DESCRIPTION
To describe the methods of payment for international trade;To explain common trade finance methods;To describe the major agencies that facilitate international trade with export insurance and/or loan programs.To explain why MNCs consider long-term financing in foreign currencies;To explain how the assessment of long-term financing in foreign currencies can be adjusted for bonds with floating interest rates.To explain why MNCs consider short term foreign financing;To illustrate the possible benefits of financing with a portfolio of currencies.
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Chapter 1919 - *
To explain common trade finance methods;
To describe the major agencies that facilitate international trade
with export insurance and/or loan programs.
To explain why MNCs consider long-term financing in foreign
currencies;
To explain how the assessment of long-term financing in foreign
currencies can be adjusted for bonds with floating interest
rates.
To explain why MNCs consider short term foreign financing;
To illustrate the possible benefits of financing with a portfolio
of currencies.
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In any international trade transaction, credit is provided by
either
the supplier (exporter),
the buyer (importer),
any combination of the above.
The form of credit whereby the supplier funds the entire trade
cycle is known as supplier credit.
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Method : Prepayments
The goods will not be shipped until the buyer has paid the
seller.
Time of payment : Before shipment
Goods available to buyers : After payment
Risk to exporter : None
Risk to importer : Relies completely on exporter to ship goods as
ordered
Payment Methods
Method : Letters of credit (L/C)
These are issued by a bank on behalf of the importer promising to
pay the exporter upon presentation of the shipping documents.
Time of payment : When shipment is made
Goods available to buyers : After payment
Risk to exporter : Very little or none
Risk to importer : Relies on exporter to ship goods as described in
documents
Payment Methods
Method : Drafts (Bills of Exchange)
These are unconditional promises drawn by the exporter instructing
the buyer to pay the face amount of the drafts.
Banks on both ends usually act as intermediaries in the processing
of shipping documents and the collection of payment. In banking
terminology, the transactions are known as documentary
collections.
Payment Methods
Goods available to buyers : After payment
Risk to exporter : Disposal of unpaid goods
Risk to importer : Relies on exporter to ship goods as described in
documents
Payment Methods
Method : Drafts (Bills of Exchange)
Sight drafts (documents against payment) : When the shipment has
been made, the draft is presented to the buyer for payment.
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Goods available to buyers : Before payment
Risk to exporter : Relies on buyer to pay
Risk to importer : Relies on exporter to ship goods as described in
documents
Payment Methods
Method : Drafts (Bills of Exchange)
Time drafts (documents against acceptance) : When the shipment has
been made, the buyer accepts (signs) the presented draft.
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Method : Consignments
The exporter retains actual title to the goods that are shipped to
the importer.
Time of payment : At time of sale by buyer to third party
Goods available to buyers : Before payment
Risk to exporter : Allows importer to sell inventory before paying
exporter
Risk to importer : None
Method : Open Accounts
The exporter ships the merchandise and expects the buyer to remit
payment according to the agreed-upon terms.
Time of payment : As agreed upon
Goods available to buyers : Before payment
Risk to exporter : Relies completely on buyer to pay account as
agreed upon
Risk to importer : None
Trade Finance Methods
Accounts Receivable Financing
An exporter that needs funds immediately may obtain a bank loan
that is secured by an assignment of the account receivable.
Factoring (Cross-Border Factoring)
The accounts receivable are sold to a third party (the factor),
that then assumes all the responsibilities and exposure associated
with collecting from the buyer.
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Letters of Credit (L/C)
These are issued by a bank on behalf of the importer promising to
pay the exporter upon presentation of the shipping documents.
The importer pays the issuing bank the amount of the L/C plus
associated fees.
Commercial or import/export L/Cs are usually irrevocable.
Trade Finance Methods
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Sometimes, the exporter may request that a local bank confirm
(guarantee) the L/C.
Trade Finance Methods
Letters of Credit (L/C)
The required documents typically include a draft (sight or time), a
commercial invoice, and a bill of lading (receipt for
shipment).
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Variations include
standby L/Cs : funded only if the buyer does not pay the seller as
agreed upon
transferable L/Cs : the first beneficiary can transfer all or part
of the original L/C to a third party
assignments of proceeds under an L/C : the original beneficiary
assigns the proceeds to the end supplier
Trade Finance Methods
Banker’s Acceptance (BA)
This is a time draft that is drawn on and accepted by a bank (the
importer’s bank). The accepting bank is obliged to pay the holder
of the draft at maturity.
If the exporter does not want to wait for payment, it can request
that the BA be sold in the money market. Trade financing is
provided by the holder of the BA.
Trade Finance Methods
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In general, all-in-rates are lower than bank loan rates. They
usually fall between the rates of short-term Treasury bills and
commercial papers.
Trade Finance Methods
Banker’s Acceptance (BA)
The bank accepting the drafts charges an all-in-rate (interest
rate) that consists of the discount rate plus the acceptance
commission.
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Working Capital Financing
Banks may provide short-term loans that finance the working capital
cycle, from the purchase of inventory until the eventual conversion
to cash.
Trade Finance Methods
Medium-Term Capital Goods Financing (Forfaiting)
The importer issues a promissory note to the exporter to pay for
its imported capital goods over a period that generally ranges from
three to seven years.
The exporter then sells the note, without recourse, to a bank (the
forfaiting bank).
Trade Finance Methods
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Countertrade
These are foreign trade transactions in which the sale of goods to
one country is linked to the purchase or exchange of goods from
that same country.
Common countertrade types include barter, compensation (product
buy-back), and counterpurchase.
The primary participants are governments and MNCs.
Trade Finance Methods
19 - *
Due to the inherent risks of international trade, government
institutions and the private sector offer various forms of export
credit, export finance, and guarantee programs to reduce risk and
stimulate foreign trade.
Agencies that Motivate International Trade
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Export-Import Bank of the U.S. (Ex-Imbank)
This U.S. government agency aims to create jobs by financing and
facilitating the export of U.S. goods and services and maintaining
the competitiveness of U.S. companies in overseas markets.
It offers guarantees of commercial loans, direct loans, and export
credit insurance.
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Private Export Funding Corporation (PEFCO)
PEFCO is a private corporation that is owned by a consortium of
commercial banks and industrial companies.
In cooperation with Ex-Imbank, PEFCO provides medium- and long-term
fixed-rate financing for foreign buyers through the issuance of
long-term bonds.
Agencies that Motivate International Trade
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Overseas Private Investment Corporation (OPIC)
OPIC is a U.S. government agency that assists U.S. investors by
insuring their overseas investments against a broad range of
political risks.
It also provides financing for overseas businesses through loans
and loan guaranties.
Agencies that Motivate International Trade
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Long-Term Financing Decision
Since MNCs commonly invest in long-term projects, they rely heavily
on long-term financing.
Once the capital structure decision has been made, the MNC must
consider the possible sources of equity or debt, and the costs and
risks associated with each source.
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private placement to home country financial institutions
private placement to host country financial institutions
Many MNCs obtain equity funding in their home country, and engage
in debt financing in foreign countries.
Long-Term Financing Decision
Cost of Debt Financing
The cost of debt financing depends on the quoted interest rate and
the changes in the exchange rate of the borrowed currency over the
life of the loan.
To estimate the cost, an MNC needs to:
determine the amount of funds needed,
forecast the issue price of the bond, and
forecast the exchange rates for the times when it has to pay the
bondholders.
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Cost of Debt Financing
If the borrowed currency appreciates over time, an M NC will need
more funds to cover the coupon or principal payments.
The potential savings from issuing lower-yield bonds denominated in
a foreign currency should be weighed against the potential risk of
incurring high costs if the borrowed currency appreciates over
time.
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Offsetting cash inflows
Foreign currency receipts can help offset bond payments in the same
currency.
In particular, an MNC can aggregate its cash inflows from all
euro-zone countries to cover the payments for its euro-denominated
bonds.
When issuing bonds in a foreign currency, the exchange rate is very
important.
The exchange rate risk from financing with bonds in foreign
currencies can be reduced in various ways.
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Forward contracts
A firm may hedge its exchange rate risk through the forward
market.
However, the firm may not be able to save costs due to interest
rate parity.
Currency swaps
A currency swap enables firms to exchange currencies at periodic
intervals.
It can be a useful alternative to forward or futures
contracts.
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Euro
Payments
Dollar
Payments
Parallel loans
In a parallel (or back-to-back) loan, two parties simultaneously
provide loans to each other (or to a subsidiary of the other party)
with an agreement to repay at a specified point in the
future.
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Subsidiary of
Diversifying among currencies
A firm may issue bonds in several foreign currencies for
diversity.
To avoid the higher transaction costs associated with multiple bond
issues, the firm may develop a currency cocktail bond.
One popular currency cocktail is the Special Drawing Right
(SDR).
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Interest Rate Risk from Debt Financing
An MNC must also decide on the maturity that it should use for its
debt.
If the bond term is too short, the MNC may have to refinance at a
higher interest rate.
However, if the bond term matches the expected business life, the
MNC is obligated to continue paying interest at the same rate even
when market interest rates fall.
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The Debt Maturity Decision
Before making the debt maturity decision, MNCs may want to assess
the yield curves of the countries in which they need funds.
A yield curve is shaped by the demand for and supply of funds at
various maturity levels in a country’s debt market.
An upward-sloping yield curve means that the annualized yields are
lower for short-term debt than for long-term debt.
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The Fixed versus Floating Rate Decision
MNCs that wish to issue a long-term bond but want to avoid the
prevailing fixed rate may consider floating rate bonds.
For example, the coupon rate is frequently tied to the London
Interbank Offer Rate (LIBOR).
If the coupon rate is floating, forecasts are required for both
exchange rates and interest rates.
19 - *
Hedging with Interest Rate Swaps
When MNCs issue floating-rate bonds that expose them to interest
rate risk, they may use interest rate swaps to hedge the
risk.
Interest rate swaps enable a firm to exchange fixed rate payments
for variable rate payments, and vice versa.
Bond issuers use swaps to reconfigure their future cash flows in a
way that offsets their payments to bondholders.
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Hedging with Interest Rate Swaps
Financial intermediaries are usually involved in swap agreements.
They match up participants and also assume the default risk
involved for a fee.
In a plain vanilla swap, the floating rate payer is typically
highly sensitive to interest rate changes and seeks to reduce
interest rate risk.
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Quality Company
Variable Rate
Payments at
LIBOR+1%
Investors in
Quality Company
Fixed Rate
Swap payments are typically determined using a notional value
contractually agreed upon by the parties to the swap.
Only the net amount owed is paid.
Quality Co.’s Risky Co.’s
LIBOR Payment Payment Net Payment
8.0% 8.5% $50m 9.5% $50m Risky pays
= $4.25m = $4.75m Quality $.5m
= $4.75m = $4.75m is made
= $5.25m = $4.75m Risky $.5m
Continuing financial innovation has resulted in a number of
variations:
Accretion swap – increasing notional value
Amortizing swap – decreasing notional value
Basis (floating-for-floating) swap
Putable swap
Zero-coupon swap
The International Swaps and Derivatives Association (ISDA) is
frequently credited with the swap market’s standardization.
The ISDA is a global trade association representing leading
participants in the privately negotiated derivatives
industry.
It developed the Master Agreement and pioneered efforts to identify
and reduce risk sources in the derivatives and risk management
business.
Hedging with Interest Rate Swaps
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Short-term notes
Euronotes are unsecured debt securities with typical maturities of
1, 3 or 6 months. They are underwritten by commercial banks.
Interest rate on these notes are based on LIBOR
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Commercial papers
MNCs may also issue Euro-commercial papers to obtain short-term
financing. These are unsecured short term securities and can also
be repurchased before maturity.
Bank loans
MNCs utilize direct Eurobank loans to maintain a relationship with
Eurobanks too.
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Internal Financing by MNCs
Before an MNC’s parent or subsidiary searches for outside funding,
it should determine if any internal funds are available.
Parents of MNCs may also raise funds by increasing their markups on
the supplies that they send to their subsidiaries.
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Foreign Financing
An MNC may finance in a foreign currency to offset a net
receivables position in that foreign currency.
An MNC may also consider borrowing foreign currencies when the
interest rates on such currencies are attractive, so as to reduce
financing costs.
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The actual cost of financing depends on
the interest rate on the loan, and
the movement in the value of the borrowed currency over the life of
the loan.
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1 year later
for 1 year
At time t
rf = (1 + if )(1 + ef ) – 1
where if = the foreign currency interest rate
ef = the % in the foreign currency’s
spot rate
Foreign Financing
There are various criteria an MNC must consider in its financing
decision, including
interest rate parity,
exchange rate forecasts.
Interest Rate Parity (IRP)
If IRP holds, foreign financing with a simultaneous hedge of that
position in the forward market will result in financing costs that
are similar to those for domestic financing.
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The Forward Rate as a Forecast
If the forward rate is an unbiased predictor of the future spot
rate, then the effective financing rate of a foreign loan will on
average be equal to the domestic financing rate.
Criteria Considered for
Exchange Rate Forecasts
Firms may use exchange rate forecasts to forecast the effective
financing rate of a foreign currency, or they may compute the
break-even exchange rate that will equate the domestic and foreign
financing rates.
Sometimes, it may be useful to develop probability distributions,
instead of relying on single point estimates.
Criteria Considered for
Financing with a
Portfolio of Currencies
While foreign financing can result in significantly lower financing
costs, the variance in costs over time is higher.