international finance fin456 michael dimond. michael dimond school of business administration the...

International FinanceFIN456

Michael Dimond

Michael DimondSchool of Business Administration

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?


Financing Trade: The Flow of Goods and Funds


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


The Mechanics of Import and Export


The Bank as the Import/Export Intermediary


The Trade Transaction Time-Line and Structure


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


Parties to a Letter of Credit (L/C)


Essence of a Letter of Credit (L/C)


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).

Letter of Credit Example (from Ch 18 problems)


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

Face amount of acceptance $100,000Less 1.5% p.a. commission for 6 months - 750Amount received by exporter in 6 months $ 99,250Less 7% p.a. discount rate for 6 months - 3,500Amount received by exporter at once $95,750

Banker’s Acceptances


L.A. Cellular has received an order for phone switches from Singapore. The switches will be exported under the terms of a letter of credit issued by Sumitomo Bank on behalf of Singapore Telecommunications. Under the terms of the L/C, the face value of the export order, $12 million, will be paid six months after Sumitomo accepts a draft drawn by L.A. Cellular. The current discount rate on 6-month acceptances is 8.5 percent per annum and the acceptance fee is 1.25 percent per annum. In addition, there is a flat commission, equal to 0.5 percent of the face amount of the accepted draft that must be paid if it is sold. a. How much cash will L.A. Cellular receive if it holds the acceptance until maturity? ANSWER. If L.A. Cellular chooses to hold the acceptance, then in six months it will receive the face amount of $12 million less the acceptance fee of 0.625% (1.25%/2):

Face amount of acceptance $12,000,000 Less: 1.25% per annum commission for six months - 75,000 Amount received by L.A. Cellular in six months $11,925,000

b. How much cash will it receive if it sells the acceptance at once? ANSWER. By selling the acceptance at once, paying the 0.5% selling commission, and taking the 4.25% discount (8.5%/2), L.A. Cellular will receive $11,355,000 immediately:

Face amount of acceptance $12,000,000 Less: 1.25% per annum commission for six months - 75,000 Less: 8.5% per annum discount for six months - 510,500 Less: 0.5% selling commission - 60,000 Amount received by L.A. Cellular immediately $11,354,500

c. Suppose L.A. Cellular's opportunity cost of funds is 8.75 percent per annum. If it wishes to maximize the present value of its acceptance, should it discount the acceptance? ANSWER. Given that L.A. Cellular's opportunity cost of money is 8.75%, then the present value of holding onto the acceptance is $11,925,000/(1 + (.0875/2)), or $11,425,150 (remember, it must pay the $75,000 commission in any case). Since this figure exceeds the amount of money it would receive from discounting the acceptance, L.A. Cellular should hold onto the acceptance.


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


Steps in a Typical Trade Transaction


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


Typical Forfaiting Transaction


Suppose Minnesota Machines (MM) is trying to price an export order from Russia. Payment is due nine months after shipping. Given the risks involved, MM would like to factor its receivable without recourse. The factor will charge a monthly discount of 2 percent plus a fee equal to 1.5 percent of the face value of the receivable for the nonrecourse financing. a. If Minnesota Machines desires revenue of $2.5 million from the sale, after paying all factoring charges, what is the minimum acceptable price it should charge? ANSWER. At a monthly discount of 2%, and an extra 1.5% fee for nonrecourse financing, Minnesota Machines will pay a total fee equal to 19.5% (9 x 2% + 1.5%) of the face amount of its price for factoring its nine-month export receivable without recourse. In other words, after paying all factoring fees, MM will clear 80.5% of the price it sets. Thus, in order to net $2.5 million on its export sale, MM must set a price P such that .805P = $2,500,000. The solution to this equation is P = $3,105,590. This is the minimum acceptable price to MM. b. Alternatively, CountyBank has offered to discount the receivable, but with recourse, at an annual rate of 14 percent plus a 1 percent fee. What price will net MM the $2.5 million it desires to clear from the sale? ANSWER. If MM decides to discount the receivable with CountyBank, it will pay a total fee equal to 11.5% (.75 x 14% + 1%). Thus, in order to net $2.5 million on its export sale, MM must now set a price P* such that .885P* = $2,500,000, or P* = $2,824,859. c. Based on your answers to parts a and b, should Minnesota Machines discount or factor its Russian receivables? MM is competing against Nippon Machines for the order, so the higher MM's price, the lower the probability that its bid will be accepted. What other considerations should influence MM's decision?