International Finance FIN456 ♦ Spring 2013 Michael Dimond

Michael Dimond School 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

Michael Dimond School of Business Administration The Trade Relationship 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 partu

Michael Dimond School of Business Administration Financing Trade: The Flow of Goods and Funds

Michael Dimond School of Business Administration Alternative International Trade Relationships

Michael Dimond School of Business Administration 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?

Michael Dimond School of Business Administration 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

Michael Dimond School of Business Administration The Mechanics of Import and Export

Michael Dimond School of Business Administration The Bank as the Import/Export Intermediary

Michael Dimond School of Business Administration The Trade Transaction Time-Line and Structure

Michael Dimond School of Business Administration 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

Michael Dimond School of Business Administration 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

Michael Dimond School of Business Administration Parties to a Letter of Credit (L/C)

Michael Dimond School of Business Administration Essence of a Letter of Credit (L/C)

Michael Dimond School of Business Administration 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

Michael Dimond School of Business Administration 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

Michael Dimond School of Business Administration 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

Michael Dimond School of Business Administration 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$100,000 Less 1.5% p.a. commission for 6 months- 750 Amount received by exporter in 6 months$ 99,250 Less 7% p.a. discount rate for 6 months- 3,500 Amount received by exporter at once$95,750 Banker’s Acceptances

Michael Dimond School of Business Administration 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

Michael Dimond School of Business Administration 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

Michael Dimond School of Business Administration Documentation in Typical 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)

Michael Dimond School of Business Administration Documentation in Typical 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

Michael Dimond School of Business Administration Documentation in Typical 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

Michael Dimond School of Business Administration Documentation in Typical 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

Michael Dimond School of Business Administration Steps in a Typical Trade Transaction

Michael Dimond School of Business Administration 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

Michael Dimond School of Business Administration 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

Michael Dimond School of Business Administration 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

Michael Dimond School of Business Administration Instruments for Financing Short-Term Domestic & International Trade Receivables

Michael Dimond School of Business Administration 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

Michael Dimond School of Business Administration Typical Forfaiting Transaction