Elements of Foreign Exchange: A Foreign Exchange Primer

by Franklin Escher

To take up the actual operation of loaning foreign money in the American market, suppose conditions to be such that an English bank's managers have made up their minds to loan out £100,000 in New York—‌not on joint account with the American correspondent, as is often done, but entirely independently. Included in the arrangements for the transaction will be a stipulation as to whether the foreign bank loaning the money wants to loan it on the basis of receiving a commission and letting the borrower take the risk of how demand exchange may fluctuate during the life of the loan, or whether the lender prefers to lend at a fixed rate of interest, say six per cent., and himself accept the risk of exchange.

What the foregoing means will perhaps become more clear if it is realized that in the first case the American agent of the foreign lender draws a ninety days' sight sterling bill for, say, £100,000 on the lender, and hands the actual bill over to the parties here who want the money. Upon the latter falls the task of selling the bill, and, ninety days later, when the time of repayment comes, the duty of returning a demand bill for £100,000, plus the stipulated commission. In the second kind of a loan the borrower has nothing to do with the exchange part of the transaction, the American banking agent of the foreign lender turning over to the borrower not a sterling draft but the dollar proceeds of a sterling draft. How the exchange market fluctuates in the meantime—‌what rate may have to be paid at the end of ninety days for the necessary demand draft—‌concerns the borrower not at all. He received dollars in the first place, and when the loan comes due he pays back dollars, plus four, five or six per cent., as the case may be. What rate has to be paid for the demand exchange affects the banker only, not the borrower.

Loans made under the first conditions are known as sterling, mark, or franc loans; the other kind are usually called "currency loans." At the risk of repetition, it is to be said that in the case of sterling loans the borrower pays a flat commission and takes the risk of what rate he may have to pay for demand exchange when the loan comes due. In the case of a currency loan the borrower knows nothing about the foreign exchange transaction. He receives dollars, and pays them back with a fixed rate of interest, leaving the whole question and risk of exchange to the lending banker.

To illustrate the mechanism of one of these sterling loans. Suppose the London Bank, Ltd., to have arranged with the New York Bank to have the latter loan out £100,000 in the New York market. The New York Bank draws £100,000 of ninety days' sight bills, and, satisfactory collateral having been deposited, turns them over to the brokerage house of Smith & Jones. Smith & Jones at once sell the £100,000, receiving therefor, say, $484,000.

The bills sold by Smith & Jones find their way to London by the first steamer, are accepted and discounted. Ninety days later they will come due and have to be paid, and ten days prior to their maturity the New York Bank will be expecting Smith & Jones to send in a demand draft for £100,000, plus three-eighths per cent. commission, making £375 additional. This £100,375, less its commission for having handled the loan, the New York Bank will send to London, where it will arrive a couple of days before the £100,000 of ninety days' sight bills originally drawn on the London Bank, Ltd., mature.

What each of the bankers concerned makes out of the transaction is plain enough. As to what Smith & Jones' ninety-day loan cost them, in addition to the flat three-eighths per cent. they had to pay, that depends upon what they realize from the sale of the ninety days' sight bills in the first place and secondly on what rate they had to pay for the demand bill for £100,000. Exchange may have gone up during the life of the loan, making the loan expensive, or it may have gone down, making the cost very little. Plainly stated, unless they secured themselves by buying a "future" for the delivery of a £100,000 demand bill in ninety days at a fixed rate, Messrs. Smith & Jones have been making a mild speculation in foreign exchange.

If the same loan had been made on the other basis, the New York Bank would have turned over to Smith & Jones not a sterling bill for £100,000, but the dollar proceeds of such a bill, say a check for $484,000. At the end of ninety days Smith & Jones would have had to pay back $484,000, plus ninety days' interest at six per cent, $7,260, all of which cash, less commission, the New York Bank would have invested in a demand bill of exchange and sent over to the London Bank, Ltd. Whatever more than the £100,000 needed to pay off the maturing nineties such a demand draft amounted to, would be the London Bank, Ltd.'s, profit.

From all of which it is plainly to be seen that when the London bankers are willing to lend money here and figure that the exchange market is on the down track, they will insist upon doing their lending on the "currency loan" basis—‌taking the risk of exchange themselves. Conversely, when loaning operations seem profitable but rates seem to be on the upturn, lenders will do their best to put their money out in the form of "sterling loans." Bankers are not always right in their views, by any means, but as a general principle it can be said that when big amounts of foreign money offered in this market are all offered on the "sterling loan" basis, a rising exchange market is to be expected.

As to the collateral on these foreign loans, it is evident that there is as much chance for different ways of looking at different stocks as there is in regular domestic loaning operations. Not only does the standing of the borrower here make a difference, but there are certain securities which certain banks abroad favor, and others, perhaps just as good, with which they will have nothing to do.

Excepting the case of special negotiation, however, it may be said that the collateral put up the case of foreign loans in this market is of a very high order. Three years ago this could hardly have been said, but one of the many beneficial effects of the panic was to greatly raise the standard of the collateral required by foreign lenders in this market. It used formerly to be more a case of the standing of the borrower. Nowadays the collateral is usually deposited here in care of a banker or trust company.