant amount of value, often very rapidly.