Read Ebook: Elements of Foreign Exchange: A Foreign Exchange Primer by Escher Franklin

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Too great drawings of loan-bills, as the long bills drawn to make foreign loans are called, are quickly reflected in a squeamish London discount market. It needs only the refusal of the Bank of England to re-discount the paper of a few London banks suspected of having "accepted" too great a quantity of American loan-bills, to make it impossible to go on loaning profitably in the New York market. In order to make loans, long bills have to be drawn and sold to somebody, and if the discount market in London will take no more American paper, buyers for freshly-created American paper will be hard to find.

To get back to the part foreign loaning operations play in the foreign exchange market here, it is plain that as no actual money is put up, the business is attractive and profitable to the bank having the requisite facilities and the right foreign connection. It means the putting of the bank's name on a good deal of paper, it is true, but only on the deposit of entirely satisfactory collateral and only in connection with the assuming of the same obligation by a foreign institution of high standing. There are few instances where loss in transacting this form of business has been sustained, while the profits derived from it are very large.

As to what the foreign department of an American bank makes out of the business, it may be said that that depends very largely upon whether the bank here acts merely as a lending agent or whether the operation is for "joint account," both as to risk and commission. In the former case both the American and the European bank stands to make a very fair return--always considering that neither is called upon to put up one real dollar or pound sterling. Take, for instance, the average sterling loan made on the basis of the borrower taking all the risk of exchange and paying a flat commission of three-eighths of one per cent. for each ninety days. That means that each bank makes three-sixteenths of one per cent. for every ninety days the loan runs--the American bank for simply drawing its ninety-day bills of exchange and the English bank for merely accepting them. Naturally, competition is keen, American banking houses vying with each other both for the privilege of acting as agents of the foreign banks having money to lend, and of going into joint-account loaning operations with them. Three-sixteenths or perhaps one-quarter of one per cent. for ninety days may not seem much of an inducement, but considering the fact that no real cash is involved, this percentage is enough to make the biggest and best banking houses in the country go eagerly after the business.

Approaching the subject of finance-bills, the author is well aware that concerning this phase of the foreign exchange business there is wide difference of opinion. Finance bills make money, but they make trouble, too. Their existence is one of the chief points of contact between the foreign exchange and the other markets, and one of the principal reasons why a knowledge of foreign exchange is necessary to any well-rounded understanding of banking conditions.

Strictly speaking, a finance-bill is a long draft drawn by a banker of one country on a banker in another, sometimes secured by collateral, but more often not, and issued by the drawing banker for the purpose of raising money. Such bills are not always distinguishable from the bills a banker in New York may draw on a banker in London in the operation of lending money for him, but in nature they are essentially different. The drawing of finance-bills was recently described by the foreign exchange manager of one of the biggest houses in New York, during the course of a public address, as a "scheme to raise the wind." Whether or not any collateral is put up, the whole purpose of the drawing of finance-bills is to provide an easy way of raising money without the banker here having to go to some other bank to do it.

The origin of the ordinary finance-bill is about as follows: A bank here in New York carries a good balance in London and works a substantial foreign exchange business in connection with the London bank where this balance is carried. A time comes when the New York banking house could advantageously use more money. Arrangements are therefore made with the London bank whereby the London bank agrees to "accept" a certain amount of the American banker's long bills, for a commission. In the course of his regular business, then, the American banker simply draws that many more pounds sterling in long bills, sells them, and for the time being has the use of the money. In the great majority of cases no extra collateral is put up, nor is the London bank especially secured in any way. The American banker's credit is good enough to make the English banker willing, for a commission, to "accept" his drafts and obligate himself that the drafts will be paid at maturity. Naturally, a house has to be in good standing and enjoy high credit not only here but on the other side before any reputable London bank can be induced to "accept" its finance paper.

The ability to draw finance-bills of this kind often puts a house disposed to take chances with the movement of the exchange market into line for very considerable profit possibilities. Suppose, for instance, that the manager of a house here figures that there is going to be a sharp break in foreign exchange. He, therefore, sells a line of ninety-day bills, putting himself technically short of the exchange market and banking on the chance of being able to buy in his "cover" cheaply when it comes time for him to cover. In the meantime he has the use of the money he derived from the sale of the "nineties" to do with as he pleases, and if he has figured the market aright, it may not cost him any more per pound to buy his "cover" than he realized from the sale of the long bills. In which case he would have had the use of the money for the whole three months practically free of interest.

It is plain speculating in exchange--there is no getting away from it, and yet this practice of selling finance-bills gives such an opportunity to the exchange manager shrewd enough to read the situation aright to make money, that many of the big houses go in for it to a large extent. During the summer, for instance, if the outlook is for big crops, the situation is apt to commend itself to this kind of operation. Money in the summer months is apt to be low and exchange high, affording a good basis on which to sell exchange. Then, if the expected crops materialize, large amounts of exchange drawn against exports will come into the market, forcing down rates and giving the operator who has previously sold his long bills an excellent chance to cover them profitably as they come due.

About the best example of how exchange managers can be deceived in their forecasts is afforded by the movement of exchange during the summer and fall of 1909. Impelled thereto by the brilliant crop prospects of early summer, foreign exchange houses in New York drew and sold finance-bills in enormous volume. The corn crop was to run over three billion bushels, affording an unprecedented exportable surplus--wheat and cotton were both to show record-breaking yields. But instead of these promises being fulfilled, wheat and corn showed only average yields, while the cotton crop turned out decidedly short. The expected flood of exchange never materialized. On the contrary, rise in money rates abroad caused such a paying off of foreign loans and maturing finance bills that foreign exchange rose to the gold export point and "covering" operations were conducted with extreme difficulty. In the foreign exchange market the autumn of 1909 will long be remembered as a time when the finance-bill sellers had administered to them a lesson which they will be a good while in forgetting.

Arbitraging in exchange--the buying by a New York banker, for instance, through the medium of the London market, of exchange drawn on Paris, is another broad and profitable field for the operations of the expert foreign exchange manager. Take, for example, a time when exchange on Paris is more plentiful in London than in New York--a shrewd New York exchange manager needing a draft on Paris might well secure it in London rather than in his home city. The following operation is only one of ten thousand in which exchange men are continually engaged, but is a representative transaction and one on which a good deal of the business in the arbitration of exchange is based.

Sale by a New York banker of a draft on Paris, say, for francs 25,250, at 5.17-1/2, bringing him in ,879.23. Purchase by same banker of a draft on London for ?1,000, at 4.84, costing him ,840. Instructions by the American banker to his London correspondent to buy a check on Paris for francs 25,250 in London, and to send it over to Paris for the credit of his . Such a draft, at 25.25 would cost just ?1,000.

The circle would then be complete. The American banker who originally drew the francs 25,250 on his Paris balance would have replaced that amount in his Paris balance through the aid of his London correspondent. The London correspondent would have paid out ?1,000 from the American banker's balance with him, a draft for which amount would come in the next mail. All parties to the transaction would be satisfied--especially the banker who started it, for whereas he paid out ,840 for the ?1,000 draft on London, he originally took in ,879.23 for the draft he sold on Paris.

It is impossible in this brief treatise to give more than a suggestion of the various kinds of exchange arbitration being carried on all the time. Experts do not confine their operations to the main centers, nor is three necessarily the largest number of points which figure in transactions of this sort. Elaborate cable codes and a constant use of the wires keep the up-to-date exchange manager in touch with the movement of rates in every part of Europe. If a chance exists to sell a draft on London and then to put the requisite balance there through an arbitration involving Paris, Brussels, and Amsterdam, the chances are that there will be some shrewd manager who will find it out and put through the transaction. Some of the larger banking houses employ men who do little but look for just such opportunities. When times are normal, the margin of profit is small, but in disturbed markets the parities are not nearly so closely maintained and substantial profits are occasionally made. The business, however, is of the most difficult character, requiring not only great shrewdness and judgment but exceptional mechanical facilities.

As a means of making--or of losing--money, in the foreign exchange business, the dealing in contracts for the future delivery of exchange has, perhaps, no equal. And yet trading in futures is by no means necessarily speculation. There are at least two broad classes of legitimate operation in which the buying and selling of contracts of exchange for future delivery plays a vital part.

Take the case of a banker who has bought and remitted to his foreign correspondent a miscellaneous lot of foreign exchange made up to the extent of one-half, perhaps, of commercial long bills with documents deliverable only on "payment" of the draft. That means that if the whole batch of exchange amounted to ?50,000, ?25,000 of it might not become an available balance on the other side for a good while after it had arrived there--not until the parties on whom the "payment" bills were drawn chose to pay them off under rebate. The exchange rate, in the meantime, might do almost anything, and the remitting banker might at the end of thirty or forty-five days find himself with a balance abroad on which he could sell his checks only at very low rates.

To protect himself in such case the banker would, at the time he sent over the commercial exchange, sell his own demand drafts for future delivery. Suppose that he had sent over ?25,000 of commercial "payment" bills. Unable to tell exactly when the proceeds would become available, the banker buying the bills would nevertheless presumably have had experience with bills of the same name before and would be able to form a pretty accurate estimate as to when the drawees would be likely to "take them up" under rebate. It would be reasonably safe, for instance, for the banker to sell futures as follows: ?5,000 deliverable in fifteen days; ?10,000 deliverable in thirty days, ?10,000 deliverable in from forty-five to sixty days. Such drafts on being presented could in all probability be taken care of out of the prepayments on the commercial bills.

The other operation is the sale of bankers' futures, not against remittances of actual commercial exchange but against exporters' futures. Exporters of merchandise frequently quote prices to customers abroad for shipment to be made in some following month, to establish which fixed price the exporter has to fix a rate of exchange definitely with some banker. "I am going to ship so-and-so so many tubs of lard next May," says the exporter to the banker, "the drafts against them will amount to so-and-so-much. What rate will you pay me for them--delivery next May?" The banker knows he can sell his own draft for May delivery for, say, 4.87. He bids the exporter 4.86-1/2 for his lard bills, and gets the contract. Without any risk and without tying up a dollar of capital the banker has made one-half cent per pound sterling on the whole amount of the shipment. In May, the lard bills will come in to him, and he will pay for them at a rate of 4.86-1/2, turning around and delivering his own draft against them at 4.87.

Selling futures against futures is not the easiest form of foreign exchange business to put through, but when a house has a large number of commercial exporters among its clients there are generally to be found among them some who want to sell their exchange for future delivery. As to the buyer of the banker's "future," such a buyer might be, for instance, another banker who had sold finance-bills and wants to limit the cost of "covering" them.

The foregoing examples of dealing in futures are merely examples of how futures may figure in every-day exchange transactions. Like operations in exchange arbitrage, there is no limit to the number of kinds of business in which "futures" may figure. They are a much abused institution, but are a vital factor in modern methods of transacting foreign exchange business.

The foregoing are the main forms of activity of the average foreign department, though there are, of course, many other ways of making money out of foreign exchange. The business of granting commercial credits, the exporting and importing of gold and the business of international trading in securities will be taken up separately in following chapters.

GOLD EXPORTS AND IMPORTS

Gold exports and imports, while not constituting any great part of the activity of the average foreign department, are nevertheless a factor of vital importance in determining the movement of exchange. The loss of gold, in quantity, by some market may bring about money conditions resulting in very violent movements of exchange; or, on the other hand, such movements may be caused by the efforts of the controlling financial interests in some market to attract gold. The movement of exchange and the movement of gold are absolutely dependent one on the other.

Considering broadly this question of the movement of gold, it is to be borne in mind that by far the greater part of the world's production of the precious metal takes place in countries ranking very low as to banking importance. The United States, is indeed, the only first-class financial power in which any very considerable proportion of the world's gold is produced. Excepting the ninety million dollars of gold produced in the United States in 1908, nearly all of the total production of 430 million dollars for that year was taken out of the ground in places where there exists but the slightest demand for it for use in banking or the arts.

The distribution of the raw gold is effected as follows: Each Monday morning there is held an auction at which are present all the representatives of home or foreign banks who may be in the market for gold. These representatives, fully apprised of the amount of the metal which has arrived during the preceding week and which is to be sold, know exactly how much they can bid. The gold, therefore, is sold at the best possible price, and finds its way to that point where the greatest urgency of demand exists. It may be Paris or Berlin, or it may be the Bank of England. According as the representatives present at the auction may bid, the disposition of the gold is determined.

In other words, both the primary movement of gold from the mines and the secondary movement from the distributive centers are merely temporary and show little as to the final lodgment of the precious metal. What really counts is exchange conditions; it is along the lines of the favorable exchange that the great currents of gold will inevitably flow.

For example, if a draft for pounds sterling drawn on London can be bought here at a low rate of exchange, anything in London that the American consumer may want to possess himself of can be bought cheaper than when exchange on London is high. The price of a hat in London is, say, ?1. With exchange at 4.83 it will cost a buyer in New York only .83 to buy that hat; if exchange were at 4.88, it would cost him .88. Similarly with raw copper or raw gold or any other commodity. Given a low rate of exchange on any point and it is possible for the outside markets to buy cheaply at that point.

And a very little difference in the price of exchange makes a very great difference so far as the price of gold is concerned. As stated in a previous chapter, a new gold sovereign at any United States assay office can be converted into .8665, so that if it cost nothing to bring a new sovereign over here, no one holding a draft for a pound would sell it for less than .8665, but would simply order the sovereign sent over here and cash it in for .8665 himself. Always assuming that it cost nothing to bring over the actual gold, every time it became possible to buy a draft for less than .8665, some buyer would snatch at the chance.

Such a case, with ?1 as the amount of the draft and the assumption of no charge for importing the gold, is, of course, mentioned merely for purposes of illustration. From it should, however, become clear the whole idea underlying gold imports. A new sovereign laid down in New York is worth, at any time, .8665. If it is possible to get the sovereign over here for less than that--by paying .83 for a ?1 draft on London, for instance, and three cents for charges, .86 in all--it is possible to bring the sovereign in and make money doing it.

Whether the gold imported is in the form of sovereigns or whether it consists of bars makes not the slightest difference so far as the principle of the thing is concerned. A sovereign is at all times worth just so and so much at any United States assay office, and an ounce of gold of any given fineness is worth just so and so much, too, regardless of where it comes from. So that in importing gold, whether the metal be in the form of coin or bars, the great thing is the cheapness with which it can be secured in some foreign market. If it can be secured so cheaply in London, for example, that the price paid for each pound of the draft, plus the charge of bringing in each sovereign, is less than what the sovereign can be sold for when it gets here, it will pay to buy English gold and bring it in.

Exactly the same principle applies where the question is of importing gold bars instead of sovereigns, except that bars cannot be bought in London at a fixed rate. That, however, in no way affects the underlying principle that in importing gold the profit is made by selling the gold here for more dollars than the combined dollar-cost of the draft on London with which the gold is bought and the charges incurred in importing the metal. To illustrate, if the draft cost 7,000 and the charges amounted to ,000, the gold would have to be sold here for at least ,000,000, to have the importer come out even.

With exports, the theory of the thing is to sell a draft on, say, London, for more dollars than the dollar-cost of enough gold, plus charges, to meet the draft. As will be seen from the figures of an actual shipment, given further on, the banker who ships gold gets the money to buy the gold from the Treasury here, by selling a sterling draft on London. Suppose, for example, a New York banker wants to create a ?200,000 balance in London. Figuring how many ounces of gold will give him the ?200,000 credit, he buys that much gold and sends it over. Suppose the combined cost of the gold and the charge for shipping it amounts to 6,000. If the banker here can sell a ?200,000 draft against it at 4.88, he will just get back the 6,000 he laid out originally and be even on the transaction.

Before passing from the theory to the practice of gold exports and imports, there is to be considered the fact that bar gold sells in London at a constantly varying price, while in New York it sells at a definitely fixed price. In New York an ounce of gold of any given fineness can always be sold for the same amount of dollars and cents, but in London the amount of shillings and pence into which it is convertible varies constantly. So that a New York banker figuring on bringing in bar gold from London has to take carefully into account what the price per ounce of bar gold over there is. Sovereigns are seldom imported because they are secured in London not by weight but by face value,--even if the sovereigns have lost weight they cost just as many pounds sterling to secure. Where the New York banker is exporting gold, on the other hand, the price at which bar gold is selling in London is just as important as where he is importing. For the price at which the gold can be disposed of when it gets to London determines into how many pounds sterling it can be converted.

These matters of the cost of gold in one market and the crediting of the gold in some other market are not the easiest thing to grasp at first thought, but will perhaps become quite clear by reference to the accompanying calculation of actual gold export and gold import transactions. All the way through it must be remembered that the figures of such calculations can never be absolute--that insurance and freight charges vary and that different operations are conducted along different lines. The two operations described embody, however, the principle of both the outward and inward movement of bar gold at New York.

In the transaction described below about a quarter of a million dollars' worth of bar gold is shipped to London, the money to pay for the gold being raised by the drawing and selling of a demand draft on London. Assuming that the draft is drawn and the gold shipped at the same time, the draft will be presented fully three days before the gold is credited, that being the time necessary for assaying, weighing, etc. In other words, there will be an "overdraft" for at least three days, interest on which will have to be figured as a part of the cost of the operation.

Following is the detailed statement:

Assay office charge 100

Cartage and packing 20

Freight 390

Insurance 125

Draft on London for ?51,380, sold by shipper of the gold, at 487.96 0,718

In the transaction described above, the "overdraft" caused by the inevitable delay in assaying and weighing the gold on its arrival in London lasted for three days, the American banker being charged interest at the rate of four per cent. 487.96 being the rate at which the banker exporting the gold was able to sell his demand draft at the time, was, under those conditions, the "gold export point."

In this particular operation, which was undertaken purely for advertising purposes, the shipper of the gold came out exactly even. Suppose, however, that he had been able to sell his draft, against the gold shipped, at 4.88 instead of 4.87-3/4. That would have meant twenty-five points more, which, on ?51,380, would have amounted to 8.25.

This question of the profit on gold exports is both interesting and, because it has a strong bearing at times on the question of whether or not to ship gold, important. No rule can be laid down as to what profit bankers expect to make on shipments. If, for instance, a banker owes ?200,000 abroad himself and finds it cheaper to send gold than to buy a bill, the question of profit does not enter at all. Then, again, many and many an export transaction is induced by ulterior motives--it may be for the sake of advertising, or for stock market purposes, or because some correspondent abroad needs the gold and is willing to pay for it. Any one of these or many like reasons may explain the phenomenon, occasionally seen, of gold exports at a time when conditions plainly indicate that the exporter is shipping at a loss.

As a rule, however, when exchange is scarce and the demand so great that bankers who do not themselves owe money abroad see a chance to supply the demand for exchange by shipping gold and drawing drafts against it, the profit amounts to anywhere from 0 to ,000 on each million dollars shipped--for less than the first amount named it is hardly worth while to go into the transaction at all; on the other hand, conditions have to be pretty much disordered to force exchange to a point where the larger amount named can be earned.

Turning now to the discussion of the conditions under which gold is imported, it will appear from the following calculation that interest plays a much more important part in the case of gold imports than in the case of exports. With exports, as has been shown, the interest charge is merely on a three days' overdraft, but in the case of imports the banker who brings in the gold loses interest on it for the whole time it is in transit and for a day or two on each end, besides. A New York banker, carrying a large balance in London, for instance, orders his London correspondent to buy and ship him a certain amount of bar gold. This the London banker does, charging the cost of the metal, and all shipping charges, to the account of the New York banker. On the whole amount thus charged, therefore, the New York banker loses interest while the gold is afloat. Even after the gold arrives in New York, of course, the depleted balance abroad continues to draw less interest than formerly, but to make up for that the gold begins to earn interest as soon as it gets here.

The transaction given below is one which was made under the above conditions--the importer in New York had a good balance in London and ordered his London correspondent to buy and ship about ,000,000 of gold, charging the cost and all expenses to his account. In this particular case the interest lost in London was at six per cent. and lasted for ten days.

Cost in the London market of 52,782 ounces of gold at 77 shillings, 11-3/4 pence per ounce ?205,795

Freight 320

Insurance 102

Boxing and carting 9

Commission for buying the gold 26

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