“What happens if everybody is selling dollars like crazy and it goes down to 3.25?” asked Mary.
“It can’t. The Swiss government, through the National Bank, is obligated to buy dollars for Swiss francs at the 3.3015 limit and to keep supplying the market with Swiss francs, taking out dollars, until the market trend reverses itself.”
“Why?”
“Because the world has agreed to maintain fixed exchange rates—well, almost fixed, since as you see they can vary 4.5 percent within the band agreed upon. Without fixed rates, nobody in business or banking could plan ahead in international transactions. I mean, some Swiss watchmaker might sell a million dollars worth of watches in the States. But he might first get paid in dollars after three months. If he could not be sure of approximately how many francs this would give him, when he exchanged them, he would face enormous risks. After all, he pays his workers and suppliers in francs, not dollars. Right?”
“But in 1973 all these fixed rates were changed, weren’t they?”
“They were. But this happens quite seldom.”
“But it happened.”
“Right. And the Swiss watch exporters got smashed, at least those who had not protected themselves in the forward foreign exchange market.”
“Now I’ve heard about that,” said Mary, “but I don’t understand how you can do that.”
“O.K. but you’ll have to follow closely,” replied Zimmerer. “Now let’s stick with that watchmaker. He knows that he’s going to be paid a million dollars in three months, so—if he’s smart—he’ll come to us and sell these dollars in advance.”
“Can you do that?”
“Sure. That, in fact, is what this whole business is about.”
“You mean he’s selling something that he hasn’t even got yet?”
“Absolutely right. It works like this. We, his bank, make an agreement with another bank—in this case, an American bank—which says in effect: We, General Bank of Switzerland, promise to deliver to you $1 million U.S. in three months. You, Chase Manhattan, promise to pay us 3.35 million francs for these dollars, upon delivery. You’ll notice that the dollar sells at a small discount on the current spot rate of 3.40 when it’s done on a three months forward basis. That’s because the market feels that it is probable that the dollar will weaken slightly in the period ahead. It’s been abnormally strong in recent weeks.”
“So then when the Swiss watchmaker finally gets his dollars, he knows exactly how many francs he’s going to get for them.”
“Exactly, otherwise he would take a risk, as I mentioned before.”
“But if he did not ‘sell his dollars forward,’ as you put it, he might have gotten more francs in the end. I mean, nobody can guarantee that the dollar will weaken.”
“Absolutely correct. If the dollar strengthened, and the spot rate went up to, say 3.45 after three months, he could sell his dollars then and get 3.45 million francs—or exactly 100,000 more than he will get by selling them ahead of time. That’s the cost of insurance.”
“I know you won’t believe this quite, but really I now start to understand this business. It’s not so complicated, is it—I mean, not when a man like you explains it. Tell me, how did you ever get into this fascinating business?”
“My uncle. I’ve got one, too, and he’s a friend of your uncle. He might even have known your mother, come to think of it. I’ll ask him. Anyway, I started at the General Bank about ten years ago, and after being trained in about ten different departments, I chose this one for a career. I like it very much.”
“Can girls do this, too?”
“Well, there’s no reason why not. But in Switzerland, you know, it’s still a little bit different than in the States.”
“Oh, I know. My mother told me. That’s why she left.”
“Maybe, Miss Rogers, we should try to finish our discussion on foreign exchange,” said Zimmerer, glancing at his watch.
“But I really don’t want to keep you if you have important things to do.”
“No, no. Now, do you have any questions?”
“Well, just one and then I’ll leave you alone. What about all those currency speculators we always read about? I mean, they’re hardly involved in the watch business.”
“No, Miss, they’re really just gamblers, gambling normally on a devaluation of a currency. It’s gotten to be very big business during the past five years. Lots of Americans are in it now, especially the big multinational corporations.”
“How do they do it?”
“I’ll explain. But then we had better go up to your uncle’s office. O.K.?”
“O.K.”
“Fine. Well, let’s say that I’m going to speculate on another devaluation of the dollar, and I think it’s going to happen within three months. A devaluation means that the old fixed rates—remember?—will be changed between the dollar and the Swiss franc, suddenly and overnight, and thereafter the dollar will be much cheaper in terms of Swiss francs. Right?
“Good. So our speculator comes to us and we sell, for his account, $10 million three months forward—dollars that he does not have. Selling short is the term used for this type of operation. So again we make a contract: We, General Bank of Switzerland, promise to deliver to you, Chase Manhattan, $10 million U.S. in three months. You, Chase Manhattan, promise to pay us 33.5 million Swiss francs for these dollars, upon delivery. We make a separate little agreement with our speculator, informing him that we are doing this transaction in our name, but for his account, and at his risk. O.K., let’s say that a 15 percent devaluation of the dollar takes place. Overnight the spot exchange rate would drop to, say, 2.90 to the dollar. When the three months are up, we go into the market—the spot market—and buy the $10 million which our speculator never had in the first place. This $10 million would now, after devaluation, cost us only 29 million Swiss francs. Follow me? Good. But then, literally one or two minutes later, we would present this $10 million we just bought to Chase Manhattan for delivery on that forward contract we had made with each other three months earlier. Chase, on the conditions of that agreement, would have to pay us 33.5 million Swiss francs. Right? So our friendly speculator has just made himself 4.5 million Swiss francs. Let me repeat, he presold dollars he did not have for 33.5 million Swiss francs, but the cost of these dollars, after devaluation, was only 29 million Swiss francs. Voilà.”
“Gee.”
“Yeah, and the beauty of it is that if this speculator is a good customer of ours otherwise, he would not even have to put up any margain, or deposit, on this foreign exchange forward contract. At least as long as he had a couple of million in the bank or was known to us as a very solvent person.”
“But why not?”
“Because it’s quite obvious that a strong currency like the Swiss franc would never be devalued. It’s almost 100 percent backed by gold. Thus, it would hardly ever rise above 3.4535—the intervention point at which the Swiss government must step in. If our speculator met the worst of all possible conditions when the three months were up, he would have to cover at this rate. Then his $10 million would cost, 34.535 million francs, but he would only get 33.5 million from Chase. So he’d be out 1,035,000 francs, or about $300,000. Big clients swallow such losses without blinking an eyelash. But it is highly unlikely that such a loss would occur. What the system does is give a government guarantee to speculators, which allows him to calculate to the last penny his greatest possible loss, while on the other hand, it allows him to make enormous profits—which can be ten times larger than the maximum possible loss. That’s why speculation in foreign exchange has become such a popular sport. As one American put it to me last week, ‘It’s the best game in town.’ And that’s why we, as a bank, run very little risk when we do such transactions for our clients, even when very large numbers are involved.”