The dirham peg and dollar exposure

What the arrangement is 

The dirham is a conventional peg against a single anchor currency. A published rate against the United States dollar is maintained by the central bank of the United Arab Emirates, the dirham is freely convertible into the anchor at that rate, and the arrangement has stood for decades. It is not a currency board and it is not dollarisation: the dirham is a distinct currency issued by its own institution, which undertakes to exchange it at a stated price rather than being legally constrained to a reserve ratio.

The operation behind the undertaking is a standing offer to the commercial banks in the jurisdiction. They can present dirhams and receive dollars, or present dollars and receive dirhams, at the published rate. Because that offer exists, no bank has a reason to deal materially away from it, and the market rate arrives at the official rate on most days without the central bank transacting at all. The domestic policy rate carries most of the remaining load, kept close enough to the anchor's that holding one currency rather than the other does not pay for itself.

What it does to a quoted pair 

A dirham against dollar quote has the outward form of any other pair. It has a bid, an offer, a chart and a settlement convention, and it sits in an instrument list beside pairs that move a great deal. What it does not have is a discovery process, because the number is administered rather than cleared, so the distance the quote travels in a session is measured in the last decimal places.

The cost of transacting it does not fall to match. A quoted spread is set by the firms willing to make a price, and there are fewer of them in a pair with very little turnover, so the quoted spread on a pegged pair is commonly wide relative to the distance the pair travels. Where a freely floating pair produces a move that is a multiple of the cost of dealing it, an administered pair can produce a move that is a fraction of it, and the same arithmetic that is a footnote in one case is the dominant term in the other.

Time behaves the same way. A position held past the daily financing cut off carries an adjustment derived from the difference between the two currencies' interest rates. Under a peg that difference is small and stable rather than absent, so on a long hold the financing term can be larger than anything the administered price itself contributes.

Every dirham cross is a dollar cross wearing a different name 

A dirham price for a currency other than the dollar is not quoted independently. It is arithmetic: the other currency's dollar rate multiplied by the dirham parity. Because one of the two factors is fixed, all of the variation in the product comes from the other one, so a euro against dirham chart and a euro against dollar chart are the same chart with the axis rescaled by a constant.

The last row is the whole point. A proportional move in the dollar leg produces the same proportional move in the cross, so nothing is added by holding the cross that was not already present in the dollar pair, other than whatever difference exists between the two quoted spreads. Practitioners describe this by saying the dirham has no independent exchange rate story to tell: the story is the dollar's.

The exposure is concentrated, not removed 

A peg is often described as removing currency risk for holders in the pegged economy. What it does is narrower and runs in two directions at once. Against the anchor, and only against the anchor, the rate is held, so a balance denominated in dollars converts back into dirhams through a constant. Against everything else, the dirham inherits every move the dollar makes, for reasons decided in another country's policy process.

The first pair of rows and the last pair say two different things. Against the dollar the conversion step is a constant and contributes nothing at all, favourably or otherwise. Against a third currency the conversion step is live, and it contributes whatever that currency did against the dollar between opening and closing, which is a movement the position itself never expressed.

For a portfolio the result is a correlation fact rather than a conversion fact. Positions across different instruments, different asset classes and different regions look diversified when they are listed, and if every one of them is denominated in the anchor currency then the currency component of each is the same component repeated. Diversification across instruments does not diversify a currency exposure; it multiplies the number of places one exposure is held. A peg makes that concentration comfortable to hold rather than making it smaller, because the step that would ordinarily reveal it is a constant.

Where pressure on the arrangement becomes visible 

A view about a pegged currency cannot be expressed in its spot price, because the spot price is administered. It is expressed in two other places. The forward market quotes the price of exchanging the two currencies at a future date, and that price is not fixed by anybody, so it moves with the interest rate difference between the two currencies and with whatever premium participants attach to the arrangement. The domestic money market is the second place: local interbank rates are set by local liquidity conditions, and the gap between them and the anchor's rates widens and narrows without any change in the spot quote.

This is why a chart of an administered pair is close to uninformative and a chart of the forward points on the same pair is not. The pressures that would move a floating rate do not stop existing when the rate is fixed. They surface in the quantity of reserves, in the forward curve and in domestic money market rates instead.

Where practitioners disagree 

The first argument is whether an administered pair belongs in an instrument list at all. One position holds that a price with no discovery process behind it carries no information, that what remains in the pair is financing and dealing cost, and that listing it invites a reader to analyse a number that is not analysable. Another holds that a quotable, convertible pair with real settlement is a real instrument used for real conversion, and that the absence of variance is a property to be understood rather than a reason to hide it. Neither side disputes the facts.

The second argument is whether the peg reduces risk or relocates it. Measured by the variation of the spot price it plainly reduces it, and that measurement is not in dispute. Measured by the shape of the distribution, the objection is that variance and discontinuity are different things and a low reading on the first says nothing about the second. Both measurements are correct about what they measure, and there is no test that settles which is the better description while the arrangement is in place.