1. International Trade Finance
Chapter 23
International Trade Finance

2. The Trade Relationship
Trade financing shares a number of common characteristics with the traditional value chain activities conducted by all firms.
All companies must search out suppliers for the many goods and services required as inputs to their own goods production or service provision processes.
Issues to consider in this process include the capability of suppliers to produce the product to adequate specifications, deliver said products in a timely fashion, and to work in conjunction on product enhancements and continuous process improvement.
All of the above must also be at an acceptable price and payment terms.
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3. The Trade Relationship
The nature of the relationship between the exporter and the importer is critical to understanding the methods for import-export financing utilized in industry.
There are three categories of relationships (see next exhibit):
Unaffiliated unknown
Unaffiliated known
Affiliated (sometimes referred to as intra-firm trade)
The composition of global trade has changed dramatically over the past few decades, moving from transactions between unaffiliated parties to affiliated transactions.
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4. Exhibit 23.1 Alternative International Trade Relationships
Exporter
Unaffiliated
Unknown Party
A new customer
which with exporter has
no historical business
relationship
Unaffiliated
Known Party
A long-term customer
with which there is an
established relationship of
trust and performance
Affiliated
Party
A foreign subsidiary
or affiliate
of exporter
Importer is ….
Requires:
1. A contract
2. Protection against
non-payment
Requires:
1. A contract
2. Possibly some protection
against non-payment
Requires:
1. No contract
2. No protection against
non-payment

5. The Trade Dilemma
International trade (i.e. between and importer and exporter) must work around a fundamental dilemma:
They live far apart
They speak different languages
They operate in different political environments
They have different religions
They have different standards for honoring obligations
In essence, there could be distrust, and clearly the importer and exporter would prefer two different arrangements for payment/goods transfer (next exhibit)
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6. Importer Exporter Importer Exporter
Exhibit The Mechanics of Import and Export
1st: Exporter ships the goods
Importer
Importer Preference
Exporter
2nd: Importer pays after goods received
1st: Importer pays for goods
Importer
Exporter
Exporter Preference
2nd: Exporter ships the goods after being paid

7. The Trade Dilemma
The fundamental dilemma of being unwilling to trust a stranger in a foreign land is solved by using a highly respected bank as an intermediary.
The following exhibit is a simplified view involving a letter of credit (a bank’s promise to pay) on behalf of the importer.
Two other significant documents are an order bill of lading and a sight draft.
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8. Importer Bank Exporter
Exhibit The Bank as the Import/Export Intermediary
1st: Importer obtains bank’s promise
to pay on importer’s behalf.
Importer
6th: Importer pays
the bank.
2nd: Bank promises exporter
to pay on behalf of importer.
Bank
5th: Bank ‘gives’ merchandise
to the importer.
4th: Bank pays the
exporter.
Exporter
3rd: Exporter ships ‘to the bank’
trusting bank’s promise.

9. Benefits of the System
The system (including the three documents discussed) has been developed and modified over centuries to protect both importer and exporter from:
The risk of noncompletion
Foreign exchange risk
To provide a means of financing
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10. Elements of an Import/Export Transaction
Each individual trade transaction must cover three basic elements: description of goods, prices, and documents regarding shipping and delivery instructions.
Contracts:
An import or export transaction is by definition a contractual exchange between parties in two countries that may have different legal systems, currencies, languages, religions or units of measure
All contracts should include definitions and specifications for the quality, grade, quantity, and price of the goods in question
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11. Elements of an Import/Export Transaction
Prices:
Price quotations can be a major source of confusion
Price terms in the contract should conform to published catalogs, specify whether quantity discounts or early payment discounts are in effect, and state whether finance charges are relevant in the case of deferred payment, and should address other relevant fees or charges
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12. Elements of an Import/Export Transaction
Documents:
Bill of lading – issued to the exporter by a common carrier transporting the merchandise
Commercial invoice – issued by the exporter and contains a precise description of the merchandise (also indicates unit prices, financial terms of the sale etc.)
Insurance documents – specified in the contract of sale and issued by insurance companies (or their agents)
Consular invoices – issued in the exporting country by the consulate of the importing country
Packing lists
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13. International Trade Risks
The following exhibit illustrates the sequence of events in a single export transaction.
From a financial management perspective, the two primary risks associated with an international trade transaction are currency risk (currency denomination of payment) and risk of non-completion (timely and complete payment).
The risk of default on the part of the importer is present as soon as the financing period begins.
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14. Exhibit 23.4 The Trade Transaction Time-Line and Structure
Time and Events
Price
quote
request
Export
contract
signed
Goods
are
shipped
Documents
are
accepted
Goods
are
received
Cash
settlement
of the
transaction
Negotiations
Backlog
Documents Are
Presented
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Financing Period

15. Letter of Credit (L/C)
A 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.
An L/C reduces the risk of noncompletion because the bank agrees to pay against documents rather than actual merchandise.
The following exhibit shows the relationship between the three parties.
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16. Beneficiary Applicant
Exhibit Parties to a Letter of Credit (L/C)
Issuing Bank
The relationship between the
importer and the issuing bank is
governed by the terms of the
application and agreement
for the letter of credit (L/C).
The relationship between the
issuing bank and the exporter
is governed by the terms of the
letter of credit, as issued by
that bank.
Beneficiary
(exporter)
Applicant
(importer)
The relationship between the importer and the
exporter is governed by the sales contract.

17. Letter of Credit (L/C)
The essence of the L/C is the promise of the issuing bank to pay against specified documents, which must accompany any draft drawn against the credit.
To constitute a true L/C transaction, all of the following five elements must be present with respect to the issuing bank:
Must receive a fee or other valid business consideration for issuing the L/C
The L/C must contain a specified expiration date or definite maturity
The bank’s commitment must have a stated maximum amount of money
The bank’s obligation to pay must arise only on the presentation of specific documents
The bank’s customer must have an unqualified obligation to reimburse the bank on the same condition as the bank has paid
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18. Letter of Credit (L/C)
Commercial letters of credit are also classified:
Irrevocable versus revocable
Confirmed versus unconfirmed
The primary advantage of an L/C is that it reduces risk – the exporter can sell against a bank’s promise to pay rather than against the promise of a commercial firm.
The major advantage of an L/C to an importer is that the importer need not pay out funds until the documents have arrived at the bank that issued the L/C and after all conditions stated in the credit have been fulfilled.
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19. Exhibit 23.6 Essence of a Letter of Credit (L/C)
Bank of the East, Ltd.
[Name of Issuing Bank]
Date: September 18, 2003
L/C Number
Bank of the East, Ltd. hereby issues this irrevocable documentary Letter of Credit
to Jones Company [name of exporter] for US$500,000, payable 90 days after sight
by a draft drawn against Bank of the East, Ltd., in accordance with Letter of
Credit number
The draft is to be accompanied by the following documents:
1. Commercial invoice in triplicate
2. Packing list
3. Clean on board order bill of lading
4. Insurance documents, paid for by buyer
At maturity Bank of the East, Ltd. will pay the face amount of the draft to the
bearer of that draft.
Authorized Signature
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20. Draft
A draft, sometimes called a bill of exchange (B/E), is the instrument normally used in international commerce to effect payment.
A draft is simply an order written by an exporter (seller) instructing and importer (buyer) or its agent to pay a specified amount of money at a specified time.
The person or business initiating the draft is known as the maker, drawer, or originator.
Normally this is the exporter who sells and ships the merchandise.
The party to whom the draft is addressed is the drawee.
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21. Draft If properly drawn, drafts can become negotiable instruments.
As such, they provide a convenient instrument for financing the international movement of merchandise (freely bought and sold).
To become a negotiable instrument, a draft must conform to the following four requirements:
It must be in writing and signed by the maker or drawer
It must contain an unconditional promise or order to pay a definite sum of money
It must be payable on demand or at a fixed or determinable future date
It must be payable to order or to bearer
There are time drafts and sight drafts.
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22. Name of Exporter Signature of Exporter
Exhibit Essence of a Time Draft
Name of Exporter
Date: October 10, 2003
Draft number 7890
Ninety (90) days after sight of this First of Exchange, pay to the order of Bank
of the West [name of exporter’s bank] the sum of Five-hundred thousand U.S.
dollars for value received under Bank of the East, Ltd. letter of credit
number
Signature of Exporter
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23. Bill of Lading (B/L)
The third key document for financing international trade is the bill of lading or B/L.
The bill of lading is issued to the exporter by a common carrier transporting the merchandise.
It serves three purposes: a receipt, a contract, and a document of title.
Bills of lading are either straight or to order.
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24. Documentation in a Typical Trade Transaction
A trade transaction could conceivably be handled in many ways.
The transaction that would best illustrate the interactions of the various documents would be an export financed under a documentary commercial letter of credit, requiring an order bill of lading, with the exporter collecting via a time draft accepted by the importer’s bank.
The following exhibit illustrates such a transaction.
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25. Exhibit 23.8 Steps in a Typical Trade Transaction
3. Importer
arranges L/C
with its bank
1. Importer orders goods
2. Exporter agrees to fill order
Exporter
Importer
5. Bank X
advises
exporter
of L/C
6. Exporter ships goods to Importer
7. Exporter presents
draft and documents
to its bank, Bank X
13. Importer
pays
its bank
12. Bank I obtains
importer’s note
and releases shipment
11. Bank X
pays
exporter
8. Bank X presents draft and
documents to Bank I
Bank X
Bank I
9. Bank I accepts draft, promising to pay in 60
days, and returns accepted draft to Bank X
10. Bank X sells
acceptance to investor
4. Bank I sends
L/C to Bank X
14. Investor presents acceptance
and is paid by Bank I
Public
Investor

26. 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.
The most important institutions usually offer export credit insurance and a government-supported bank for export financing.
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27. Trade Financing Alternatives
In order to finance international trade receivables, firms use the same financing instruments as they use for domestic trade receivables, plus a few specialized instruments that are only available for financing international trade.
There are short-term financing instruments and longer-term instruments in addition to the use of various types of barter to substitute for these instruments.
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28. Forfaiting
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 following exhibit illustrates a typical forfaiting transaction (involving five parties – importer, exporter, forfaiter, investor and the importers bank).
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.
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29. Exhibit 23.10 Typical Forfaiting Transaction
Step 1
Importer
(private firm or government
purchaser in emerging market)
Exporter
(private industrial firm)
Step 2
Step 4
FORFAITER
(subsidiary of a
European bank)
Step 3
Step 5
Step 6
Investor
(institutional or individual)
Importer’s Bank
(usually a private bank in
the importer’s country
Step 7

30. Countertrade
The word countertrade refers to a variety of international trade arrangements in which goods and services are exported by a manufacturer with compensation linked to that manufacturer accepting imports of other goods and services.
In other words, an export sale is tied by contract to an import.
The countertrade may take place at the same time as the original export, in which case credit is not an issue; or the countertrade may take place later, in which case financing becomes important.
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