Financing International Trade Lecture 13 Financing International Trade

Important Information Last Exam: Wednesday, December 3rd 150 points Chapters 11, 12, 13, 15, 18, 19, and 23 Lecture 1 – 13 Research papers (general themes) Review Session: Monday, December 1st Office Hours: Tuesday: 1 – 3 (No office hours the rest of the week)

Definition Import or export transaction: a contractual exchange involving goods/services for money between parties in two countries that may have: different legal systems, currencies, cultures

Viewing International Trade Finance Issues Financing Trade: The Flow of Goods and the Flow of Funds Domestic Supplier (US) Domestic Buyer EXPORTING Canadian Buyer IMPORTING Mexican Supplier Trident Corp. (Los Angeles) Goods & Services Flow from Supplier to Trident to Buyer Goods & Services Flow from Supplier to Trident to Buyer US$ Mexican Pesos US$ Canadian $

Two Issues Facing Firm Foreign Exchange Exposure: Risk of Default Importing (Accounts Payable) Problem if the foreign currency strengthens Hedge with a forward purchase Exporting (Accounts Receivable) Problem if the foreign currency weakens Hedge with a forward sale Risk of Default Not receiving goods ordered/paid for! Not receiving payments for goods shipped/sold!

International Trade Risks: Exporter The Trade Transaction Timeline Time and Events Price Quote request Export contract signed Goods are shipped Documents are accepted Goods are received Cash settlement of the transaction Negotiation Production Documents are presented Financing Period

International Trade Possibilities International trade takes place between three categories of relationships: affiliated parties (subsidiaries of parent) unaffiliated unknown parties unaffiliated known parties Trade transactions between affiliated parties typically do not require contractual arrangements or external financing. Trade transactions between unaffiliated parties typically do require contractual arrangements as well as some type of external financing such as letters of credit

International Trade Finance Trident as an Exporter Affiliated Party Unaffiliated Known Party Unaffiliated Unknown Importer is… This is a new customer which Trident has no historical business relationship with Requires: A contract Protection against non-payment This is a Long-term customer with which there is an established relationship of trust and performance Requires: A contract Possible protection against non-payment This is a foreign subsidiary of Trident, a business unit of Trident Corporation Requires: No contract No protection against non-payment

Basic Elements of an Import/Export Transaction Each individual export sales transaction covers three basic elements: The Contract: description of goods (quantity, grade, quality, technical details, payment instructions). Prices (do they include shipping charges insurance fees), and Documents regarding shipping and delivery instructions. These include: Bills of lading (B/L) – is issued to the exporter by a common carrier transporting the merchandise Commercial invoice – is issued by the exporter and contains a precise description of the merchandise. Unit prices, financial terms of sale, and amount due from the importer are indicated such as “FOB” (free on board), “FAS” (free alongside), “CFR” (cost & freight), or “CIF” (cost, insurance, freight)

Still More Documents Insurance documents – must be as specified in the contract of sale and must be issued by insurance companies or their agents. Consular invoices – issued in the exporting country by the consulate of the importing country to provide customs information and statistics for that country and to help prevent false declarations of value Packing lists – may be required so that the contents of containers can be identified, either for customs purposes or for importer identification of the contents of separate containers

Additional Elements of an Import/Export Transaction Shipping deadline – most importers insist on a specified deadline or time interval by which the shipment will be made Payment instructions – which of the parties, exporter or importer, is to pay such charges as freight, insurance, import duties, handling fees, taxes, etc., must be carefully specified in the sales contract Packaging and marking – depending on the nature of the goods, proper packaging may be critical to preserving and protecting items being shipped Warranties, Guarantees, and inspection – assurances regarding the performance or qualities demonstrated by the goods from the exporter may also be included in the sales contract

Financing Trade Sales Over many years, established procedures have arisen to finance international trade. The basic procedure rests on the interrelationship between three key documents: The letter of credit (L/C) The draft, and The bill of lading Variations in each type of these three documents provide a variety of ways to accommodate any type of transaction

Financing Trade Sequence In the simplest transaction, in which all three documents are used, an importer applies for and receives a L/C from its bank In the L/C, the bank substitutes its credit for that of the importer and promises to pay if certain documents are submitted to the bank. The exporter may now rely on the promise of the bank rather than that of the importer The exporter typically ships on an order bill of lading, i.e., attaches the bill of lading to a draft ordering payment from the importer’s bank and presents these documents, plus any additional documents, through its own bank to the importer’s bank

Letter of Credit 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 Bank’s customer must have unqualified obligation to reimburse bank on same condition of bank’s payment

A 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

Banker’s Acceptances If the documents are in order, the importer’s bank either pays the draft (sight draft) or accepts the draft (time draft). In the latter case, payment is at a future date. At this step the importer’s bank acquires title to the merchandise through the bill of lading and releases it to the importer against a promise to pay If a sight draft is used, the exporter is paid at once, if a time draft is used the exporter receives the accepted draft, now called a banker’s acceptance, back from the bank and holds it until maturity or sells it at a discount

Bankers’ 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 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 Exporter may discount the acceptance note in order to receive the funds up-front

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

Protection of Parties The three key documents noted in the previous slides have been crafted over time to protect all parties involved in a trade transaction. These documents serve to determine who bears the financial loss if one of the parties defaults at any time Risk of non-completion – once both parties agree to terms, they each want assurance that other party will complete its portion of the transaction Financing the trade – some is required typically so parties must secure financing through a bank which acts as an intermediary utilizing the three key documents

Example of a Trade Transaction Example: Assume Trident receives order from Canadian buyer; Trident will export financed under L/C requiring a bill of lading with exporter collecting a time draft accepted by Canadian buyer’s bank The Canadian buyer places order with Trident Trident agrees to ship under L/C Canadian buyer applies to bank (Northland Bank) for L/C to be issued in favor of Trident for merchandise Northland Bank issues L/C in favor of Trident and sends it to Southland Bank (Trident’s bank)

Example of a Trade Transaction Trident ships the goods to the Canadian buyer Trident prepares a time draft and presents it to Southland Bank. The draft is drawn on Northland Bank with required documents including bill of lading Trident endorses the order bill of lading in blank so that title to goods goes with holder of documents – Southland Bank Southland Bank presents draft and documents to Northland Bank for acceptance, Northland accepts and promises to pay draft at maturity – 60 days

Example of a Trade Transaction Northland Bank returns accepted draft to Southland Bank; Southland Bank could ask for discounted draft receiving funds today Southland Bank, now having a banker’s acceptance, may sell the acceptance in the open market or it may hold the acceptance in its own portfolio If Southland Bank had kept the acceptance, it would transfer the proceeds less commission to Trident

Example of a Trade Transaction Northland Bank notifies Canadian buyer of arrival of documents; Canadian buyer signs note to pay Northern Bank for the merchandise in 60 days After 60 days, Northland Bank receives payment from Canadian buyer On same day, holder of matured acceptance presents it for payment and receives it face value; it may be presented at Northland Bank or returned to Southland Bank for collection through normal bank channels

Complete Trade Transaction 1. Canadian Buyer orders goods Northland Bank 3. Canadian buyer arranges L/C with bank Trident (exporter) Canadian Buyer (importer) 2. Trident agrees to fill order 5. Southland advises Trident of the L/C 6. Trident ships goods to Canadian buyer 11. Southland pays Trident 7. Trident presents draft & documents to its bank 12. Northland obtains Canadian buyer’s note and releases shipment 13. Canadian buyer pays bank 8. Southland presents draft & documents to Northland Southland Bank 4. Northland Bank sends L/C to Southland Bank 9. Northland accepts draft, promising to pay in 60 days and returns acceptance to Southland Public Investor 10. Southland sells acceptance to investor 14. Investor presents acceptance for payment

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