Exchange rate expectation formation in the foreign exchange market when the base currency is pegged to a basket

An attempt is made to identify the expectation formation mechanism dominating the foreign exchange market when the domestic currency is pegged to a basket, using the Kuwaiti dinar (KD) as the pegged currency. The criterion used to identify the dominance or otherwise of a particular mechanism is the profitability of trading based on that mechanism. It is found that regressive expectations are dominant, which is unlike what is found for floating currencies. These results have implications for foreign exchange trading and for policy.