FOREIGN EXCHANGE IN ITS RELATION TO INTERNATIONAL SECURITY TRADING
On account of the huge fixed investment of foreign money in the United
States, on account of Europe's continuous speculative interest in our
markets, and the activity of the "arbitrageurs" in both bonds and
shares, dealings in securities between ourselves and the Old World are
always on a very great scale. Not infrequently, indeed, Europe's
position on American securities is an influence of dominating
importance.
From the maturities, refunding operations, and interest remittances
alone, growing out of the permanent investment of foreign money in our
securities, there results a very great amount of international security
and exchange business. Whether Europe's investment here amounts to
three billions or four billions or five billions, it is impossible to
say; the fact remains that it is so large that every year a very great
amount of foreign-held bonds come due and have to be paid off or
refunded, and, further, that the remitting abroad of coupon and
dividend money each year calls for upward of $150,000,000.
This matter of maturing investments, alone, calls for continuous
international security trading and on a large scale. Each year there
comes due in this country an amount of railroad and other bonds running
well up into the hundreds of millions, of which a large proportion are
held on the other side. Some of these maturities are paid off in
cash--more often, refunding bonds are offered in exchange; seldom,
indeed, are the maturing investments allowed to remain unreplaced.
European investors, especially, have consistently done well with money
placed in this country, and the running off to maturity of a
foreign-held American bond is nearly sure to be followed up by
replacement with some other American security.
Bond houses doing an international business are therefore keenly
watchful of the maturity of issues largely held abroad, and are ever
ready with offers of new and attractive investments. Knowledge of the
location of American investments in Europe is thus a business asset of
the greatest importance, and records are carefully kept. The fact that
a dealer here knows that some bank in London has a wealthy client who
holds a big block of certain bonds about to mature, may very possibly
mean that the house here may be able to make a very profitable trade.
Information of this character is carefully gathered wherever possible
and as carefully guarded. The longer a house has been in business,
naturally, and the closer its financial relationship with investment
interests abroad, the more of this sort of information it is bound to
possess.
Foreign exchange growing out of these renewals and refundings is on a
very large scale. Sometimes the placing of a new issue abroad means
such immediate drawing of drafts on foreign buyers of the securities as
to depress the exchange market sharply. Sometimes, as in the case of
new issues of railroad stock, where payments are usually made in
instalments covering a year or more, the drawing of exchange is
distributed in such a way that its influence, if felt at all, is felt
merely as an underlying element of weakness.
Of a somewhat different character are the foreign exchange transactions
originating from what might be called Europe's "floating" investment in
American securities and from the out-and-out speculations carried on in
this market by the foreigners.
There is never a time, probably, when the floating foreign investment
in American stocks and bonds does not run up with the hundreds of
millions of dollars. "Speculation," such operations would probably be
called by many people, but whether speculation or not, a form of
activity which is continually giving rise to big dealings in foreign
exchange. For this "floating" investment is very largely for account of
bankers whose international connections and credit make it possible for
them to carry stocks and bonds through the agency of the exchange
market, and without having to put up any actual money. The ingenious
method by which this is accomplished is about as follows:
A banker here, for instance, decides that a certain low-priced bond is
cheap and that if purchased it will show a substantial profit within
six months or a year. Not wanting to buy the bonds and borrow on them
here, he invites his foreign correspondent into the deal on joint
account, arranging to raise the money with which to buy the bonds by
drawing a ninety-day sight draft on the foreign correspondent. This he
does, drawing, say, a L50,000 draft at ninety days' sight, and selling
it in the exchange market at, let us say, $4.83.
The $241,500 received from the sale of the draft, the American banker
uses to buy the bonds. Ninety days later the draft will come due in
London, and have to be covered (or renewed) from this side, but in the
meantime, a profitable chance to sell the bonds may present itself. If
not, the draft can be "renewed" at the end of the ninety days, and
again and again if necessary, until the bankers are willing to close
out the bonds.
This operation of "renewing" long drafts drawn for the purpose of
carrying securities is one of the most interesting phases of foreign
exchange business in connection with international security dealings.
The draft has been drawn, say, for L50,000. The end of the ninety-day
period comes, the draft is due, is presented, and has to be paid. But
the bankers do not choose to sell out the bonds and close the deal.
They arrange instead to renew the maturing draft. This they do by
paying the original ninety-day draft out of the proceeds of a new
ninety-day draft.
The original draft for L50,000 comes due let us say on October 19, so
that about October 10th the New York banker will be under the necessity
of sending over to London a demand draft for L50,000. The rate
realizable for ninety-day drafts being always considerably lower than
the price of demand drafts, it follows that if the banker proposes to
buy L50,000 of demand out of the proceeds of a fresh ninety-day bill he
will have to draw his fresh bill for more than L50,000. If the demand
rate happened to be 4.86, the L50,000 he needs would cost him $243,000.
In order to raise $243,000 by selling a ninety-days' sight draft (say
at 4.83) he would have to make the new draft for L50,310. The extra
L310 would constitute the interest. Each time he renewed the draft he
would have to draw for more and more.
Requiring the tying up of no actual capital, this form of financing
"floating investments" has become exceedingly popular and is carried on
on a large scale. Where the relationships between the foreign and the
American houses are close, there is almost no limit to the number of
times an original bill may be renewed. As for the constantly increasing
amount of the drafts which have to be drawn, that is taken care of by
the interest on the investment carried.
Not all the floating investment in American securities is carried in
this way, but in whatever form the financing is done it is bound to
involve foreign exchange operations and to necessitate the drawing of
drafts by banking houses in this country on their correspondents
abroad. Quiet conditions may result in long periods when investments of
this kind are left undisturbed, but even then, the constant remitting
and renewing of drafts originates a good deal of exchange market
activity. And with considerable frequency occur periods when the
floating investment is strongly affected by immediate conditions, and
when purchases, sales, and transfers of securities stir the exchange
market to a high pitch of excitement.
Speculative operations in this market for foreign account, are,
however, the cause of the greatest amount of exchange market activity
caused by international security transactions. There are times, as has
been said, when individuals and banking houses abroad speculate heavily
and continuously in this market, at which times the exchange market is
strongly affected by the buying and selling of exchange which
necessarily takes place. Such periods may last for weeks or even
months, and during all of the time, London's immediate attitude toward
the market is apt to be the controlling influence on the movement of
exchange rates.
Concerning arbitraging in stocks, operations of this kind will be found
to divide themselves readily into two classes--trades which are closed
off at both ends at once, and trades which are allowed to run over
night or even for a day or two. The former is a class of business out
of which a dozen or twenty well-equipped houses in New York are making
a great deal of money. With an expert "at the rail" on the floor of the
New York Stock Exchange, and continuous quotations as to prices on the
various stock exchanges in Europe coming in, these houses are in a
position to take advantage of the slightest disparity in prices. The
chance to buy a hundred shares of some stock, in London, for instance,
and to sell it out at the same time in New York, at one-eighth or
one-quarter more, is what the arbitrageurs are constantly on the
lookout for. With the proper facilities, an expert, in the course of
the hour during which the London and New York Stock Exchanges are
simultaneously in session, is often able to put through a number of
profitable trades.
Such operations are possible, primarily, because of the fact that the
same influences affect different markets in different ways. A piece of
news which might cause a little selling of some stock in London, for
instance, might have exactly the opposite effect in New York. With the
wires continually hot between the two markets and a number of experts
on the watch for the chance to make a fraction, quotations here and
abroad can hardly get very far apart, at least in the active issues,
but occasionally, it does happen that the arbitrageur is able to take
advantage of a substantial difference. Always without risk, the bid in
one market being in hand before the stock is bought in the other
market.
But not so in the case of the other kind of arbitrage, where stocks
bought in one market are carried over night for the sake of selling
them out in some other market the next morning. There a decided risk is
taken, the success of the operation depending absolutely upon the
judgment of the operator. Under the stimulus of some favorable
development, for instance, which becomes known here only after the
Stock Exchanges abroad are closed for the day, the New York market
closes buoyant. The chances are that the receipt of the news abroad
over night will make the London market open up strong in the morning.
To buy stock right at the closing of the market here for the purpose of
selling it out next morning in London at the opening is an operation
not without risk, but one which is likely to make money. A lower
opening abroad would, of course, spoil the whole plan, and force a
loss, but just there comes in the ability and judgment of the man who
is handling the business. His judgment need by no means be infallible
for the house to make a great deal of money.
Concerning arbitraging in bonds, practically everything depends not
only on the judgment and skill, but on the facilities and connections
of the man in charge. In the great "open" market in New York and in the
great "open" market in London, American bonds are being continually bid
for and offered in a way which gives an expert in touch with both
markets a chance to buy here and sell there, or vice versa, at a
profit. Such men are employed by bond houses with international
connections, and spend their time doing practically nothing else but
keeping in close touch with open market bids and offers for stocks and
bonds and trying to buy in one market and sell in another. Such trades
are frequently put through on a very profitable basis, profits of a
clear point or more being not at all uncommon.
As for the degree of risk to be taken in business of this kind, that is
entirely at the discretion of the arbitrageur. Where a firm bid of
ninety-nine, good for the day, for instance, is given, there is no risk
in cabling a bid of ninety-eight to London, but where the bid is not
firm at all, or where it is only firm for five minutes, or in many
other cases, the man who cables his own bid of ninety-eight is taking a
certain amount of risk. Often enough he gets the bonds in London at
ninety-eight, only to find that the ninety-nine bid in New York has
been withdrawn.
Knowledge of what risks to take and of what risks to leave alone
constitutes expertness in this line of business. Seldom can the
transaction be absolutely closed at both ends and any substantial
profit be made. Most of the time the correctness of the bond expert's
judgment as to how he can sell somewhere else what he has bought, is
what determines the amount of money he will make or lose.