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Chapter 20

International
Trade Finance

Copyright 2009 Pearson Prentice Hall. All rights reserved.

International Trade Finance:


Learning Objectives
Learn how international trade alters both the supply
chain and general value chain of the domestic firm,
thereby beginning the globalization process in the trade
phase
Consider what the key elements in an import or export
transaction are in business
Discover how the three key documents in import-export
the letter of credit, the draft, and the bill of lading
combine to finance the transaction and to manage its
risks

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International Trade Finance:


Learning Objectives
Identify what the documentation sequence is for a
typical international trade transaction
Learn how the various stages and their costs affect the
ability of an exporter to enter a foreign market and
potentially compete in both credit terms and pricing
See what organizations and resources are available for
exporters to aid in managing trade risk and financing
Examine the various trade financing alternatives

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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
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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

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Exhibit 20.1 Financing Trade: The


Flow of Goods and Funds

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Exhibit 20.2 Alternative


International Trade Relationships

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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?

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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
banks promise to pay on its behalf, knowing the exporter will trust the
bank
When the exporter ships the merchandise to the importers 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
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Exhibit 20.3 The Mechanics of


Import and Export

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Exhibit 20.4 The Bank as the


Import-Export Intermediary

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Exhibit 20.5 The Trade Transaction


Timeline and Structure

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Letter of Credit (L/C)


Letter of Credit (L/C) is a banks 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
Banks L/C must contain specified maturity date
Banks commitment must have stated maximum amount
Banks obligation must arise only on presentation of specific documents
and bank cannot be called on for disputed items
Banks customer must have unqualified obligation to reimburse bank on
same condition of banks payment
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Letter of Credit (L/C)


Commercial L/Cs 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

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Exhibit 20.6
Parties to a Letter of Credit (L/C)

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Exhibit 20.7
Essence of a Letter of Credit (L/C)

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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 buyers bank when it is called a bank
draft

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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

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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 bankers
acceptance
When drawn on a business firm it becomes a trade acceptance

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Bankers Acceptances
Bankers Acceptance
When a draft is accepted by a bank, it becomes a bankers
acceptance
Example: Acceptance of $100,000 for exporter
Face amount of acceptance

$100,000

Less 1.5% p.a. commission for 6 months

Amount received by exporter in 6 months

$ 99,250

Less 7% p.a. discount rate for 6 months

Amount received by exporter at once

$95,750

750

3,500

Exporter may discount the acceptance note in order to receive


the funds up-front
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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

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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

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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 buyers 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 (Tridents bank)

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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

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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 bankers 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

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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

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Exhibit 20.8 Steps in a Typical


Trade Transaction

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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
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Government Programs to Help


Finance Exports
Export Credit Insurance
Provides assurance to the exporter or the exporters 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

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Trade Financing Alternatives


In order to finance international trade receivables, firms
use the same financing instruments as they use for
domestic trade receivables including;

Bankers Acceptances
Trade Acceptances
Factoring
Securitization
Bank Credit Lines Covered by Export Credit Insurance
Commercial Paper

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Exhibit 20.9 Instruments for Financing


Short-Term Domestic and International
Trade Receivables

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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
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Exhibit 20.10
Typical Forfaiting Transaction

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Summary of Learning Objectives


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

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Summary of Learning Objectives


Over many years, established procedures have arisen to
finance international trade. The basic procedure rests on
the interrelationship between three key documents, the
L/C, the draft, and the bill of lading
Variations in each type of the three documents provide
a variety of ways to accommodate any type of
transaction
In the simplest transaction, in which all three
documents are used, an importer applies for and
receives a L/C from its bank
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Summary of Learning Objectives


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,
attaches the bill of lading to a draft ordering payment
from the importers bank and presents these documents,
plus any additional documents, through its own bank to
the importers bank

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Summary of Learning Objectives


If the documents are in order, the importers 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 importers 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 a bankers acceptance, back from the bank
and holds it until maturity or sells it at a discount
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Summary of Learning Objectives


Total costs of an exporter entering a foreign market
include the transaction costs of trade financing,
import/export duties and the costs of foreign market
penetration which includes distribution, inventory and
transportation expenses
Export credit insurance provides assurance to exporters
that insurance will pay should importer default
In the US, the Foreign Credit Insurance Association
provides this insurance
The Ex-Im bank is an independent agency established
to stimulate and facilitate the foreign trade of the US
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Summary of Learning Objectives


Trade financing uses the same financing instruments as
in domestic receivables financing, plus some
specialized instruments that are only available for
financing international trade
A popular instrument for short-term financing is a
bankers acceptance; its all-in-cost being comparable to
other money market instruments such as marketable
bank certificates of deposit
Other short-term financing instruments with a domestic
counterpart are trade acceptances
Forfaiting is an international trade technique that can
provide medium and long-term financing
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