Bills drawn in other kinds of currency—guilders on Holland, for instance, form an important part of the foreign exchange dealt in in a market like New York, but are subservient in their rate fluctuations to the movement of sterling, marks, and francs. The latter are, indeed, the three great classes of exchange, and are the basis of at least nine-tenths of all foreign exchange operations.
In the following chapter will be taken up the various forms of activity of the foreign exchange department. No attempt is made to state out of which kind of business bankers make most money, but before looking into the more detailed description of how exchange business is conducted, it may be well to fix in mind the fact that it is out of the "straight" forms of foreign exchange business that the most profit is made. Highly complicated operations are indulged in by some managers with more theoretical than practical sense, and money is at times made out of them, but on the whole the real money is made out of the kinds of business about to be described. To the author's certain knowledge, the exchange business of one of the largest houses in New York was for years thus limited to what might be called "straight" operations. While the profits might at times have been materially increased by the introduction of a little more of a speculative element into the business, the house made money on a large scale and avoided the losses inevitable where business is conducted along speculative lines.
CHAPTER VI
HOW MONEY IS MADE IN FOREIGN EXCHANGE. THE OPERATIONS OF THE FOREIGN DEPARTMENT
Complete description of the various forms of activity of the foreign exchange department of an important firm would fill a large volume, but there are certain stock operations in foreign exchange which are the basis of most of the transactions carried out and the understanding of which ought to go a long way toward making clear what the nature of the foreign exchange department's business really is.
1. Selling "Demand" Against "Demand"
The first and most elementary form of activity is, of course, the buying of demand bills at a certain price and the selling of the banker's own demand drafts against them at a higher price. A banker finds, for instance, that he can buy John Smith & Co.'s sight draft for £1,000, on London, at the rate of 4.86, and that he can sell his own draft for £1,000 on his London banking correspondent at 4.87. All he has to do, therefore, is to buy John Smith's draft for $4,860, send it to London for credit of his account there, and then draw his own draft for £1,000 on the newly created balance, selling it for $4,870. It cost him $4,860 to buy the commercial draft, and he has sold his own draft against it for $4,870. His gross profit on the transaction, therefore, is $10.
As may be imagined, not very much money is made in transactions exactly of this kind—the one cited is taken only because it illustrates the principle. For whether the banker sends over in every mail a bewildering assortment of every conceivable form of foreign exchange to be credited to his account abroad, or whether he confines himself to remittances of the simplest kinds of bills, the idea remains exactly the same—he is depositing money to the credit of his account in order that he may have a balance on which he can draw. That is, indeed, the sum and substance of the exchange business of the foreign department of most banking houses—the maintaining of deposit accounts in banks at foreign centers on which deposit account the bank here is in a position to draw according to the wants and needs of its customers.
To analyze the underlying transaction a little more closely, it is evident that the banker, in order to make a profit, must be able to buy the commercial bill at a lower rate of exchange than he can realize on his own draft. Which suggests at once that the extent of the banker's profit is dependent largely upon the amount of risk he is willing to take. For the rate on commercial bills is purely a matter of the drawer's credit. The best documentary commercial exchange, drawn at sight on banks abroad or houses of the highest standing will command a rate of exchange in the open market only a little less than the banker's own draft. From which point the rate realizable on commercial bills tapers off with the credit of the house in question, some bills regularly selling a cent or a cent and a half per pound sterling below the best bills of their class.