A Tract on Monetary Reform: Chapter III - IV. The Forward Market in Exchanges

A Tract on Monetary Reform, by John Maynard Keynes is part of HackerNoon’s Book Blog Post series. You can jump to any chapter in this book here. Chapter III: IV. The Forward Market in Exchanges.

IV. The Forward Market in Exchanges

When a merchant buys or sells goods in a foreign currency the transaction is not always for immediate settlement by cash or negotiable bill. During the interval before he can cover himself by buying or selling (as the case may be) the foreign currency involved, he runs an exchange risk, losses or gains on which may often, in these days, swamp his trading profit. He is thus involuntarily engaged in a heavy risk of a kind which it is hardly in his province to undertake. The subject of what follows is a piece of financial machinery—namely, the market in “forward” exchanges as distinguished from “spot” exchanges—for enabling the merchant to avoid this risk, not, indeed, during the interval when he is negotiating the contract, but as soon as the negotiation is completed.Transactions in “spot” exchange are for cash—that is to say, cash in one currency is exchanged for cash in another currency. But merchants who have bought goods in terms of foreign currency for future delivery may not have the cash available pending delivery of the goods; whilst merchants who have sold goods in terms of foreign currency, but are not yet in a position to sell a draft on the buyer, cannot, even if they have plenty of cash in their own currency, protect themselves by a “spot” sale of the exchange involved, save in the exceptional case when they have cash available in the foreign currency also.A “forward” contract is for the conclusion of a “spot” transaction in exchanges at a later date, fixed on the basis of the spot rate prevailing at the original date. Pending the date of the maturity of the forward contract no cash need pass (although, of course, the contracting party may be required to give some security or other evidence for his ability to complete the contract in due course), so that the merchant entering into a forward contract is not required to find cash any sooner than if he ran the risk on the exchange until the goods were delivered; yet he is protected from the consequences of any fluctuation in the exchanges in the meantime.The tables given below show that in London, in the case of the exchanges which have a big market (the dollar, the franc, and the lira), competition between dealers has brought down the charges for these facilities to a fairly moderate rate. During 1920 and 1921 the cost to an English buyer of foreign currency for forward delivery was a little more expensive than for spot delivery in the case of francs, lire, and marks, and a little cheaper in the case of dollars. Correspondingly, French, Italian, and German merchants were generally in a position to buy both sterling and dollars for forward delivery at a slightly cheaper rate than for spot delivery—that is to say, if they dealt in London. As regards the rates charged in foreign centres my information is not extensive, but it indicates that in Milan, for example, very much less favourable terms for these transactions are frequently charged to the seller of forward sterling than those ruling in London. During 1922, however, the effect of the progressive cheapening of money in London was, for reasons to be explained in a moment, to cheapen the cost to English buyers of foreign currency for forward delivery, forward francs falling to an appreciable discount on spot francs, and forward dollars becoming at the end of the year decidedly cheaper than spot dollars. Later on, the raising of the bank-rate in June 1923 acted again, as could have been predicted, in the opposite direction.Proceeding to details, we see below (pp. 118, 119) the quotations for forward exchange ruling in the London market since the beginning of 1920. During 1920–21 forward dollars were generally cheaper than spot dollars to a London buyer to the extent of from 1 to 1½ per cent per annum. Occasionally, however, when big movements of the exchange were taking place, the discount on forward dollars was temporarily much higher, having risen, for example, in November 1920, when sterling was at its lowest point, to nearly 6 per cent—for reasons which I will endeavour to elucidate later. During the first half of 1922 the discount on forward dollars dwindled, but rose again during the latter half of the year, reacting again in the middle of 1923 after money rates in London had been slightly raised. Thus a London merchant, who has had dollar commitments for the purchase of goods, has not only been able to cover his exchange risk by means of a forward transaction, but on the average he has got his exchange a little cheaper by providing for it in advance.

Table of Exchange Quotations in
London One Month Forward

Table of Exchange Quotations in
London One Month Forward

 Nominal.Forward purchases of francs, after being dearer than spot transactions by 2½ per cent per annum or more from the middle of 1920 to the middle of 1921, were nearly level in price from the middle of 1921 to the middle of 1922, whilst since that time they have been ½ to 2½ per cent per annum cheaper. In the case of lire there have been much wider gaps, forward purchases being frequently 3 per cent or more dearer than spot. In the case of German marks, the forward rate, after ranging round about 5 per cent per annum dearer than spot, has reached, since the autumn of 1922 and the complete collapse of the mark, a figure fantastically cheaper, thus reflecting the sensational rate of interest for short loans current inside Germany.But in all these cases (except in Germany since the complete collapse of the mark), whether forward exchange is at a discount or at a premium on spot, the expense, if any, of dealing forward has been small in relation to the risks that are avoided.Nevertheless, in practice merchants do not avail themselves of these facilities to the extent that might have been expected. The nature of forward dealings in exchange is not generally understood. The rates are seldom quoted in the newspapers. There are few financial topics of equal importance which have received so little discussion or publicity. The present situation did not exist before the war (although even at that time forward rates for the dollar were regularly quoted), and did not begin until after the “unpegging” of the leading exchanges in 1919, so that the business world has only begun to adapt itself. Moreover, for the ordinary man, dealing in forward exchange has, it seems, a smack of speculation about it. Unlike Manchester cotton spinners, who have learnt by long experience that it is not the hedging of open cotton commitments on the Liverpool futures market, but the failure to do so, which is speculative, merchants, who buy or sell goods of which the price is expressed in a foreign currency, do not yet regard it as part of the normal routine of prudent business to hedge these indirect exchange commitments by a transaction in forward exchange.It is important, on the other hand, not to exaggerate the extent to which, at the present time, merchants can by this means protect themselves from risk. In the first place, for reasons, some of which will be considered below, it is only in certain of the leading exchanges that these transactions can be carried out at a reasonable charge. It is not clear that even the banks themselves have yet learnt to look on the provision for their clients of such facilities at fair and reasonable rates as one of the most useful services they can offer. They have been too much influenced, perhaps, by the fear that these facilities might tend at the same time to increase speculation.But there is a further qualification, not to be overlooked, to the value of forward transactions as a protection against risk. The price of a particular commodity, in terms of a particular currency, does not exactly respond to changes in the value of that currency on the exchange markets of the world, with the result that a movement in a country’s exchanges may, in the case of a commodity of which that country is a large seller or a large purchaser, change the commodity’s world-value expressed in terms of gold. In that case a merchant, even though he is hedged in respect of the exchange itself, may lose, in respect of his unsold trading stocks, through a movement in the world-value of the commodity he is dealing in, directly occasioned by the exchange fluctuation.* * * * *If we turn to the theoretical analysis of the forward market, what is it that determines the amount and the sign (whether plus or minus) of the divergence between the spot and forward rates as recorded above?If dollars one month forward are quoted cheaper than spot dollars to a London buyer in terms of sterling, this indicates a preference by the market, on balance, in favour of holding funds in New York during the month in question rather than in London,—a preference the degree of which is measured by the discount on forward dollars. For if spot dollars are worth $4.40 to the pound and dollars one month forward $4.40½ to the pound, then the owner of $4.40 can, by selling the dollars spot and buying them back one month forward, find himself at the end of the month with $4.40½, merely by being during the month the owner of £1 in London instead of $4.40 in New York. That he should require and can obtain half a cent, which, earned in one month, is equal to about 1½ per cent per annum, to induce him to do the transaction, shows, and is, under conditions of competition, a measure of, the market’s preference for holding funds during the month in question in New York rather than in London.Conversely, if francs, lire, and marks one month forward are quoted dearer than the spot rates to a London buyer, this indicates a preference for holding funds in London rather than in Paris, Rome, or Berlin.

The difference between the spot and forward rates is, therefore, precisely and exactly the measure of the preference of the money and exchange market for holding funds in one international centre rather than in another, the exchange risk apart, that is to say under conditions in which the exchange risk is covered. What is it that determines these preferences?

1. The most fundamental cause is to be found in the interest rates obtainable on “short” money—that is to say, on money lent or deposited for short periods of time in the money markets of the two centres under comparison. If by lending dollars in New York for one month the lender could earn interest at the rate of 5½ per cent per annum, whereas by lending sterling in London for one month he could only earn interest at the rate of 4 per cent, then the preference observed above for holding funds in New York rather than in London is wholly explained. That is to say, forward quotations for the purchase of the currency of the dearer money market tend to be cheaper than spot quotations by a percentage per month equal to the excess of the interest which can be earned in a month in the dearer market over what can be earned in the cheaper. It must be noticed that the governing factor is the rate of interest obtainable for short periods, so that a country where, owing to the absence or ill-development of an organised money market, it is difficult to lend money satisfactorily at call or for very short periods, may, for the purposes of this calculation, reckon as a low interest-earning market, even though the prevailing rate of interest for longer periods is not low at all. This consideration generally tends to make London and New York more attractive markets for short money than any Continental centres.

The effect of the cheap money rates ruling in London from the middle of 1922 to the middle of 1923 in diminishing the attractiveness of London as a depository of funds is strikingly shown, in the above tables, by the cheapening of the forward quotations of foreign currencies relatively to the spot quotations. In the case of the dollar the forward quotation had risen by the beginning of 1923 to a rate 3 per cent per annum above the spot quotation (i.e. forward dollars were 3 per cent per annum cheaper than spot dollars in terms of sterling), which meant (subject to modification by the other influences to be mentioned below) that the effective rate for short loans approached 3 per cent higher in New York than in London.

In the case of francs forward quotations which had been below spot, so long as money was dear in London, rose above the spot quotations, thus indicating that the relative dearness of money in London as compared with Paris had disappeared; whilst in the case of lire forward quotations, although still below spot quotations, rose, under the same influence, nearer to the spot level. Nevertheless, in the case of both these currencies, a preponderance of bearish anticipations about their future prospects probably also played a part, for the reasons given in detail below, in producing the observed result.The most interesting figures, however, are those relating to marks, which illustrate vividly what I have mentioned on page 23 above concerning the enormous money rates of interest current in Germany subsequent to the collapse of October 1922, as a result of the effort of the real rate of interest to remain positive in face of a general anticipation of a catastrophic collapse of the monetary unit. It will be noticed that the effective short money rate of interest in terms of marks ranged from 50 per cent per annum upwards, until finally the quotations were merely nominal.2. If questions of credit did not enter in, the factor of the rate of interest on short loans would be the dominating one. Indeed, as between London and New York, it probably is so under existing conditions. Between London and Paris it is still important. But elsewhere the various uncertainties of financial and political risk, which the war has left behind, introduce a further element which sometimes quite transcends the factor of relative interest. The possibility of financial trouble or political disturbance, and the quite appreciable probability of a moratorium in the event of any difficulties arising, or of the sudden introduction of exchange regulations which would interfere with the movement of balances out of the country, and even sometimes the contingency of a drastic demonetisation,—all these factors deter bankers, even when the exchange risk proper is eliminated, from maintaining large floating balances at certain foreign centres. Such risks prevent the business from being based, as it should be, on a mathematical calculation of interest rates; they obliterate by their possible magnitude the small “turns” which can be earned out of differences between interest rates plus a normal banker’s commission; and, being incalculable, they may even deter conservative bankers from doing the business on a substantial scale at any reasonable rate at all. In the case of Roumania or Poland, for example, this factor is, at times, the dominating one.3. There is a third factor of some significance. We have assumed so far that the forward rate is fixed at such a level that the dealer or banker can cover himself by a simultaneous spot transaction and be left with a reasonable profit for his trouble. But it is not necessary to cover every forward transaction by a corresponding spot transaction; it may be possible to “marry” a forward sale with a forward purchase of the same currency. For example, whilst some of the market’s clients may wish to sell forward dollars, other clients will wish to buy forward dollars. In this case the market can set off these, one against the other, in its books, and there will be no need of any movement of cash funds in either direction. The third factor depends, therefore, on whether it is the sellers or the buyers of forward dollars who predominate. To fix our minds, let us suppose that money-market conditions exist in which a sale of forward dollars against the purchase of spot dollars, at a discount of 1½ per cent per annum for the former, yields neither profit nor loss. Now if in these conditions the purchasers of forward dollars, other than arbitragers, exceed sellers of forward dollars, then this excess of demand for forward dollars can be met by arbitragers, who have cash resources in London, at a discount which falls short of 1½ per cent per annum by such amount (say ½ per cent) as will yield the arbitragers sufficient profit for their trouble. If, however, sellers of forward dollars exceed the purchasers, then a sufficient discount has to be accepted by the former to induce arbitrage the other way round—that is to say, by arbitragers who have cash resources in New York—namely, a discount which exceeds 1½ per cent per annum by, say, ½ per cent. Thus the discount on forward dollars will fluctuate between 1 and 2 per cent per annum according as buyers or sellers predominate.4. Lastly, we have to provide for the case, quite frequent in practice, where our assumption of a large and free market breaks down. A business in forward exchange can only be transacted by banks or similar institutions. If the bulk of the business in a particular exchange is in a few hands, or if there is a tacit agreement between the principal institutions concerned to maintain differences which will allow more than a competitive profit, then the surcharge representing the profit of a bank for arbitraging between spot and forward transactions may much exceed the moderate figure indicated above. The quotations of the rates charged in Milan for forward dealings in lire, when compared with the rates current in London at the same date, indicate that a bank which is free to operate in both markets can frequently make an abnormal profit.But there is a further contingency of considerable importance which occurs when speculation is exceptionally active and is all one way. It must be remembered that the floating capital normally available, and ready to move from centre to centre for the purpose of taking advantage of moderate arbitrage profits between spot and forward exchange, is by no means unlimited in amount, and is not always adequate to the market’s requirements. When, for example, the market is feeling unusually bullish of the European exchanges as against sterling, or of sterling as against dollars, the pressure to sell forward sterling or dollars, as the case may be, may drive the forward price of these currencies to a discount on their spot price which represents an altogether abnormal profit to any one who is in a position to buy these currencies forward and sell them spot. This abnormal discount can only disappear when the high profit of arbitrage between spot and forward has drawn fresh capital into the arbitrage business. So few persons understand even the elements of the theory of the forward exchanges that there was an occasion in 1920, even between London and New York, when a seller of spot dollars could earn at the rate of 6 per cent per annum above the London rate for short money by converting his dollars into sterling and providing at the same time by a forward sale of the sterling for reconversion into dollars in a month’s time; whilst, according to figures supplied me, it was possible, at the end of February 1921, by selling spot sterling in Milan and buying it back a month forward, to earn at the rate of more than 25 per cent per annum over and above any interest obtainable on a month’s deposit of cash lire in Milan.It is interesting to notice that when the differences between forward and spot rates have become temporarily abnormal, thus indicating an exceptional pressure of speculative activity, the speculators have often turned out to be right. For example, the abnormal discount on forward dollars, which persisted more or less from November 1920 to February 1921, thus indicating that the market was a bull of sterling, coincided with the sensational rise of sterling from 3.45 to 3.90. This discount was at its maximum when sterling touched its lowest point and at its minimum (in the middle of May 1921) when sterling reached its highest point on that swing, which showed a remarkably accurate anticipation of events by the balance of professional opinion. The comparatively high discount on forward dollars current at the end of 1922 may, in the same way, have been partly due to an excess of bull speculation in favour of sterling based on an expectation of its recovery towards par, and not merely to the cheapness of money in London as compared with New York.The same thing seems to have been true for the franc. In January and February 1921, the abnormal premium on the forward franc indicated that, in the view of the market, the franc had fallen too low, which turned out to be the case. They turned round at the precise moment when the franc reached its highest value (end of July 1921), and were right again. During the first five months of 1922, when the franc was almost stable, spot and forward quotations were practically at par with one another, whilst the progressive fall of the franc since June 1922 has been accompanied by a steady and sometimes substantial discount on forward francs; indicating, on this test, that the professional market was bearish of francs and therefore right once more. The lira tells somewhat the same tale. Thus, whilst the reader can see for himself by a study of the tables that no precise generalisation would be accurate, nevertheless the market has been broadly right when it has taken a very decided view, as measured by forward rates.This result may seem surprising in view of the huge amounts which exchange speculators in European currencies, more particularly on the bull side, are reputed to have lost. But the mass of amateur speculators throughout the world operate by cash purchases of the currency of which they are bulls, forward transactions being neither known nor available to them. Such speculation may afford temporary support to the spot exchange, but it has no influence on the difference between spot and forward, the subject now under discussion. The above conclusion is limited to the fact that when the type of professional speculation which makes use of the forward market is exceptionally active and united in its opinion, it has proved roughly correct, and has, therefore, been a useful factor in moderating the extreme fluctuations which would have occurred otherwise.* * * * *Out of the various practical conclusions which might be drawn from this discussion and the figures which accompany it, I will pick out three.1. Those exchanges in which the fluctuations are wildest and the merchant is most in need of facilities for hedging his risk are precisely those in which facilities for forward dealing at moderate rates are least developed. But this is to be explained, not necessarily by the instability of the exchange in itself, but by certain accompanying circumstances, such as distrust of the country’s internal arrangements or its banking credit, a fear of the sudden imposition of exchange regulations or of a moratorium, and the other analogous influences mentioned above (pp. 126–7). There is no theoretical reason why there should not be an excellent forward market in a highly unstable exchange. In those countries, therefore, where regulation is still premature, it may nevertheless be possible to mitigate the evil consequences of fluctuation by organising facilities for forward dealings.This is a function which the State banks of such countries could usefully perform. For this they must either themselves command a certain amount of foreign currency or they must provide facilities for accepting short-period deposits in their own currency from foreign bankers, on conditions which inspire these bankers with complete confidence in the freedom and liquidity of such deposits. Various technical devices could be suggested. But the simplest method might be for the State banks themselves to enter the forward market and offer to buy or sell forward exchange at a reasonable discount or premium on the spot quotation. I suggest that they should deal not direct with the public but only with approved banks and financial houses, from whom they should require adequate security; that they should quote every day their rates for buying and selling exchange either one or three months forward; but that such quotation should take the form, not of a price for the exchange itself, but of a percentage difference between spot and forward, and should be a quotation for the double transaction of a spot deal one way and a simultaneous forward deal the other—e.g. the Bank of Italy might offer to sell spot sterling and buy forward sterling at a premium of ⅛ per cent per month for the former over the latter, and to buy spot sterling and sell forward sterling at par. For the transaction of such business the State banks would require to command a certain amount of resources abroad, either in cash or in borrowing facilities. But this fund would be a revolving one, automatically replenished at the maturity of the forward contracts, so that it need not be on anything like the scale necessary for a fund for the purpose of supporting the exchange. Nor is it a business which involves any more risk than is inherent in all banking business as such; from exchange risk proper is free.With free forward markets thus established no merchant need run an exchange risk unless he wishes to, and business might find a stable foothold even in a fluctuating world. A recommendation in favour of action along these lines was included amongst the Financial Resolutions of the Genoa Conference of 1922.

I shall develop below (Chap. V.) a proposal that the Bank of England should strengthen its control by fixing spot and forward prices for gold every Thursday just as it now fixes its discount rate. But other Central Banks also would increase their control over fluctuations in exchange if they were to adopt the above plan of quoting rates for forward exchange in terms of spot exchange. By varying these rates they would be able, in effect, to vary the interest offered for foreign balances, as a policy distinct from whatever might be their bank-rate policy for the purpose of governing the interest obtainable on home balances.

2. It is not unusual at present for banks to endeavour to distinguish between speculative dealings in forward exchange and dealings which are intended to hedge a commercial transaction, with a view to discouraging the former; whilst official exchange regulations in many countries have been aimed at such discrimination. I think that this is a mistake. Banks should take stringent precautions to make sure that their clients are in a position to meet any losses which may accrue without serious embarrassment. But, having fully assured themselves on this point, it is not useful that they should inquire further—for the following reasons.In the first place, it is almost impossible to prevent the evasion of such regulations; whilst, if the business is driven to methods of evasion, it tends to be pressed underground, to yield excessive profits to middlemen, and to fall into undesirable hands.But, what is more important and is less appreciated, the speculator with resources can provide a useful, indeed almost an essential, service. Since the volume of actual trade is spread unevenly through the year, the seasonal fluctuation, as explained above, is bound to occur with undue force unless some financial, non-commercial factor steps in to balance matters. A free forward market, from which speculative transactions are not excluded, will give by far the best facilities for the trader, who does not wish to speculate, to avoid doing so. The same sort of advantages will be secured for merchants generally as are afforded, for example, to the cotton trade by the dealings in “futures” in the New York and Liverpool markets. Where risk is unavoidably present, it is much better that it should be carried by those who are qualified or are desirous to bear it, than by traders, who have neither the qualification nor the desire to do so, and whose minds it distracts from their own business. The wide fluctuations in the leading exchanges over the past three years, as distinct from their persisting depreciation, have been due, not to the presence of speculation, but to the absence of a sufficient volume of it relatively to the volume of trade.3. A failure to analyse the relation between spot and forward exchange may be, sometimes, partly responsible for a mistaken bank-rate policy. Dear money—that is to say, high interest rates for short-period loans—has two effects. The one is indirect and gradual—namely, in diminishing the volume of credit quoted by the banks. This effect is much the same now as it always was. It is desirable to produce it when prices are rising and business is trying to expand faster than the supply of real capital and effective demand can permit in the long run. It is undesirable when prices are falling and trade is depressed.

The other effect of dear money, or rather of dearer money in one centre than in another, used to be to draw gold from the cheaper centre for temporary employment in the dearer. But nowadays the only immediate effect is to cause a new adjustment of the difference between the spot and forward rates of exchange between the two centres. If money becomes dearer in London, the discount on forward dollars diminishes or gives way to a premium. The effect has been pointed out above of the relative cheapening of money in London in the latter half of 1922 in increasing the discount on forward dollars, and of the relative raising of money-rates in the middle of 1923 in diminishing the discount. Such are, in present circumstances, the principal direct consequences of a moderate difference between interest rates in the two centres, apart, of course, from the indirect, long-period influence. Since no one is likely to remit money temporarily from one money market to another on any important scale, with an uncovered exchange risk, merely to take advantage of ½ or 1 per cent per annum difference in the interest rate, the direct effect of dearer money on the absolute level of the exchanges, as distinguished from the difference between spot and forward, is very small, being limited to the comparatively slight influence which the relation between spot and forward rates exerts on exchange speculators. The pressure of arbitragers between spot and forward exchange, seeking to take advantage of the new situation, leads to a rapid adjustment of the difference between these rates, until the business of temporary remittance, as distinct from exchange speculation, is no more profitable than it was before, and consequently does not occur on any increased scale; with the result that there is no marked effect on the absolute level of the spot rate.

 If interest rates are raised in London, the discount on forward dollars will decrease or a premium will appear. This is likely to have some influence in encouraging speculative sales of forward dollars (how much influence depends on the proportion borne by the difference between the spot and forward rates to the probable range of fluctuation of the spot rate which the speculator anticipates); and in so far as this is the case, the covering sales of spot dollars by banks will move the rate of exchange in favour of London.The reasons given for the maintenance of a close relationship between the Bank of England’s rate and that of the American Federal Reserve Board sometimes show confusion. The eventual influence of an effective high bank-rate on the general situation is undisputed; but the belief that a moderate difference between bank-rates in London and New York reacts directly on the sterling-dollar exchange, as it used to do under a régime of convertibility, is a misapprehension. The direct reaction of this difference is on the discount for forward dollars as against spot dollars; and it cannot much affect the absolute level of the spot rate unless the change in relative money-rates is comparable in magnitude (as it used to be but no longer is) with the possible range of exchange fluctuations.

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