Trade Finance and Exchange rate Risk Management

Trade Finance and Exchange rate Risk Management Topic 4: Trade Finance Management •Shortterm trade finance (Trade cycle; Open account trade; When shortterm trade finance is required) •Medium and long term trade finance (Supplier and buyer credit; Lines of credit; Forfeiting; Bond)

Credit management for exporting firm

• Short term trade finance is provided and repaid within 2 years

• Covers purchase and sale of consumer goods

Trade cycle and Operating cycle?

- Trade cycle: the time period bw the start of supply chain (ordering good

and raw materials and receipt of payment for corresponding sales of finished products)

- Business use working capital to finance the trade cycle

- Operating cycle:Operating cycle is the time period between the acquisition

of inventory and when cash is collected from receivables

Operating cycle = average days sales in inventory + the average collection period

Cash Conversion Cycle = Inventory conversion period + Receivables conversion period - Payables deferral period

Cash Flow Time Line

Operating and Cash Conversion Cycles

Inventory period

Inventory sold

Cash received Inventory

purchased

Accounts receivable period

Operating cycle (OC)

Cash Conversion Cycle (CCC)

Cash paid for inventory Accounts payable period

Time

Financing of international trade

business to another

Credit management for exporting company

Trade financing:

Bank’s acceptance

Negotiating financing

Factoring/forfeiting

Batter/ countertrade

Compensation…

Trade credit

– Open Accounts: the seller ships goods to the buyer

with an invoice specifying goods shipped, total amount due, and terms of the sale.

– Notes Payable: the buyer signs a note that evidences

a debt to the seller.

– Trade Acceptances: the seller draws a draft (B/E) on the buyer that orders the buyer to pay

the draft at some future time period.

extended, the seller specifies the period of time allowed for payment “Net 30” implies full payment

in 30 days from the invoice date.

Trade credit

• Net Period - Cash Discount when credit is extended, the seller specifies the period of time allowed for

payment and offers a cash discount if paid in the early

part of the period

• An example would be “3/10 net 30”

– The customer can take a 3% discount if he pays within 10 days.

– In any event, he must pay within 30 days.

The Interest Rate Implicit in 3/10 net 30

A firm offering credit terms of 3/10 net 30 is essentially offering their customers a 20-day loan

To see this, consider a firm that makes a $1,000 sale on day 0 Some customers will pay on day 10 and take the discount

Other customers will pay on day 30 and forgo the discount

$970

$1,000

0 10 30

A customer that forgoes the 3% discount to pay on day

30 is borrowing $970 for 20 days and paying $30 interest:

365 20

) 1

(

000 , 1

970

$

000 , 1 )

1 ( r 20365

% 35 74 7435 0 1 970

$

000

,

365

r

The Decision to Grant Credit: Risk and

Information

• Consider a firm that is choosing between two alternative credit policies:

– “In God we trust—everybody else pays cash.” – Offering their customers credit.

)

0 P C Q

• The only cash flow of the first strategy

is

• The expected cash flows of the credit strategy

0

’

0P Q h

’

0

’

0Q

C

We incur costs

up front…

…and get paid in 1

period by h% of our

customers

Example of the Decision to Grant Credit

• A firm currently sells 1,000 items per month

on a cash basis for $500 each.

• If they offered terms net 30, the marketing department believes that they could sell 1,300 items per month.

• The collections department estimates that 5%

of credit customers will default.

• The cost of capital is 10% per annum.

Example of the Decision to Grant Credit

The NPV of cash only: 1 , 000 ($ 500 $ 400 ) $ 100 , 000

No Credit Net 45

The NPV of Net 30:

58 181 , 60

$ )

10 1 (

95 0 500

$ 300 , 1 425

$ 300 ,

No credit credit

considering dropping its policy of no credit The credit policy under consideration by Bershire follows:

Example of the Decision to Grant Credit

• How high must the credit price be to make it worthwhile for the firm to extend credit? The NPV of Net 30 must be at least as big

as the NPV of cash only:

365 / 30

’ 0

) 10 1 (

95 0 300 , 1 425

$ 300 , 1 000

,

100

95 0 300 , 1 ) 10 1 ( ) 425

$ 300 , 1 000

,

100

50 532

$ 95

0 300 , 1

) 10 1 ( ) 425

$ 300 , 1 000 , 100

’

0

P

Bank’s acceptance (BA)

• This is time darft that is drawn on and accepted by a bank (importer’s bank) The accepting bank is obliged to pay the holder of the draft at maturity

• If exporter does not want to wait to payment, it can request that BA be sold in the money market Trade financing is provided by the holder of the BA

• The bank accepting the draft charges an all in rate (interest rate) that consists of the discount rate plus acceptance commission

• In general, all in rates are lower than bank loan rates

Trade financing – Bank’s acceptance

• Bank’s acceptance: Financing for exporter base on time Draft

(time B/E)

Example:

B/E issued by exporter with face value $100,000 for 90days Bank’s acceptance commission: 1.5% /annum

Discount rate for 90days: 1.14%/annum

Scenario 1: Exporter hold draft until maturity and then collect money:

Face value of the acceptance: $100,000

Less 1.5% per annum commission for 90days =

0.015*3/12*$100,000 = 375

Amount received by exporter in 90days (three months) =

$99,625

Trade finance – Banker’s acceptance

Scenario 2: Exporter may ‘discount’ with its bank in order to receive funds at once

Face value of the acceptance: $100,000

Less 1.5% per annum commission for 90days =

0.015*3/12*$100,000 = 375

Less 1.14% per annum discount rate for 90days =

0.0114*3/12*100,000 = 285

Amount received by exporter in 90days (three months) = 100,000 - 375 - 285 = $99,340

Therefore, the all in cost of finance this banker’s acceptance is:

(commission+discount)/proceeds x (360/90) = (375+285)/99,340

x (360/90) = 0.266 or 2.66%

Example 2

Assume the time from acceptance to maturity on

a $2,000,000 banker’s acceptance is 90 days Further assume that the importing bank’s

acceptance commission is 1.25 percent and that the market rate for 90- day B/As is 7 percent.

Determine the amount the exporter will receive if

he holds the B/A until maturity and also the amount the exporter will receive if he discounts the B/A with the importer’s bank.

The time from acceptance to maturity on a $1,000,000 banker’s acceptance is 120 days The importer’s bank’s acceptance commission is 1.75 % and the market rate for 120-day B/As is 5.75 %

1 What amount will the exporter receive if he holds the B/A until maturity?

2 If he discounts the B/A with the importer’s bank? Also determine the bond equivalent yield the importer’s bank will earn from discounting the B/A with the exporter

3 If the exporter’s opportunity cost of capital is 11 %, should he discount the B/A or hold it to maturity?

Exercises Q1: Jackson Automotive Inc of California agrees to sell specialized automotive parts to Hidatsi of Korea Because the two companies have never done business with each other, Jackson requires a banker’s acceptance as payment for the

$1,000,000 order The banker’s acceptance carries a 1.4% commission per annum and payment is to be received in 6 months If Jackson Inc chooses to discount or sell the bankers acceptance to its bank, the discount rate is 1.00% per annum.

1 What is the size of the commission Jackson Automotive will pay the bank for the banker’s acceptance?

2 What is the total Jackson Automotive can expect to receive if the firm takes payment today?

3 What is the size of the discount (not including the commission fee) Jackson must take for receiving the proceeds of the sale today rather than waiting for six months?

Q2 Custom Granite Inc has a Canadian receivables contract for $200,000 due in

270 days The firm has been approached by a factoring firm that offers to purchase the receivables at a 12% per annum discount plus a 1% charge for a nonrecourse clause What is the annualized percentage all-in-cost of this factoring alternative?

Trade finance – Factoring

- Factor purchase receivable at discount on either a non-recourse or

recourse basic

- Non-recourse: factor assumes the credit, political and forex risk

of receivables it purchase

- Recourse: factor can give back receivable that are not collectable

- All in cost of factoring non-recourse receivables is similar structure acceptances The factor charges commission cover the non-recourse risk + interest as discount rate

- Example:

US company wishes to factor its receivable it face amount 5,000,000 USD for 3 month, non-recourse fee 1.5% and factoring fee

(2.5%/,month x 3month)

Net proceed on sale (US company receives now) = 5,000,000 – 75,000- 375,000 = 4,550,000 USD (91% of face value receivable)

Trade finance – Alternatives

- Securitization: The securitization of export receivable for financing trade by selling them to a legal entity established to create marketable securities based on package of individual export receivable from exporter’s balance sheet because they have been sold without recourse

- Bank credit line covered by Export Credit Insurance

- Forfaiting: Medium and long-term financing

+ using to eliminate the risk of non-payment 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

Demand of Guarantees (L/G)

Rule for guarantee:

URDG 758, ICC, 2010

For bank’s perspective the most important articles:

-Art 8: content of instruction and guarantees

- Art: 10: Advising of a guarantees or amendment

- Art 11: Amendment

- Art 14: presentation and Art 19: examination

- Art: time for examination of demand and payment: 5 days following the day of presentation

- Art 23: extend or pay: in the event of a complying demand being presente the guarantor is now faced with two choices:

+ pay immediately

+ suspend payment for a sprecified period

Art 24: Non- complying demand, waiver and notice

.

Check for Guarantees

1 The ICC guidelines for guarantees is:

UCP 600

URDG 758

URC 522

Incoterms 2010

2 Company A contracts to build a bridge for Company B Company A asks its bank to issue a bond company A is known as the:

a Applicant

b Beneficiary

c Guarantor

d Issuer

Stand-by LC

• Rules:

ISP 98 and UCP 600 ( as stated in Art 1-UCP 600)

- Standby LC is used to protect against non-performance BUT NOT a primary means of making a payment

Typical uses include:

- As a type of guarantee that a loan will be repaid

- As a back up guarantee that buyer/importer will meet some other pre-agreed payment obligation such a settlement of a sight B/E attached to a collection or open account

- The situation outline in the introduction where protection against a failure

to perform a contracts is required

….

Stand-by LC ISP 98 rules for standby:

- Irrevocable: 1.06b

- Enforceable: 1.06c

- For payment against documents: 1.06d

- Limited as to the issuer’s responsibility: 1.08

- Undertaking: 2.01/2.05

- Capable of amendment: 3.09

- ISP 98 also contains rules in the event of dis-honour (5.01), notice of which must be timely – more than 7 days being unreasonable

- STANBY can transfer ISP 98 DIFFER WITH UCP 600: they may not be partially transferred but may be transferred more than once (6.02)

A comparision bw standby LCs AND demand of guarantees

Foreign Exchange Risk Management

Nikken has sold Internet servers to TE company for EUR 700,000 Payment in due in three months and will be made with bank’s acceptance commission 1% per annum of the face value and discount rate 4%/annum

1 What is the annualized percentage all-in cost in EUR of this method of trade financing?

2 Assume that Nikken prefers to receive USD rather than EUR for trade transaction It is considering two alternatives: (1) Sell the acceptance for EUR at once and covert the EUR immediately to USD at spot rate: $1/EUR

(2) Hold the EUR acceptance until maturity but at the start sell the expected EUR proceeds forward for USD 3months forward rate $1.02/EUR

a What are the USD net proceeds received at once from the discounted trade acceptance in alternative 1?

b What are the USD net proceeds received in 3 months in alternative 2?

c Which alternative should Nikken choose?