financing of foreign trade

1. Module 5
Financing Foreign Trade
Financing of Foreign trade
Interest and currency risk
Risk Management
Tools for Risk Management
Hedging & Hedging Instruments
 International Investment Strategies

2. Trade Cycle in Foreign Trade
Importer
Exporter
The Transaction over Time
Contract
Production
Land Transport
Port of Departure Sea Transport
Port of Destination
Customs!
Land Transport
and Delivery
Final Payment
Types of Risk
1. Preshipment 2. Shipment 3. Postshipment

3. Payment Terms In Foreign Trade
Four Principal Means of Payment:
 Cash in advance
 Letter of Credit
 Documentary Acceptance
 Open Account

4. Short Term Financing of Foreing
Trade
Basically there are 4 types of financing foreing trade.
 Banker’s Acceptance
 Discounting
 Factoring
 Forfaiting

5. Bankers’ Acceptances
 Creation: drafts acceptance
 Terms: Payable at maturity to holder
Discounting
 Converts exporters’ drafts to cash minus
interest to maturity and commissions.
 Low cost financing with low fees.
 May be with (exporter still liable) or without
recourse (bank takes liability for nonpayment).

6. Factoring
Firms sell accounts receivable to another firm
known as the factor.
 Discount charged by factor
 Non-recourse basis: Factor assumes all payment
risk.
Application of this Method:
 Occasional exporting.
 Clients geographically dispersed.

7. Forfaiting
 Discounting at a fixed rate without recourse for
medium-term accounts receivable.
 Use: Large capital purchases
 Most popular in W. Europe

8. Risk in Foreign Trade
 Risk in Foreign Trade is broadly classified into two types:
Exchange Rate Risk
Interest Rate Risk

9. Risk in Foreign Trade
 Exchange Rate Risk means eventual losses that could be incurred
by the enterprises due to adverse movements of exchange rates
between the dates of contract and payment.
 ERR does not imply that there would be always losses, gains may
also accrue if the movements of rates is favourable.
 Eg: In 1985, appreciation of Dollar, benefit for exporter & loss
for importer.
In 1995 depreciation of Dollar, benefit for importer & loss for
exporter

10. Types of Exchange Rate Risk
MNC’s are subjected to the following three types of
risks exposure.
 Transaction Exposure
 Consolidation(Translation) Exposure
 Economic Exposure

11. Types of Exchange Rate Risk
 Transaction Exposure:
Transaction Exposure arise on account of commitment to pay or
receive foreign currency at a future date, and any movement in the
exchange rate will affect the domestic value of the transaction.
Transaction could be the trade transaction or banking & financial
transaction.
Transaction Exposure is a form of short term economic exposure
due to fixed price contracting in an atmosphere of exchange-rate
volatility

12. Types of Exchange Rate Risk
 Consolidation(Translation) Exposure:
Consolidation Exposure arise as a result from direct(joint ventures)
or indirect investment (portfolio participation) in foreign countries.
When balance sheets are consolidated, the value of assets
expressed in the national currency varies as a function of the
variation of the currency of the country where investment was
made.
Responsibility of corporate finance manager is high as he is
expected to Managing Assets & Liabilities in the light of fluctuating
exchange rate in a way that stick to budgeted level of profits and
cash-flow.

13. Types of Exchange Rate Risk
 Economic Exposure:
Economic Exposure is not a direct foreign exchange risk exposure.
It refers to the change in expected cash flows as a result of an
unexpected change in exchange rates.
Economic exposure is the extent to which a firm's market value, in
any particular currency, is sensitive to unexpected changes in
foreign currency.
Economic risks cannot be quantified, managed as they are not
reported in accounts.
Economic Exposure are unhedgable.

14. Interest Rate Risk
 Risk emanating from a loan contracted at a higher or floating rate
linked to base lending rate by an enterprise, a bank or an
insurance company is referred as interest rate risk.
 Interest rate risk results from a mismatch of maturity of assets
and liabilities respectively.
 MNC’s are subjected to interest rate risk on their
lending/borrowing operations.
 Interest rate risk results into an increase in financial charge on
borrowing or into a capital loss on bonds.
 Instruments like future & options are designed to cover interest
rate risk.

15. Foreign Exchange Risk Management
 The process of identifying risks faced by the firm
and implementing the process of protection from
these risks by financial or operational hedging is
defined as foreign exchange risk management.
 Tools for managing Risk:
 Forecasts
 Risk Estimation
 Benchmarking
 Hedging
 Stop Loss
 Reporting and Review

17. Hedging
 Hedging means reducing or controlling risk
by taking a position in the futures market
that is opposite to the one in the physical
market with the objective of reducing or
limiting risks associated with price
changes.
IOW
 Taking a buy or sell position in a futures
market opposite to a position held in the
cash market to minimize the risk of

20. Hedging Instruments
 A derivative is a financial contract whose value is
derived from the value of some other financial asset,
such as a stock price, a commodity price, an
exchange rate, an interest rate, or even an index of
prices.
 The main role of derivatives is that they reallocate risk
among financial market participants, help to make
financial markets more complete.
 Hedging tools to hedge foreign exchange risk.
 Forwards
 Futures
 Options
 Swaps

22. How hedging is done?
 In this type of transaction, the hedger tries to fix the price
at a certain level with the objective of ensuring certainty in
the cost of production or revenue of sale.
Example - Case of steel
An automobile manufacturer purchases huge
quantities of steel as raw material for automobile
production. The automobile manufacturer enters into
a contractual agreement to export automobiles three
months hence to dealers in the East European market.
This presupposes that the contractual obligation has
been fixed at the time of signing the contractual
agreement for exports. The automobile manufacturer
is now exposed to risk in the form of increasing steel
prices. In order to hedge against price risk, the
automobile manufacturer can buy steel futures
contracts, which would mature three months hence.

23. Example
 if RIL wants to buy crude oil in US dollars six months hence,
it can enter into a forward contract to pay INR and buy USD
and lock in a fixed exchange rate for INR-USD to be paid
after 6 months regardless of the actual INR-Dollar rate at the
time.
 In this example the downside is an appreciation of Dollar
which is protected by a fixed forward contract.
 The main advantage of a forward is that it can be tailored to
the specific needs of the firm and an exact hedge can be
obtained.
 On the downside, these contracts are not marketable, they
can’t be sold to another party when they are no longer
required and are binding.

24. Hedging Tool - Futures
 A futures contract is similar to the forward contract
but is more liquid.
 It is a contractual agreement, made only on the
trading floor of a futures exchange, to buy or sell a
particular commodity, financial instrument, etc, at a
pre-determined price in future.
 Depreciation of a currency can be hedged by selling
futures and appreciation can be hedged by buying
futures.
 Some futures contracts may call for physical
delivery of the asset, while others are settled in
cash.
 Futures require a small initial outlay (a proportion of
the value of the future) with which significant

25. The previous example for a forward contract for
RIL applies here also;
 RIL will have to go to a USD futures exchange
to purchase standardized dollar futures equal
to the amount to be hedged as the risk is that
of appreciation of the dollar.
 Tailorability of the futures contract is limited
i.e. only standard denominations of money
can be bought instead of the exact amounts
that are bought in forward contracts.

37. Summary of the topic
 Financing of Foreign trade
 Interest and currency risk
 Risk Management
 Tools for Risk Management
 Hedging & Hedging Instruments
 International Investment Strategies