Exchange (Forex and Trade Financing)September 15, 2015
Exchange is a method invented by merchants to facilitate the payment of money at a distance.
Suppose I am in Glasgow and owe £100 to Merchant A in London. I apply to a banker in Glasgow for a bill upon another Merchant B in London, payable to Merchant A. For this, I must give the banker £100 and reward him for his trouble. This reward is called the value or premium of exchange.
- Between Glasgow and London it is around 2%.
- Between London and Glasgow again it is sometimes 4% or 5% below par.
- Between Glasgow and the West India colonies, it is often at 50 % below par.
The value of exchange is always regulated by the risk of sending money between two places. However, it is often greater than the risk due to paper circulation.
Between Glasgow and London, one can easily move £100 in gold or silver at a cost of 15 shillings or 0.75%. But the currency of Scotland is mostly in paper and it is inconvenient to exchange bank notes for gold and silver. Thus, a merchant would rather pay a higher rate of 2% than take the trouble of changing the paper notes for cash and sending the money.
This is also the cause of the high price of exchange between Virginia and Glasgow.
In the American colonies, the currency is paper. Their notes are 40 or 50% below par because their funds are not enough. In every exchange, you must pay=
- the price,
- the risk,
- some profit to the banker, and
- the degradation of money in notes
These cause the rise in the price of exchange. It rises above the insurance price if the money of one country is devalued relative to the other.
This was the cause of the high price of exchange between France and Holland at the time of the Mississippi Company, which was then at 80 or 90%. All the money had been expelled from France by Mr. Law and the whole circulation was in paper and the credit of the bank had fallen.
These conspired to raise the exchange so high.