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International Finance. FIN456 Michael Dimond. 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
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International Finance FIN456Michael Dimond
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
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?
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
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
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
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
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
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
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
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
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
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
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
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
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
International Parity Conditions The economic theories which link exchange rates, price levels, and interest rates together are called international parity conditions These theories may not always work out to be “true” when compared to what students and practitioners observe in the real world, but they are central to any understanding of how multinational business is conducted
Prices and Exchange Rates The Law of one price states that all else being equal (no transaction costs) a product’s price should be the same in all markets Even if prices for a particular product are in different currencies, the law of one price states that P$ S = P¥ Where the price of the product in US dollars (P$), multiplied by the spot exchange rate (S, yen per dollar), equals the price of the product in Japanese yen (P¥)
Prices and Exchange Rates Conversely, if the prices were stated in local currencies, and markets were efficient, the exchange rate could be deduced from the relative local product prices ¥ $
Purchasing Power Parity & The Law of One Price If the Law of One Price were true for all goods, the purchasing power parity (PPP) exchange rate could be found from any set of prices Through price comparison, prices of individual products can be determined through the PPP exchange rate This is the absolute theory of purchasing power parity Absolute PPP states that the spot exchange rate is determined by the relative prices of similar basket of goods
Relative Purchasing Power Parity If the assumptions of absolute PPP theory are relaxed, we observe relative purchasing power parity This idea is that PPP is not particularly helpful in determining what the spot rate is today, but that the relative change in prices between countries over a period of time determines the change in exchange rates Moreover, if the spot rate rate between 2 countries starts in equilibrium, any change in the differential rate of inflation between them tends to be offset over the long run by an equal but opposite change in the spot rate
Relative Purchasing Power Parity Empirical tests of both relative and absolute purchasing power parity show that for the most part, PPP tends to not be accurate in predicting future exchange rates Two general conclusions can be drawn from the tests: PPP holds up well over the very long term but is poor for short term estimates The theory holds better for countries with relatively high rates of inflation and underdeveloped capital markets
Exchange Rate Indices: Real and Nominal In order to evaluate a single currency’s value against all other currencies in terms of whether or not the currency is “over” or “undervalued,” exchange rate indices were created These indices are formed by trade-weighting the bilateral exchange rates between the home country and its trading partners The nominal exchange rate index uses actual exchange rates to create an index on a weighted average basis of the value of the subject currency over a period of time
Exchange Rate Indices: Real and Nominal The real effective exchange rate index indicates how the weighted average purchasing power of the currency has changed relative to some arbitrarily selected base period Example: The real effective rate for the US dollar (E$ ) is found by multiplying the nominal rate index (E$ ) by the ratio of US dollar costs (C$) over foreign currency costs (CFC) R N
Exchange Rate Indices: Real and Nominal If changes in exchange rates just offset differential inflation rates – if purchasing power parity holds – all the real effective exchange rate indices would stay at 100 If a rate strengthened (overvalued) or weakened (undervalue) then the index value would be ± 100
Exchange Rate Pass-Through Incomplete exchange rate pass-through is one reason that country’s real effective exchange rate index can deviate from it’s PPP equilibrium point The degree to which the prices of imported & exported goods change as a result of exchange rate changes is termed pass-through Example: assume BMW produces a car in Germany and all costs are incurred in euros. When the car is exported to the US, the price of the BMW should be the euro value converted to dollars at the spot rate Where P$ is the BMW price in dollars, P€ is the BMW price in euros and S is the spot rate € €/$
Exchange Rate Pass-Through Incomplete exchange rate pass-through is one reason that a country’s real effective exchange rate index can deviate for lengthy periods from its PPP-equilibrium level If the euro appreciated 20% against the dollar, but the price of the BMW in the US market rose to only $40,000, and not $42,000 as is the case under complete pass-through, the pass-through is partial The degree of pass-through is measured by the proportion of the exchange rate change reflected in dollar prices The degree of pass-through in this case is partial, 14.29% ÷ 20.00% or approximately 0.71. Only 71.0% of the change has been passed through to the US dollar price
Prices between countries are related by exchange rates and now we discuss how exchange rates are linked to interest rates The Fisher Effect states that nominal interest rates in each country are equal to the required real rate of return plus compensation for expected inflation. As a formula, The Fisher Effect is Interest Rates and Exchange Rates i = r + + r Where i is the nominal rate, r is the real rate of interest, and is the expected rate of inflation over the period of time The cross-product term, r , is usually dropped due to its relatively minor value
Applied to two different countries, like the US and Japan, the Fisher Effect would be stated as Interest Rates and Exchange Rates i = r + ; i = r + $ $ $ ¥ ¥ ¥ It should be noted that this requires a forecast of the future rate of inflation, not what inflation has been, and predicting the future can be difficult!
Interest Rates and Exchange Rates The international Fisher effect, or Fisher-open, states that the spot exchange rate should change in an amount equal to but in the opposite direction of the difference in interest rates between countries if we were to use the US dollar and the Japanese yen, the expected change in the spot exchange rate between the dollar and yen should be (in approximate form) ¥
Interest Rates and Exchange Rates Justification for the international Fisher effect is that investors must be rewarded or penalized to offset the expected change in exchange rates The international Fisher effect predicts that with unrestricted capital flows, an investor should be indifferent between investing in dollar or yen bonds, since investors worldwide would see the same opportunity and compete it away
Interest Rates and Exchange Rates The Forward Rate A forward rate is an exchange rate quoted today for settlement at some future date The forward exchange agreement between currencies states the rate of exchange at which a foreign currency will be bought or sold forward at a specific date in the future (typically 30, 60, 90, 180, 270 or 360 days) The forward rate is calculated by adjusting the current spot rate by the ratio of euro currency interest rates of the same maturity for the two subject currencies
Interest Rates and Exchange Rates The Forward Rate
The Forward Rate example with spot rate of Sfr1.4800/$, a 90-day euro Swiss franc deposit rate of 4.00% p.a. and a 90-day euro-dollar deposit rate of 8.00% p.a. Interest Rates and Exchange Rates
Interest Rates and Exchange Rates The forward premium or discount is the percentage difference between the spot and forward rates stated in annual percentage terms When stated in indirect terms (foreign currency per home currency units, FC/$) then formula is For direct quotes ($/FC), then (F-S)/S should be applied
Interest Rates and Exchange Rates Using the previous Sfr example, the forward discount or premium would be as follows: The positive sign indicates that the Swiss franc is selling forward at a premium of 3.96% per annum (it takes 3.96% more dollars to get a franc at the 90-day forward rate)
Interest Rate Parity (IRP) Interest rate parity theory provides the linkage between foreign exchange markets and international money markets The theory states that the difference in the national interest rates for securities of similar risk and maturity should be equal to, but opposite sign to, the forward rate discount or premium for the foreign currency, except for transaction costs
Interest Rate Parity (IRP) In this diagram, a US dollar-based investor with $1 million to invest, is shown indifferent between dollar-denominated securities for 90 days earning 8.00% per annum, or Swiss franc-denominated securities of similar risk and maturity earning 4.00% per annum, when “cover” against currency risk is obtained with a forward contract
