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Elements of Foreign Exchange
A FOREIGN EXCHANGE PRIMER
By FRANKLIN ESCHER
Special Lecturer on Foreign Exchange at New York University
_Fifth Edition_
NEW YORK
THE BANKERS PUBLISHING COMPANY
1915
LONDON
EFFINGHAM WILSON, 54 THREADNEEDLE ST.
Copyright 1910
By the Bankers Publishing Co.
New York
CONTENTS
PAGE
CHAPTER I. WHAT FOREIGN EXCHANGE IS AND WHAT BRINGS IT INTO EXIST 3
The various forms of obligation between the bankers and
merchants of one country and the bankers and merchants of
another, which result in the drawing of bills of exchange.
CHAPTER II. THE DEMAND FOR BILLS OF EXCHANGE 15
A discussion of the six sources from which spring the demand for
the various kinds of bills of exchange.
CHAPTER III. THE RISE AND FALL OF EXCHANGE RATES 25
Operation of the five main influences tending to make exchange
rise as opposed to the five main influences tending to make
exchange fall.
CHAPTER IV. THE VARIOUS KINDS OF EXCHANGE 45
A detailed description of: Commercial "Long" Bills--Clean
Bills--Commercial "Short" Bills--Drafts drawn against securities
sold abroad--Bankers' demand drafts--Bankers' "long" drafts.
CHAPTER V. THE FOREIGN EXCHANGE MARKET 59
How the exchange market is constituted. The bankers, dealers and
brokers who make it up. How exchange rates are established. The
relative importance of different kinds of exchange.
CHAPTER VI. HOW MONEY IS MADE IN FOREIGN EXCHANGE. THE OPERATIONS
OF THE FOREIGN DEPARTMENT 68
An intimate description of: Selling demand bills against
remittances of demand bills--Selling cables against remittances
of demand bills--Selling demand drafts against remittances of
"long" exchange--The operation of lending foreign money
here--The drawing of finance bills--Arbitraging in Foreign
Exchange--Dealing in exchange "futures."
CHAPTER VII. GOLD EXPORTS AND IMPORTS 106
The primary movement of gold from the mines to the markets, and
its subsequent distribution along the lines of favorable exchange
rates. Description (with presentation of actual figures) of: The
export of gold bars from New York to London--Import of gold bars
from London--Export of gold bars to Paris under the "triangular
operation." Shipments to Argentina.
London as a "free" gold market and the ability of the Central
Banks in Europe to control the movement of gold.
CHAPTER VIII. FOREIGN EXCHANGE IN ITS RELATION TO INTERNATIONAL
SECURITY TRADING 130
Europe's "fixed" and "floating" investment in American bonds
and stocks a constant source of international security trading.
Consequent foreign exchange business. Financing foreign
speculation in "Americans." Description of the various kinds of
bond and stock "arbitrage."
CHAPTER IX. THE FINANCING OF EXPORTS AND IMPORTS 141
A complete description of the international banking system by
which merchandise is imported into and exported from the United
States. An actual operation followed through its successive
steps.
PREFACE
"Where can I find a little book from which I can get a clear idea of
how foreign exchange works, without going too deeply into it?"--that
question, put to the author dozens of times and by many different kinds
of people, is responsible for the existence of this little work. There
_are_ one or two well-written textbooks on foreign exchange, but never
yet has the author come across a book which covered this subject in
such a way that the man who knew little or nothing about it could pick
up the book and within a few hours get a clear idea of how foreign
exchange works,--the causes which bear upon its movement, its influence
on the money and security markets, etc.
That is the object of this little book--to cover the ground of foreign
exchange, but in such a way as to make the subject interesting and its
treatment readable and comprehensible to the man without technical
knowledge. Foreign exchange is no easy subject to understand; there are
few important subjects which are. But, on the other hand, neither is it
the complicated and abstruse subject which so many people seem to
consider it--an idea only too often born of a look into some of the
textbooks on exchange, with their formidable pages of tabulations,
formulas, and calculations of all descriptions. For the average man
there is little of interest in these intricacies of the subject. Many
of the shrewdest and most successful exchange bankers in New York City,
indeed, know less about them than do some of their clerks. What is
needed is rather a clear and definite knowledge of the movement of
exchange--why it moves as it does, what can be read from its movements,
what effects its movements exert on the other markets. It is in the
hope that something may be added to the general understanding of these
important matters that this little book is offered to the public.
THE ELEMENTS OF FOREIGN EXCHANGE
CHAPTER I
WHAT FOREIGN EXCHANGE IS AND WHAT BRINGS IT INTO EXISTENCE
Underlying the whole business of foreign exchange is the way in which
obligations between creditors in one country and debtors in another
have come to be settled--by having the creditor draw a draft directly
upon the debtor or upon some bank designated by him. A merchant in New
York has sold a bill of goods to a merchant in London, having thus
become his creditor, say, for $5,000. To get his money, the merchant in
New York will, in the great majority of cases, draw a sterling draft
upon the debtor in London for a little over L1,000. This draft his
banker will readily enough convert for him into dollars. The buying and
selling and discounting of countless such bills of exchange constitute
the very foundation of the foreign exchange business.
Not all international obligations are settled by having the creditor
draw direct on the debtor. Sometimes gold is actually sent in payment.
Sometimes the debtor goes to a banker engaged in selling drafts on the
city where the obligation exists, gets such a draft from him and sends
that. But in the vast majority of cases payment is effected as
stated--by a draft drawn directly on the buyer of the goods. John Smith
in London owes me money. I draw on him for L100, take the draft around
to my bank and sell it at, say, 4.86, getting for it a check for
$486.00. I have my money, and I am out of the transaction.
Obligations continually arising in the course of trade and finance
between firms in New York and firms in London, it follows that every
day in New York there will be merchants with sterling drafts on London
which they are anxious to sell for dollars, and vice versa. The supply
of exchange, therefore, varies with the obligations of one country to
another. If merchants in New York, for instance, have sold goods in
quantity in London, a great many drafts on London will be drawn and
offered for sale in the New York exchange market. The supply, it will
of course be apparent, varies. Sometimes there are many drafts for
sale; sometimes very few. When there are a great many drafts offering,
their makers will naturally have to accept a lower rate of exchange
than when the supply is light.
The par of exchange between any two countries is the price of the gold
unit of one expressed in the money of the other. Take England and the
United States. The gold unit of England is the pound sterling. What is
the price of as much gold as there is in a new pound sterling,
expressed in American money? $4.8665. That amount of dollars and cents
at any United States assay office will buy exactly as much gold as
there is contained in a new British pound sterling, or sovereign, as
the actual coin itself is called. 4.8665 is the mint par of exchange
between Great Britain and the United States.
The fact that the gold in a new British sovereign (or pound sterling)
is worth $4.8665 in our money by no means proves, however, that drafts
payable in pounds in London can always be bought or sold for $4.8665
per pound. To reduce the case to a unit basis, suppose that you owed
one pound in London, and that, finding it difficult to buy a draft to
send in payment, you elected to send actual gold. The amount of gold
necessary to settle your debt would cost $4.8665, in addition to which
you would have to pay all the expenses of remitting. It would be
cheaper, therefore, to pay considerably more than $4.8665 for a
one-pound draft, and you would probably bid up until somebody consented
to sell you the draft you wanted.
Which goes to show that the mint par is not what governs the price at
which drafts in pounds sterling can be bought, but that demand and
supply are the controlling factors. There are exporters who have been
shipping merchandise and selling foreign exchange against the shipments
all their lives who have never even heard of a mint par of exchange.
All they know is, that when exports are running large and bills in
great quantity are being offered, bankers are willing to pay them only
low rates--$4.83 or $4.84, perhaps, for the commercial bills they want
to sell for dollars. Conversely, when exports are running light and
bills drawn against shipments are scarce, bankers may be willing to pay
4.87 or 4.88 for them.
For a clear understanding of the mechanics of the exchange market there
is necessary a clear understanding of what the various forms of
obligations are which bring foreign exchange into existence.
Practically all bills originate from one of the following causes:
1. Merchandise has been shipped and the shipper draws his draft on
the buyer or on a bank abroad designated by him.
2. Securities have been sold abroad and the seller is drawing on
the buyer for the purchase price.
3. Foreign money is being loaned in this market, the operation
necessitating the drawing of drafts on the lender.
4. Finance-bills are being drawn, _i.e._, a banker abroad is
allowing a banker here to draw on him in pounds sterling at 60 or
90 days' sight in order that the drawer of the drafts may sell them
(for dollars) and use the proceeds until the drafts come due and
have to be paid.
1. Looking at these sources of supply in the order in which they are
given, it is apparent, first, what a vast amount of foreign exchange
originates from the direct export of merchandise from this country.
Exports for the period given below have been as follows:
1913 $2,465,884,000
1912 2,204,322,000
1911 2,049,320,000
1910 1,744,984,000
1909 1,663,011,000
Not all of this merchandise is drawn against; in some cases the buyer
abroad chooses rather to secure a dollar draft on some American bank
and to send that in payment. But in the vast majority of cases the
regular course is followed and the seller here draws on the buyer
there.
There are times, therefore, when exchange originating from this source
is much more plentiful than at others. During the last quarter of each
year, for instance, when the cereal and cotton crop exports are at
their height, exchange comes flooding into the New York market from all
over the country, literally by the hundreds of millions of dollars. The
natural effect is to depress rates--sometimes to a point where it
becomes possible to use the cheaply obtainable exchange to buy gold on
the other side.
In a following chapter a more detailed description of the New York
exchange market is given, but in passing, it is well to note how the
whole country's supply of commercial exchange, with certain exceptions,
is focussed on New York. Chicago, Philadelphia, and one or two other
large cities carry on a pretty large business in exchange, independent
of New York, but by far the greater part of the commercial exchange
originating throughout the country finds its way to the metropolis. For
in New York are situated so many banks and bankers dealing in bills of
exchange that a close market is always assured. The cotton exporter in
Memphis can send the bills he has drawn on London or Liverpool to his
broker in New York with the fullest assurance that they will be sold to
the bankers at the highest possible rate of exchange anywhere
obtainable.
2. The second source of supply is in the sale abroad of stocks and
bonds. Here again it will be evident how the supply of bills must vary.
There are times when heavy flotations of bonds are being made here with
Europe participating largely, at which times the exchange drawn against
the securities placed abroad mounts up enormously in volume. Then again
there are times when London and Paris and Berlin buy heavily into our
listed shares and when every mail finds the stock exchange houses here
drawing millions of pounds, marks, and francs upon their correspondents
abroad. At such times the supply of bills is apt to become very great.
Origin of bills from this source, too, is apt to exert an important
influence on rates, in that it is often sudden and often concentrated
on a comparatively short period of time. The announcement of a single
big bond issue, often, where it is an assured fact that a large part of
it will be placed abroad, is enough to seriously depress the exchange
market. Bankers know that when the shipping abroad of the bonds begins,
large amounts of bills drawn against them will be offered and that
rates will in all probability be driven down.
Announcements of such issues, as well as announcements that a block of
this or that kind of bonds has been placed abroad with some foreign
syndicate, are apt to come suddenly and often find the exchange market
unprepared. For the supply of exchange originated thereby, it must be
remembered, is not confined to the amount actually drawn against bonds
sold but includes also all the exchange which other bankers, in their
anticipation of lower rates, hasten to draw. The exchange market is,
indeed, a sensitive barometer, from which those who understand it can
read all sorts of coming developments. It often happens that buying or
selling movements in our securities by the foreigners are so clearly
forecasted by the action of the exchange market that bankers here are
able to gain great advantage from what they are able to foresee.
3. The third great source of supply is in the drafts which bankers in
one country draw upon bankers in another in the operation of making
international loans. The mechanism of such transactions will be treated
in greater detail later on, but without any knowledge of the subject
whatever, it is plain that the transfer of banking capital, say from
England to the United States, can best be effected by having the
American house draw upon the English bank which wants to lend the
money. In the finely adjusted state of the foreign exchanges nowadays,
loans are continually being made by bankers in one country to bankers
and merchants in another. Very little of the capital so transferred
goes in the form of gold. A London house decides to loan, say, $100,000
in the American market. The terms having been arranged, the London
house cables its New York correspondent to draw for L20,000, at 60 or
90 days' sight, as the case may be. The New York house, having drawn
the draft, sells it in the exchange market, realizing on it the
$100,000, which it then proceeds to loan out according to instructions.
The arranging of these loans, it will be seen, means the continuous
creation of very large amounts of foreign exchange. As the financial
relationships between our bankers and those of the Old World have been
developed, it has come about that European money is being put out in
this market in increasing volume. Conditions of money, discount, and
exchange are constantly being watched for the opportunity to make loans
on favorable terms, and the aggregate of foreign money loaned out here
at times reaches very large figures. In 1901 Europe had big amounts of
money outstanding in the New York market, and again in 1906 very large
sums of English and French capital were temporarily placed at our
disposal. But in the summer of 1909 all records were surpassed,
American borrowings in London and Paris footing up to at least half a
billion dollars. Such loans, running only a couple of months on the
average and then being sometimes paid off, but more often shifted about
or renewed, give rise to the drawing of immense amounts of foreign
exchange.
4. Drawing of so-called "finance-bills," of which a complete
description will be found in chapters IV and VI, is the fourth source
whence foreign exchange originates. Whenever money rates become
decidedly higher in one of the great markets than in the others,
bankers at that point who have the requisite facilities and credit,
arrange with bankers in other markets to allow them (the bankers at the
point where money is high) to draw 60 or 90 days' sight bills. These
bills can then be disposed of in the exchange market, dollars being
realized on them, which can then be loaned out during the whole life of
the bills. The advantages or dangers of such an operation will not be
touched upon here, the purpose of this chapter being merely to set
forth clearly the sources from which foreign exchange originates.
And when money is decidedly higher in New York than in London an
immense volume of foreign exchange does originate from this source. A
number of firms and banks, with either their own branches in London or
with correspondents there to whom they stand very close, are in a
position where they can draw very large amounts of finance bills
whenever they deem it profitable and expedient to do so. Eventually, of
course, these 60 and 90 day bills come due and have to be settled by
remittances of demand exchange, but in the meantime the house which
drew them will have had the unrestricted use of the money. In a market
like New York this is only too often a prime consideration. With money
rates soaring as they do so frequently here, a banker can pay almost
any commission his correspondent abroad demands and still come out
ahead on the transaction.
These are the principal sources from which foreign exchange
originates--shipments of merchandise, sales abroad of securities,
transfer of foreign banking capital to this side, sale of
finance-bills. Other causes of less importance--interest and profits on
American capital invested in Europe, for instance--are responsible for
the existence of some quantity of exchange, but the great bulk of it
originates from one of the four sources above set forth. In the next
chapter effort will be made to show whence arises the demand which
pretty effectually absorbs all the supply of exchange produced each
year.