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 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 Cash received Inventory sold Inventory purchased Inventory period Accounts receivable period Time Accounts payable period Cash paid for inventory Operating cycle (OC) Cash Conversion Cycle (CCC) Financing of international trade Trade Credit credit granted from one 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 – Net Period - No Cash Discount when credit is 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 Some customers will pay on day 10 and take the discount $970 10 30 Other customers will pay on day 30 and forgo the discount $1,000 10 30 A customer that forgoes the 3% discount to pay on day 30 is borrowing $970 for 20 days and paying $30 interest: -$1,000 +$970 10 $970 r 30 $1,000 (1 r ) 20 365 $1,000 $970 365 20 (1 r ) 20 365 $1,000 $970 0.7435 74.35% 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 • The only cash flow of the first strategyQ0 ( P0 C0 ) is • The expected cash flows of the credit strategy are: ’ ’ h Q0’ P0’ C0 Q0 We incur costs up front… …and get paid in 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 No Credit 1.000 $500 $400 100% Quantity sold Selling price Unit cost Probability of payment Credit period (days) Discount rate p.a The NPV of cash only: 1,000 ($500 $ 400) Net 45 1.300 $500 $425 95% 30 10% $ 100,000 The NPV of Net 30: 1,300 $425 1,300 $500 0.95 (1.10)30 / 365 $60,181.58 Bershire Sport, Incs., operates a mail-order running shoe business Management is considering dropping its policy of no credit The credit policy under consideration by Bershire follows: unit price cost per unit quantity sold probability payment credit period discount rate No credit $45 $35 2000 100% 0% credit $50 $42 3000 95% 2% 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: $100,000 1,300 $425 1,300 P0’ 0.95 (1.10) 30 / 365 ($100,000 1,300 $425) (1.10)30 / 365 1,300 P0’ 0.95 P0’ ($100,000 1,300 $425) (1.10) 30 / 365 1,300 0.95 $532.50 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 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 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 Exercise 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 % What amount will the exporter receive if he holds the B/A until maturity? 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 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 months If Jackson Inc chooses to discount or sell the bankers acceptance to its bank, the discount rate is 1.00% per annum What is the size of the commission Jackson Automotive will pay the bank for the banker’s acceptance? What is the total Jackson Automotive can expect to receive if the firm takes payment today? 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 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: 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 The ICC guidelines for guarantees is: UCP 600 URDG 758 URC 522 Incoterms 2010 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 preagreed 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 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 What is the annualized percentage all-in cost in EUR of this method of trade financing? 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 Question: 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 months in alternative 2? c Which alternative should Nikken choose? ... 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... 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... 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