2 The Trade Relationship Trade financing shares a number of common characteristics with traditional value chain activities conducted by all firmsAll companies must search out suppliers for goods and servicesMust determine if supplier can provide products at required specifications and qualityAll must be at an acceptable price and delivered in a timely mannerUnderstanding the nature of the relationship between the exporter and the importer is critical to understanding the methods for import-export financing utilized in industryThree categories of relationships:Unaffiliated unknown partyUnaffiliated known partyAffiliated party
3 The Trade DilemmaInternational trade must work around a fundamental dilemma:Imagine an importer and an exporter who would like to do business with one anotherBecause of the distance between the two, it is not possible to simultaneously hand over goods and receive payments in personHow do participants in international trade mitigate the risks associated with conducting business with a stranger?
5 Key DocumentsAs we will see in the following exhibits, letters of credit, order bills of lading and sight drafts are critical in conducting international tradeAn example of a letter of credit occurs when an importer obtains a bank’s promise to pay on its behalf, knowing the exporter will trust the bankWhen the exporter ships the merchandise to the importer’s country, title to the merchandise is given to the bank on a document called an order bill of ladingThe exporter asks the bank to pay for the goods using a sight draftThe bank, having paid for the goods, now passes title to the importer who eventually reimburses the bank
9 Letter of Credit (L/C)Letter of Credit (L/C) is a bank’s conditional promise to pay issued by a bank at the request of an importer in which the bank promises to pay an exporter upon presentation of documents specified in the L/CThe essence of an L/C is the promise of the issuing bank to pay against specified documents, which means that certain elements must be present for the bankIssuing bank must receive a fee for issuing L/CBank’s L/C must contain specified maturity dateBank’s commitment must have stated maximum amountBank’s obligation must arise only on presentation of specific documents and bank cannot be called on for disputed itemsBank’s customer must have unqualified obligation to reimburse bank on same condition of bank’s payment
10 Letter of Credit (L/C) Commercial L/C’s are classified as follows Irrevocable Vs. Revocable – irrevocable letters of credit are non-cancelable while its opposite can be cancelled at any timeConfirmed Vs. Unconfirmed – An L/C issued by one bank can be confirmed by another bankAdvantages of L/Cs are that it reduces risk of default and a confirmed L/C helps secure financingDisadvantages of L/Cs are the fees charged and that the L/C reduces the available credit of the importer
13 Letter of Credit Example (from Ch 18 problems) Texas Computers (TC) recently has begun selling overseas. It currently has 30 foreign orders outstanding, with the typical order averaging $2,500. TC is considering the following three alternatives to protect itself against credit risk on these foreign sales:• Request a letter of credit from each customer. The cost to the customer would be $75 plus 0.25% of the invoice amount. To remain competitive, TC would have to absorb the cost of the letter of credit.• Factor the receivables. The factor would charge a nonrecourse fee of 1.6%.• Buy FCIA insurance. The FCIA would charge a 1% insurance premium.a. Which of these alternatives would you recommend to Texas Computers? Why?Answer. The L/C will cost TC an average of $81.25 ($ *$2,500) per order, or a total of $2, (30 x $81.25). The factoring alternative will cost an average of $40 (0.016 x $2,500) per order, or $1,200 in all. The FCIA insurance will cost an average of $25 (0.01 x $2,500) per order, or $750 in all. Thus, the least expensive alternative is the FCIA insurance.b. Suppose that TC's average order size rose to $250,000. How would that affect your decision?Answer. If TC's average order size rises to $250,000, then the L/C will cost an average of $700 per order ($ x $250,000), or $21,000 in total. The FCIA insurance will cost an average of $2,500 per order, or $75,000 in total. Thus, the L/C is now the least expensive alternative (factoring is dominated by the FCIA insurance).
14 DraftA draft, sometimes called a bill of exchange (B/E), is the instrument normally used in international commerce to effect paymentIt is a written order by an exporter instructing an importer or its agent to pay a specified amount at a specified timeThe party initiating the draft is the maker, drawer, or originator while the counterpart is the draweeIn a commercial transaction where the buyer is the drawee it is a trade draft, or the buyer’s bank when it is called a bank draft
15 Draft If properly drawn, drafts can become negotiable instruments As such they provide a convenient instrument for financing the international movement of merchandiseTo become a negotiable instrument, there are four requirementsMust be written and signed by buyerMust contain unconditional promise to payMust be payable on demand or at a fixed dateMust be payable to bearer
16 Draft Types of drafts include Sight drafts which is payable on presentation to the draweeTime drafts, also called usance draft, allows a delay in payment. It is presented to the drawee who accepts it with a promise to pay at some later dateWhen a time draft is drawn on a bank, it becomes a banker’s acceptanceWhen drawn on a business firm it becomes a trade acceptance
17 Banker’s Acceptances Banker’s Acceptance When a draft is accepted by a bank, it becomes a banker’s acceptanceExample: Acceptance of $100,000 for exporterExporter may discount the acceptance note in order to receive the funds up-frontFace amount of acceptance $100,000Less 1.5% p.a. commission for 6 monthsAmount received by exporter in 6 months $ 99,250Less 7% p.a. discount rate for 6 months ,500Amount received by exporter at once $95,750
19 Bill of LadingBill of Lading (B/L) is issued to the exporter by a common carrier transporting the merchandiseIt serves the purpose of being a receipt, a contract and a document of titleAs a receipt the B/L indicates that the carrier has received the merchandiseAs a contract the B/L indicates the obligation of the carrier to provide certain transportationAs a document of title, the B/L is used to obtain payment or written promise of payment before the merchandise is released to the importer
20 Bill of Lading Characteristics of the Bill of Lading A straight B/L provides that the carrier deliver the merchandise to the designated consignee onlyAn order B/L directs the carrier to deliver the goods to the order of a designated party, usually the shipperA B/L is usually made payable to the order of the exporter
22 Government Programs to Help Finance Exports Governments of most export-oriented industrialized countries have special financial institutions that provide some form of subsidized credit to their own national exportersThese export finance institutions offer terms that are better than those generally available from the competitive private sectorThus, domestic taxpayers are subsidizing lower financial costs for foreign buyers in order to create employment and maintain a technological edge
23 Government Programs to Help Finance Exports Export Credit InsuranceProvides assurance to the exporter or the exporter’s bank that an insurer will pay should the foreign customer defaultIn the US the Foreign Credit Insurance Association (FCIA) provides this type of insuranceExport-Import BankKnown as the Eximbank, it facilitates the financing of US exports through various loan guarantee and insurance programs
24 Trade Financing Alternatives In order to finance international trade receivables, firms use the same financing instruments as they use for domestic trade receivables including;Banker’s AcceptancesTrade AcceptancesFactoringSecuritizationBank Credit Lines Covered by Export Credit InsuranceCommercial Paper
25 Forfaiting: Medium and Long Term Financing Forfaiting is a specialized technique to eliminate the risk of nonpayment by importers in instances where the importing firm and/or its government is perceived by the exporter to be too risky for open account creditThe essence of forfaiting is the non-recourse sale by an exporter of bank-guaranteed promissory notes, bills of exchange, or similar documents received from an importer in another countryThe following exhibit outlines a typical forfaiting transaction