International Finance

1. International Finance FIN456Michael Dimond

2. The Trade Relationship Trade financing shares a number of common characteristics with traditional value chain activities conducted by all firms All companies must search out suppliers for goods and services Must determine if supplier can provide products at required specifications and quality All must be at an acceptable price and delivered in a timely manner Understanding the nature of the relationship between the exporter and the importer is critical to understanding the methods for import-export financing utilized in industry Three categories of relationships: Unaffiliated unknown party Unaffiliated known party Affiliated party

3. The Trade Dilemma International trade must work around a fundamental dilemma: Imagine an importer and an exporter who would like to do business with one another Because of the distance between the two, it is not possible to simultaneously hand over goods and receive payments in person How do participants in international trade mitigate the risks associated with conducting business with a stranger?

4. Financing Trade: The Flow of Goods and Funds

5. Key Documents As we will see in the following exhibits, letters of credit, order bills of lading and sight drafts are critical in conducting international trade An 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 bank When 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 lading The exporter asks the bank to pay for the goods using a sight draft The bank, having paid for the goods, now passes title to the importer who eventually reimburses the bank

6. The Mechanics of Import and Export

7. The Bank as the Import/Export Intermediary

8. The Trade Transaction Time-Line and Structure

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/C The 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 bank Issuing bank must receive a fee for issuing L/C Bank’s L/C must contain specified maturity date Bank’s commitment must have stated maximum amount Bank’s obligation must arise only on presentation of specific documents and bank cannot be called on for disputed items Bank’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 time Confirmed Vs. Unconfirmed – An L/C issued by one bank can be confirmed by another bank Advantages of L/Cs are that it reduces risk of default and a confirmed L/C helps secure financing Disadvantages of L/Cs are the fees charged and that the L/C reduces the available credit of the importer

11. Parties to a Letter of Credit (L/C)

12. Essence of a Letter of Credit (L/C)

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 ($75 + 0.0025*$2,500) per order, or a total of $2,437.50 (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 ($75 + 0.0025 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. Draft A draft, sometimes called a bill of exchange (B/E), is the instrument normally used in international commerce to effect payment It is a written order by an exporter instructing an importer or its agent to pay a specified amount at a specified time The party initiating the draft is the maker, drawer, or originator while the counterpart is the drawee In 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 merchandise To become a negotiable instrument, there are four requirements Must be written and signed by buyer Must contain unconditional promise to pay Must be payable on demand or at a fixed date Must be payable to bearer

16. Draft Types of drafts include Sight drafts which is payable on presentation to the drawee Time 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 date When a time draft is drawn on a bank, it becomes a banker’s acceptance When drawn on a business firm it becomes a trade acceptance

17. Banker’s Acceptance When a draft is accepted by a bank, it becomes a banker’s acceptance Example: Acceptance of $100,000 for exporter Exporter may discount the acceptance note in order to receive the funds up-front Banker’s Acceptances Face amount of acceptance $100,000 Less 1.5% p.a. commission for 6 months - 750 Amount received by exporter in 6 months $ 99,250 Less 7% p.a. discount rate for 6 months - 3,500 Amount received by exporter at once $95,750

19. Bill of Lading Bill of Lading (B/L) is issued to the exporter by a common carrier transporting the merchandise It serves the purpose of being a receipt, a contract and a document of title As a receipt the B/L indicates that the carrier has received the merchandise As a contract the B/L indicates the obligation of the carrier to provide certain transportation As 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 only An order B/L directs the carrier to deliver the goods to the order of a designated party, usually the shipper A B/L is usually made payable to the order of the exporter

21. Steps in a Typical Trade Transaction

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 exporters These export finance institutions offer terms that are better than those generally available from the competitive private sector Thus, 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 Insurance Provides assurance to the exporter or the exporter’s bank that an insurer will pay should the foreign customer default In the US the Foreign Credit Insurance Association (FCIA) provides this type of insurance Export-Import Bank Known 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 Acceptances Trade Acceptances Factoring Securitization Bank Credit Lines Covered by Export Credit Insurance Commercial 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 credit The 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 country The following exhibit outlines a typical forfaiting transaction

26. Typical Forfaiting Transaction