In times when exchange rates are fluctuating widely, specula tion in exchange becomes prevalent, and the practices common in trading in stocks and produce obtain in trading in foreign money. These speculations 'include buying and selling for future delivery, buying long and selling short, and dealing in options. Some houses advertise the sale of options on marks, francs, lire, etc. An option is a means of protecting the speculator against excessive losses, at the same time giving him an opportunity for great gains. For a sum paid in advance, the buyer of the option procures the right to buy a certain number of marks or other units at a certain price if he finds it desirable to do so at any time within the period of the option. For instarrce, say, for $2,5oo paid to the exchange house the speculator procures the right to buy t,000,000 marks at any time during the next six months at 3.5 cents per mark. Whether the price of marks rises or falls in the market, the seller of the option will not ask the buyer for margins, nor does he usually ask for commissions. If the price of marks rises, say, to 8.5 cents, the holder of the option will find it advantageous to use the option; he will purchase the i,000,000 marks at 3.5 cents and sell at 8.5 cents, his resultant net profits being $5o,000, less the $2,5oo paid for the option.
An option may also cover the right to sell i,000,000 marks at 3.5 cents. Then if the price of marks falls below 3.5 the holder of the option will be assured a market at 3.5 cents; if the price falls, say, to 1.5 cents, he can buy i,000,000 marks at 1.5 cents on the market and sell them straightway under his option at 3.5 cents, his net profits being $2o,000, less the $2,5oo paid for the option. If the price of marks moves above or below 3.5 cents by more than o.25 cents, the buyer of the option profits; but if it does not move so widely the seller of the option gains the price of the option.
Triangular Exchange Operations—Arbitrage The preceding discussion of the determination of exchange rates assumes that the whole trade and all the international transactions of the United States are with England alone, whereas in fact they are with every part of the world. The United States may have a favorable balance of trade and other transactions with certain countries and an unfavorable balance with others, and the net sum of all may be favorable or unfavorable. The adjustment of international payments is effected by both direct and indirect settlements through the instrurnentality of bills of exchange, however numerous are the trading countries.
For illustration (still using the preceding symbols), suppose A exported wheat to E, B exported coffee to A, and E exported woolens to B. The bills drawn by Ea on Ie might be sent by Ba to Bb to cover the debt of Ia to Eb, and Bb might send these bills received from Ba to Be to cover the debt of Ib to Ee. The result would be that the greater part of these triple obligations would be settled by the exchange of these bills, and only the net obligation would have to be adjusted by shipping gold or extending a loan.
The scheme is improved if the importers in A, B, and E ar range with Be to let the exporters in those countries draw on it rather than on the importers, and Be agrees to accept and pay at maturity all such bills as are drawn under the agreement. Then
if all importers have such arrangements with a single Be, the plan amounts to an international checking system and settle ment by book balances. Even if the arrangements are made with several Be's, their obligations may be collected by messenger or clearing house.
If A draws on B in milreis and on E in pounds sterling, the prevailing rates of exchange on these two countries may indicate that the rate of exchange between E and B is out of line, and an exchange operator may take advantage of the situation by selling where exchange is high and buying where it is low. For instance if the rate in A on E is high, while the rate in A on B is low, and if in B the rate on E is low, an arbitrageur in A could buy ex change on B and cable his agent in B to buy exchange on E; this would create him a balance in E against which he can sell ex change in A. By increasing the demand in A for exchange on B and in B for exchange on E, he tends to raise those rates; but by increasing the supply of exchange in A on E he tends to lower the rate in A on E. Such operations are known as " arbitraging" and have the effect of equalizing the rates of exc.hange and limit ing their variations. The chain of operations may cover more than three exchange markets.
Gold exportations are also sometimes of a roundabout nature. If Ba wishes for some reason to establish a balance in Be, and he finds the rates for sterling bills are relatively cheaper in B than in A, but that bills on B are scarce, then, instead of buying bills in A on B to remit to Bb for sale, he finds it better to ship gold to Bb and when the gold arrives in B to order his agent Bb there to buy exchange on E. The bill on E is then sent to Be for sale and credit to Ba's account. The lower the rate at which Bb can buy on E, and the higher the rate at which Ba can sell exchange on Be, the greater the profit from the transactions.
Cable Exchange Telegraphic transfers, or cables, are telegraphic orders to pay money abroad. They are practically all drawn by banks on their foreign branches or correspondents. They are not strictly bills of exchange but have all the effects of bills, the fundamental difference being that the order is telegraphed rather than written, and payments can therefore be more expeditiously made; for the written order must be delivered by mail, which is affected by marine and war risks, whereas the transmission of cables is not so affected. The cable cannot be used for certain purposes, such as, for instance, the delivery of the documents against payment; and cable charges generally exceed postage on written bills. To reduce cable charges as well as provide a means of authenticating cables, cipher codes are adopted by the bank and its correspond ent; some of these are very ingenious, and the code is used for all cabling between the two parties. The first and last words of the message are test words and are known only by one or two trusted employees.