In the above illustrations, London and New York alone have been referred to ; finance bills, of course. obtain between other countries but to a much less de gree 7. Forward exchange.—Operations in "forward ex change" have several points in common with finance bills; both anticipate fluctuations in the rate of ex change and both involve a large element of risk. In its simpler and more commercial form, forward ex change or "futures," as it is sometimes called, is a term used to express the buying or selling of foreign ex change for future delivery. For instance, in July, a manufacturer in Canada accepts an order for goods to be manufactured and shipped to England before Oc tober 15th. Knowing from experience that a change in the rate of exchange in October might make serious inroads into his profits, he asks his bank to quote him a rate for the amount of his shipment, and contracts to deliver the bills of exchange to the bank in October. In this way the rate is definitely fixed, and the risk of a falling rate is eliminated.
The bank can protect itself in two ways; by selling its own bills to fall due in October in London, or by selling London exchange for future delivery. As far as the obligation is concerned both cases amount to the same thing, except that in the latter no money trans action is involved. The decision of the bank is gov erned by the rate of interest obtaining in London in July. It is obvious that dealing in forward exchange is not necessarily based on an actual prospective trans action.
Franklin Escher, in his book, "The Elements of Foreign Exchange," in reference to the making of money in dealing in "futures," says : As a means of making—or of losing—money, in the foreign exchange business, 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 150,000, £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 a 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 he 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 fif teen days, £10,000 deliverable in thirty days, £10,000 de liverable in 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.
By figuring with judgment, foreign exchange bankers are often able to make substantial profits on operations of this kind. An exchange broker comes in and offers a banker here a lot of good "payment" commercial bills. The banker finds that he can sell his own draft for delivery at about the time the commercial drafts are apt to be paid under rebate, at a price which means a good net profit. The operation ties up capital, it is true, but is practically without risk. Not infrequently good commercial "payment" bills can be bought at such a price and bankers' futures sold against them at such a price that there is a substantial profit to be made.
The other operation is the sale of bankers' futures, not against remittances of actual commercial exchange but against exporters' futures. Exporters of merchandise fre quently 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 at, say, 4.87. He bids the exporter 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 turning around and delivering his own draft against 4.87.
Selling futures against futures is not the easiest form of foreign exchange business to put thru, 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 wanted 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.