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Fundamentals of Multinational Finance Sixth Edition

Chapter 16 International Trade Finance

Learning Objectives 16.1 Discover the key elements of an import or export business transaction that define the trade relationship

16.2 Explore how the three key documents in import/export combine to finance both the transaction and to manage its risks

16.3 Describe the variety of government programs to help finance exports

16.4 Examine the major trade financing alternatives

16.5 Evaluate the use of a specialized technique, forfaiting, for medium- to long-term trade financing

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The Trade Relationship (1 of 5) • Trade financing shares a number of common characteristics

with the traditional value chain activities conducted by all firms

• All companies must search out suppliers for the many goods and services required as inputs to their own goods production or service provision processes

• Issues to consider in this process include the capability of suppliers to produce the product to adequate specifications, deliver said products in a timely fashion, and to work in conjunction on product enhancements and continuous process improvement

• All of the above must also be at an acceptable price and payment terms

Exhibit 16.1: Financing Trade: The Flow of Goods and Funds

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The Trade Relationship (2 of 5)

• The nature of the relationship between the exporter and the importer is critical to understanding the methods for import-export financing utilized in industry

– Unaffiliated unknown – Unaffiliated known – Affiliated (aka intrafirm trade)

Exhibit 16.2: Alternative International Trade Relationships

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The Trade Relationship (3 of 5) • International trade must work around a fundamental dilemma

– Because of the distance between the importer and exporter, it is not possible to simultaneously hand over goods with one hand and accept payment with the other

– This dilemma of being reluctant to trust a stranger in a foreign land is resolved by using a highly respected bank as intermediary § Letter of Credit

– The bank’s promise to pay § Bill of Lading (B/L)

– Document that serves as title to the merchandise § Sight Draft

– Document requesting payment

Exhibit 16.3: the Mechanics of Import and Export

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Exhibit 16.4: The Bank as the Import/Export Intermediary

The Trade Relationship (4 of 5) • Benefits of the System

– Protection Against Risk of Noncompletion § The letter of credit, bill of lading, and sight draft are part of a system

carefully constructed to determine who bears the financial loss if one of the parties defaults at any time

– Protection Against Foreign Exchange Risk § If the transaction requires payment in the exporter’s currency, the

importer carries the foreign exchange risk § Transaction exposure can be hedged § The letter of credit, bill of lading, and sight draft ensure both amount

and time of payment and thus lay the groundwork for effective hedging

– Financing the Trade § Once the risks of noncompletion and of exchange rate changes are

disposed of, banks are willing to finance goods in transit

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The Trade Relationship (5 of 5)

• Noncompletion Risks – From a financial management perspective, the two

primary risks associated with an international trade transaction are currency risk and risk of noncompletion

– The risk of default on the part of the importer is present as soon as the financing period begins

Exhibit 16.5: The Trade Transaction Time Line and Structure

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Key Documents (1 of 11) • Letter of Credit (L/C)

– 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/C

– Reduces the risk of noncompletion because the bank agrees to pay against documents rather than actual merchandise

Key Documents (2 of 11) • Letter of Credit (L/C)

– Parties to a Letter of Credit § Beneficiary

– Exporter § Applicanta

– Importer) § Issuing Bank

– Importer’s bank that issues a L/C

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Exhibit 16.6: Parties to a Letter of Credit (L/C)

Key Documents (3 of 11) • Letter of Credit (L/C)

– Parties to a Letter of Credit § To constitute a true L/C transaction, the following elements must be

present with respect to the issuing bank: § The issuing bank must receive a fee or other valid business

consideration for issuing the L/C § The bank’s L/C must contain a specified expiration date or a definite

maturity § The bank’s commitment must have a stated maximum amount of

money § The bank’s obligation to pay must arise only on the presentation of

specific documents, and the bank must not be called on to determine disputed questions of fact or law

§ The bank’s customer must have an unqualified obligation to reimburse the bank on the same condition as the bank has paid

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Key Documents (4 of 11)

• Letter of Credit (L/C) – Irrevocable Versus Revocable L/C

§ An irrevocable L/C obligates the issuing bank to honor drafts drawn in compliance with the credit and can be neither canceled nor modified without the consent of all parties, including in particular the beneficiary (exporter)

§ A revocable L/C can be canceled or amended at any time before payment; it is intended to serve as a means of arranging payment but not as a guarantee of payment

Key Documents (5 of 11)

• Letter of Credit (L/C) – Confirmed Versus Unconfirmed L/C

§ A confirmed L/C is issued by one bank and can be confirmed by another bank, in which case the confirming bank can honor drafts drawn in compliance with the L/C

§ An unconfirmed L/C is the obligation only of the issuing bank

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Exhibit 16.7: Essence of a Letter of Credit (L/C)

Key Documents (6 of 11)

• Draft – aka Bill of Exchange (B/E) – The instrument normally used in international

commerce to effect payment – An order written by an exporter (seller) instructing an

importer (buyer) or its agent to pay a specified amount of money at a specified time

– Bank drafts are usually drawn according to the terms of an L/C

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Key Documents (7 of 11) • Draft

– Negotiable Instruments § To become a negotiable instrument, a draft must conform

to the following UCC requirements: – It must be in writing and signed by the maker or

drawer – It must contain an unconditional promise or order to

pay a definite sum of money – It must be payable on demand or at a fixed or

determinable future date – It must be payable to order or to bearer

Key Documents (8 of 11) • Draft

– Types of Drafts § Sight Draft

– Payable on presentation to the drawee; the drawee must pay at once or dishonor the draft

§ Time Draft – aka Usance Draft – Allows a delay in payment – It is presented to the drawee, who accepts it by writing or

stamping a notice of acceptance on its face – Once accepted, the time draft becomes a promise to pay

by the accepting party (the buyer)

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Key Documents (9 of 11) • Draft

– Bankers’ Acceptances § When a draft is accepted by a bank, it becomes a

bankers’ acceptance § As such it is the unconditional promise of that bank to

make payment on the draft when it matures § In quality, a bankers’ acceptance is practically identical to

a marketable bank certificate of deposit § The holder of a bankers’ acceptance need not wait until

maturity to liquidate the investment, but may sell the acceptance in the money market, where constant trading in such instruments occurs

Key Documents (10 of 11) • Bill of Lading (B/L)

– Issued to the exporter by a common carrier transporting the merchandise

– It serves three purposes: § A receipt

– Indicates that the carrier has received the merchandise described on the face of the document

§ A contract – Indicates the obligation of the carrier to provide certain

transportation in return for certain charges § A document of title

– Used to obtain payment or a written promise of payment before the merchandise is released to the importer

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Key Documents (11 of 11)

• Documentation in a Typical Trade Transaction – A trade transaction could conceivably be handled in

many ways – The transaction that would best illustrate the

interactions of the various documents would be an export financed under a documentary commercial letter of credit, requiring an order bill of lading, with the exporter collecting via a time draft accepted by the importer’s bank

Exhibit 16.8: Steps in a Typical Trade Transaction

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Government Programs to Help Finance Exports • Export Credit Insurance

– Provides assurance to the exporter or the exporter’s bank that, should the foreign customer default on payment, the insurance company will pay for a major portion of the loss

– In the U.S., export credit insurance is provided by the Foreign Credit Insurance Association (FCIA)

• Export-Import Bank and Export Financing – The Export-Import Bank (Eximbank) is an independent agency of

the U.S. government that facilitates the financing of U.S. exports through various loan guarantee and insurance programs

– Essentially, the Eximbank lends dollars to borrowers outside the United States for the purchase of U.S. goods and services

Trade Financing Alternatives (1 of 3) • In order to finance international trade receivables, firms use the

same financing instruments as they use for domestic trade receivables, plus a few specialized instruments that are only available for financing international trade

• Bankers’ Acceptances – Can be used to finance both domestic and international

trade receivables

• Trade Acceptances – Similar to bankers’ acceptances except that the accepting

entity is a commercial firm, like General Motors Acceptance Corporation (GMAC), rather than a bank

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Trade Financing Alternatives (2 of 3) • Factoring

– Specialized firms, known as factors, purchase receivables at a discount on either a non-recourse or recourse basis

– Non-recourse § The factor assumes the credit, political, and foreign exchange risk of

the receivables it purchases § Recourse

– The factor can give back receivables that are not collectable

• Securitization – A firm can securitize its export receivables by selling them to a legal entity

established to create marketable securities based on a package of individual export receivables

– Receivables are normally sold at a discount

Trade Financing Alternatives (3 of 3) • Bank Credit Lines

– A firm’s bank credit line can typically be used to finance, up to a fixed upper limit, say 80%, of accounts receivable

• Commercial Paper – An unsecured promissory note to fund short-term financing

needs, including both domestic and export receivables

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Exhibit 16.9: Instruments for Financing Short-Term Domestic and International Trade Receivables

Instrument Cost or Yield for 3-Month Maturity

Bankers’ acceptances* 1.14% yield annualized

Trade acceptances* 1.17% yield annualized

Factoring Variable rate but much higher cost than bank credit lines

Securitization Variable rate but competitive with bank credit lines

Bank credit lines 4.25% plus points (fewer points if covered by export credit insurance)

Commercial paper* 1.15% yield annualized

*These instruments compete with 3-month marketable bank time certificates of deposit that yield 1.17%.

Forfaiting (1 of 3) • 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 credit

• Role of Forfaiter – The forfeiter arranges the entire operation prior to the execution of

the transaction – Although the exporting firm is responsible for the quality of

delivered goods, it receives a clear and unconditional cash payment at the time of the transaction

– All political and commercial risk of nonpayment by the importer is carried by the guaranteeing bank

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Forfaiting (2 of 3) • A Typical Forfaiting Transaction

– Step 1: Agreement § Importer and exporter agree on a series of imports to be paid for over

a period of time – Step 2: Commitment

§ The forfaiter promises to finance the transaction at a fixed discount rate, with payment to be made when the exporter delivers to the forfaiter the appropriate promissory notes or other specified paper

– Step 3: Aval or Guarantee § The importer obligates itself to pay for its purchases by issuing a

series of promissory notes, usually maturing every six or twelve months, against progress on delivery or completion of the project

– Step 4: Delivery of Notes § The now-endorsed promissory notes are delivered to the exporter

Forfaiting (3 of 3) • A Typical Forfaiting Transaction (cont.)

– Step 5: Discounting § The exporter endorses the notes “without recourse” and

discounts them with the forfaiter receiving the agreed-upon proceeds

– Step 6: Investment § The forfaiting bank either holds the notes until full maturity as

an investment or endorses and rediscounts them in the international money market

– Step 7: Maturity § At maturity, the investor holding the notes presents them for

collection to the importer or to the importer’s bank

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Exhibit 16.10: Typical Forfaiting Transaction