The investor may realize upon his bills before their maturity, however. If the discount rate in Paris falls and it becomes ad vantageous to sell at the higher price, he may indorse the seconds and send them with orders to sell and credit his account with the proceeds. In order to be able to take advantage of any sudden drdp in the Paris discount rate, it may be advisable for the in vestor to indorse the seconds shortly after purchase and remit them to a Paris correspondent with instructions to hold subject to cable order. Whether the account is credited at or before maturity, the profit the investor can realize depends upon the rate of exchange at which he can sell in New York demand bills or cables against the credit thus created in Paris. If exchange rates in New York rise, say, X per cent between the time of the purchase of the time bills and the sale of the demand bills, he realizes additional profit; but on the other hand, if the exchange rates fall his profits are reduced. A high demand rate will there fore tempt the investor to close out his investment. In other words, the conditions favorable for investment in foreign ex change time bills are : (r) that there be a prospect of the demand exchange rate rising in New York; and (2) that the discount rate be lower in New York than in Paris, and there be a prospect that the Paris rate will not go higher but will fall or that the New York rate will rise. Obviously investments in long-time bills may be and usually are speculations on the drift of the exchange and discount rates. The investor goes long on the market.
Hedging Operations in Foreign Exchange It is possible for the investor to realize in another way upon his time bills and take advantage of fluctuations in exchange rates. Some time before the maturity of the time bills he can enter into a contract with a party in New York to deliver, at maturity or at a certain time before that maturity, cables or demand bills, respectively, at a certain price. This contract is a sale for future delivery. He might in fact have hedged, when buying the time bills, against fluctuations in the rate of exchange, by engaging on the same day in a contract to deliver at certain dates, in demand bills or cables, the face value of the time bills bought.
A common and legitimate occasion for selling exchange for future delivery arises when a banker, in order to establish or 'in crease his balance abroad, buys 3o-day and 6o-day documentary payment bills. These instruments are payable at maturity or, under rebatement of interest, at an earlier date, and the banker does not know just when they will actually be paid. To sell demand drafts to an amount equivalent to the face value of these remitted payment bills might result in expensive overdrafts, for the payment bills might not be taken up immediately upon the arrival of the goods. The banker may await advices from his agents as to the dates of payments of the bills, and then sell ex change against the proceeds; or he may sell his own 3o-day and 6o-day sight bills drawn against the time bills which he bought and remitted; or he may sell his demand drafts for future delivery to an amount equivalent to the proceeds of the bills. To exe
cute this last option he would divide the bills into lots according to the probable dates of payment which his business experience had taught him to expect from the drawees of the bills and the kinds of bills and goods represented. One lot might average, say, 15 days, another 3o days, another 45 days, and another 6o days; and against these lots he would sell contracts to deliver demand exchange after 15, 3o, 45, and 6o days, in amounts equiva lent to the bills probably thken up after those intervals. By entering into these contracts to deliver demand exchange at a price the bank protects itself against a decline in the selling price of the demand bills which it will draw later.
The problem of realizing on documentary payment bills pur chased by the New York bank is also solved in another way. The London or Paris bank or acceptance house usually requires the New York banker who draws on it for acceptance to deposit collateral to protect it and is willing to take these documentary payment bills for such collateral purposes. If the New York banker, having some of these bills abroad, deposits them with the accepting house, he can then draw his long bills against them. It is supposed, of course, that the documentary bills will be col lected in such amounts and within such times as will cover the long bills drawn against them. If collected before the maturity date of the long bills, the New York banker will be allowed in terest at the retirement rate for the time the payment bills are rebated and interest at the rate allowed on deposits for the re mainder of the time. But if not collected by the time the long bills mature, overdrafts will occur.
Where a bank sells contracts to deliver demand exchange at future dates, as described above, the transaction is often one side of a hedging operation; for the bank may have entered that day into a contract to buy demand exchange on certain dates at cer tain rates, from exporters or others. To execute both the pur chase of futures and the sale of futures deliverable on a certain day eliminates altogether the risk from fluctuations in the ex change rate. The most common case when a bank obligates itself to buy demand exchange at a future date is when exporters quote a fixed price to foreign customers for goods to be shipped at a certain date, and in order to arrive at that price have to know in advance just what price they can get for their demand bills at date of shipment. The price quoted to the exporter will depend upon the price the banker can get for his own time bill due at that shipping date, or upon the price at which he can engage to sell his own cable on that date. The purchase will not be made except at a margin of profit, unless other motives enter into the transaction.