This document discusses export financing options available to exporters in India. It describes pre-shipment financing, which provides working capital to purchase raw materials, process goods, and prepare for export. Post-shipment financing is also described, which provides credit after goods have been shipped until payment is received. Specific financing products like packing credit, clean packing credit, and running account facilities are explained. Requirements, periods of advance, and liquidation of pre-shipment credit are outlined. Financing of service exports is also briefly covered.

1. MIB 3.6 export financing
EXPORT
financing

2. •Export
FIANCING

3. Export Financing
Exporters naturally want to get paid as quickly as
possible, while importers usually prefer to
delay payment until they have received the
goods. Because of the intense competition for
export markets, being able to offer attractive
payment terms customary in the trade is often
necessary to make a sale. Exporters should be
aware of the many financing options open to
them so that they choose the most acceptable
one to both the buyer and the seller.

4. Export credit can be broadly classified into
• Pre-shipment finance and
• post shipment finance.
• Preshipment
finance refers to finance extended to
purchase, processing or packing of goods
meant for exports
• Financial assistance extended after the shipment of
exports falls within the scope of post
shipment finance

5. PACKING CREDIT
• As loan or cash credit against pledge or hypothecation.
• Verification of Exporter-Importer Code No. issued by
DGFT.
• Party should not be in the RBI Caution
list or ECGC Special Approval List.
• Export is not to a listed country
• Verify order/LC
• Up-to date knowledge of export policy
• Commodity should not be in the negative list.
• Commodity should have a good market
• Terms of contract
• No FEMA violation
• Borrower should be credit worthy.

6. • Working capital may be defined as funds required
to carry the required level of Current
assets to enable the industry to carry
on its operations at the expected levels
uninterruptedly..
• The guidelines set by Nayak Committee for
computation of WrkCptl finance quantum for
village, tiny and other SSI industries
to a minimum extent of 20% of Projected/
Accepted Turnover to continue Guidelines
with regard to specific activities / industries / situa
tions to continue (Sugar / tea
industries, Rehabilitation cases, Export Financing
etc.) Banks
may consider Cash Flow approach of financing
in order to close the gap between

7. Quantum of finance:
• FOB value of goods minus profit and credit
margin
Cost of production less margin (can be
more if the domestic cost is more
than the FOB value and the difference
is accounted as incentives like duty draw-back
etc. subject to export production finance
guarantee of ECGC).
• In the case of exports on CIF value basis PC
can be granted towards insurance and freight also
• Period of finance: to coincide
with the date for shipment and normally up
to 180 days

8. Clean Packing Credit
• Granted to credit worthy parties where advance
payment is required to be made to the supplier.
• Quantum determined based on the likely purchase
pattern of the exporter with their suppliers.
• Period of CPC is determined based on the
facts of each case (but not later
than the period of contract /LC.
• A higher margin of say 25% should be stipulated,
collected each time and remitted along with PC to
the supplier.
• CPC should be converted as PC or Bills

9. EXPORT FINANCE
• PRE SHIPMENT finance : Deals with the
finance schemes available before the
shipment has been made.
• POST SHIPMENT finance : on the
contrary deals with credit available after
the goods have shipped.
Both stages are crucial for the exporter

10. Pre-shipment finance
• PSF.. Offer liquidity to the
exporter to produce raw
materials, carry out
processing, packing,
transporting and warehousing
of the goods to be exported.

11. • Pre-Export Finance: provision of funds to
cover the period between signing of purchase
orders and payment (short-term, working
capital)
• –Pre-export finance typically covers:
• Cost of inland transport to port
• Purchase of raw materials for processing
• Cost of processing
• Storage costs

12. Illustrative procedure (commodities)
• Exporter provides title to or pledges products to bank
• –Products that have yet to be produced
• –Products that have been produced (warehouse
receipt)
• Bank provides credit facility
• Payment
• –Trader takes delivery
• –Bank receives payment directly from buyer
• »Escrow account
• »Evidence account

13. Methods of Pre-Export Finance
• Open Account: –Exporter ships goods without any guarantee of
payment, thereby financing importer
–Risk of transaction dependent on relationship/importer integrity.
• Documentary letter of credit (see UCC Art. 5 and UCP 500): Letter
from bank, addressed to exporter, in which bank promises to pay or accept
drafts if exporter conforms 100% to conditions within the letter.
• Three parties:
• –Issuer: the issuing bank
• –Account party (importer)
• –Beneficiary (exporter)
• •Three agreements
• –Trade contract between importer and exporter
• –Documentary credit between bank and exporter
• –Reimbursement agreement between bank and importer

14. Documentary Letter of credit
Revocable/Irrevocable
• –A revocable letter of credit can be cancelled or amended by the issuing
bank; the bank does not need the exporter/beneficiary’s consent.
Confirmed/Unconfirmed
• –Issuing bank forwards letter of credit to exporter’s bank
• –Exporter’s bank promises to pay exporter (confirms l/c)
• –In an unconfirmed transaction, the advising bank acts as the issuing
bank’s agent and bears no obligation to exporter
Back-to-back
• –Typically used by brokers, the letter of credit allows the beneficiary to
assign its rights in one letter of credit to the issuer of a second letter of
credit
• –Both letters of credit must require identical documents
Transferable
• –The original beneficiary can transfer the letter of credit to third parties

15. Documentary Letter of credit
• Revolving
• –Typically used in construction contracts
• –Allows beneficiary to draw on the letter of credit, up to a certain
amount, usually without presentation of documents
• –The account party replenishes the account
“Red clause” letter of credit
• –Exporter can use to obtain pre-shipment finance by providing either (i)
a statement of purpose or (ii) an undertaking to provide specified
documents.
• –Issuing bank provides exporter with a percentage of the L/C amount
• –Advising bank guarantees reimbursement
“Green clause” letter of credit
• –Similar to “red clause” letters of credit, but pre-shipment finance is
contingent upon the production of warehouse receipts…

16. Letter of credit Settlement
Sight payment (sight draft)
• –Exporter presents documents and receives payment
Deferred payment (dated draft)
• –Exporter presents documents and receives payment at some
specified future time
Acceptance (time draft)
• –Exporter (i) presents documents and (ii) draws a usance draft
• –Bank accepts bill of exchange for payment on a future date
Negotiation
• –Exporter may choose a bank and negotiate the payment of a
sight or usance draft
• –Bank will either:
• »Advance payment with recourse to the exporter
• »Advance payment less a fee (discount)
• »Pay exporter when issuing bank provides payment

17. Post shipment Finance
• Provides credit facility from the date
shipment of the goods to the time
export payment is realized
( expenses between period of
shipment dispatch and payment
realisation…

18. Export Finance –Post-Export
-Post-Export Finance (medium/long-term)
Post-Export finance typically covers:
• Account receivables
• equipment
• Other fixed assets
–Methods of Post-Export Finance
• Revolving line of credit
• Term loan
• Finance accounts receivable

19. Methods of Post-Export Finance
Finance account receivables
–Typically used in two instances
• Undercapitalized company with permanent financing
need
• Temporary insufficient cashflow
–Banks provide loan secured by:
• Assignment of receivables
• Assignment of commodity inventory
–Loan
• Made on a revolving basis against a pool of receivables
–Borrower
• Responsible for collecting from customers
• Responsible for 100% loan repayment despite inability to
collect from customers

20. Export Finance –Forms of Risk
Commercial risk
•The risk that either party will not fulfill its obligations
Transportation risk
•The risk that goods become damaged or destroyed
during transport
Exchange risk
• The risk that currency fluctuations will affect the
value of the transaction
Political risk
• •The risk that government policy changes, wars,
embargoes, etc., will prevent the conclusion or affect
the value of the transaction

21. Indian Case study ; RBI sources !
• PRE-SHIPMENT EXPORT CREDIT, Definition:
…any loan or advance granted or any other credit provided by a
bank to an exporter for financing the purchase, processing,
manufacturing or packing of goods prior to shipment / working
capital expenses towards rendering of services on the basis of
letter of credit opened in his favour or in favour of some other
person, by an overseas buyer or a confirmed and irrevocable
order for the export of goods / services from India or any other
evidence of an order for export from India having been placed on
the exporter or some other person, unless lodgement of export
orders or letter of credit with the bank has been waived.

22. Period of Advance
The period for which a packing credit advance may be
given by a bank will depend upon the circumstances
of the individual case, such as the time required for
procuring, manufacturing or processing (where
necessary) and shipping the relative goods /
rendering of services.
It is primarily for the banks to decide the period for which a
packing credit advance may be given, having regard to the
various relevant factors so that the period is sufficient to
enable the exporter to ship the goods / render the services

23. • If pre-shipment advances are not
adjusted by submission of export
documents within 360 days from the
date of advance, the advances will
cease to qualify for concessive rate of
interest to the exporter ab initio.
• RBI would provide refinance only for a
period not exceeding 180 days.

24. Disbursement of Packing Credit
Banks may also maintain different
accounts at various stages of processing,
manufacturing, etc. depending on the
types of goods / services to be exported,
e.g. hypothecation, pledge, etc.,
accounts and may ensure that the
outstanding balance in accounts are
adjusted by transfer from one account to
the other and finally by proceeds of
relative export documents on purchase,
discount, etc.

25. Banks should continue to keep a close
watch on the end-use of the funds and
ensure that credit at lower rates of
interest is used for genuine
requirements of exports. Banks should
also monitor the progress made by the
exporters in timely fulfillment of
export orders.

26. Liquidation of Packing Credit
The packing credit / pre-shipment credit granted
to an exporter may be liquidated out of
proceeds of bills drawn for the exported
commodities on its purchase, discount etc.,
thereby converting pre-shipment credit into
post-shipment credit. Further, subject to
mutual agreement between the exporter and
the banker it can also be repaid / prepaid out
of balances in Exchange Earners Foreign
Currency Account ( EEFC A/c ) as also from
rupee resources of the exporter to the extent
exports have actually taken place.

27. What is an EEFC Account and what are its benefits?
Exchange Earners' Foreign Currency Account
(EEFC) is an account maintained in foreign
currency with an Authorised Dealer i.e. a bank
dealing in foreign exchange. It is a facility
provided to the foreign exchange earners,
including exporters, to credit 50 per cent of their
foreign exchange earnings to the account, so that
the account holders do not have to convert
foreign exchange into Rupees and vice versa,
thereby minimizing the transaction costs.
Thanks to RBI

28. Running Account' Facility
In many cases, the exporters have to procure raw
material, manufacture the export product and keep
the same ready for shipment, in anticipation of
receipt of letters of credit / firm export orders from
the overseas buyers. Having regard to difficulties
being faced by the exporters in availing of adequate
pre-shipment credit in such cases, banks have been
authorized to extend Pre-shipment Credit ‘Running
Account’ facility in respect of any commodity,
without insisting on prior lodgment of letters of
credit / firm export orders, depending on the bank’s
judgment regarding the need to extend such a
facility and subject to the following conditions:

29. a) Banks may extend the ‘Running Account’ facility only to those
exporters whose track record has been good as also to Export
Oriented Units (EOUs) / Units in Free Trade Zones / Export
Processing Zones (EPZs) and Special Economic Zones (SEZs)
(b) In all cases where Pre-shipment Credit ‘Running Account’ facility has
been extended, letters of credit / firm orders should be produced
within a reasonable period of time to be decided by the banks.
(c) Banks should mark off individual export bills, as and when they are
received for negotiation / collection, against the earliest outstanding
pre-shipment credit on 'First In First Out' (FIFO) basis. Needless to
add that, while marking off the preshipment credit in the manner
indicated above, banks should ensure that concessive credit available
in respect of individual pre-shipment credit does not go beyond the
period of sanction or 360 days from the date of advance, whichever
is earlier.
(d) Packing credit can also be marked-off with proceeds of export
documents against which no packing credit has been drawn by the
exporter.

30. Export Credit against Proceeds of Cheques, Drafts, etc.
Representing Advance/ Payment for Exports
Where exporters receive direct remittances from
abroad by means of cheques, drafts, etc. in
payment for exports, banks may grant export
credit at concessive interest rate to exporters of
good track record till the realization of proceeds
of the cheque, draft etc. received from abroad,
after satisfying themselves that it is against an
export order, is as per trade practices in respect
of the goods in question and is an approved
method of realization of export proceeds as per
extant rules.

31. Rupee Export Packing Credit to Manufacturer Suppliers for Exports
Routed through STC/MMTC/Other Export Houses, Agencies, etc.
Banks may grant export packing credit to
manufacturer suppliers who do not
have export orders/letters of credit in
their own name, and goods are
exported through the State Trading
Corporation/Minerals and Metal
Trading Corporation or other export
houses, agencies, etc.

32. Requirements
(a) Banks should obtain from the export house a letter
setting out the details of the export order and the portion
thereof to be executed by the supplier and also certifying
that the export house has not obtained and will not ask for
packing credit in respect of such portion of the order as is
to be executed by the supplier.
(b) Banks should, after mutual consultations and taking into
account the export requirements of the two parties,
apportion between the two i.e. the Export House and the
Supplier, the period of packing credit for which the
concessionary rate of interest is to be charged. The
concessionary rates of interest on the pre-shipment credit
will be available up to the stipulated periods in respect of
the export house/agency and the supplier put together.

33. The export house should open inland L/Cs in favour of the supplier
giving relevant particulars of the export L/Cs or orders and the
outstandings in the packing credit account should be extinguished
by negotiation of bills under such inland L/Cs. If it is inconvenient
for the export house to open such inland L/Cs in favour of the
supplier, the latter should draw bills on the export house in
respect of the goods supplied for export and adjust packing credit
advances from the proceeds of such bills. In case the bills drawn
under such arrangement are not accompanied by bills of lading or
other export documents, the bank should obtain through the
supplier a certificate from the export house at the end of every
quarter that the goods supplied under this arrangement have in
fact been exported. The certificate should give particulars of the
relative bills such as date, amount and the name of the bank
through which the bills have been negotiated.

34. Export of Services
In view of the large number of categories of
service exports with varied nature of
business as well as in the environment of
progressive deregulation where the
matters with regard to micromanagement
are left to be decided by the individual
financing banks, the banks may formulate
their own parameters to finance the
service exporters.

35. Exporters of services qualify for working capital export credit (pre and
post shipment) for consumables, wages, supplies etc.
• The proposal is a genuine case of export of services.
• The item of service export is covered under
Appendix – 36 of the Hand Book (Vol.1)
• The exporter is registered with the Export
Promotion Council for services
• There is an Export Contract for the export of the
Service
• There is a time lag between the outlay of working
capital expense and actual receipt of payment from
the service consumer or his principal abroad.
• There is a valid Working Capital gap i.e. service is
provided first while the payment is received some
time after an invoice is raised.

36. • Banks should ensure that there is no double
financing/excess financing.
• The export credit granted does not exceed the
foreign exchange earned less the
• margins if any required, advance
payment/credit received.
• Invoices are raised
• Inward remittance is received in Foreign
Exchange.
• Company will raise the invoice as per the
contract where payment is received from
overseas party, the service exporter would utilize
the funds to repay the export credit availed of
from the bank.

37. India: POST-SHIPMENT EXPORT CREDIT
Post-shipment Credit' means any loan or
advance granted or any other credit provided
by a bank to an exporter of goods / services
from India from the date of extending credit
after shipment of goods / rendering of
services to the date of realization of export
proceeds and includes any loan or advance
granted to an exporter, in consideration of,
or on the security of any duty drawback
allowed by the Government from time to

38. Types of Post-shipment Credits:
(i)Export bills purchased/
discounted/ negotiated.
(ii) Advances against bills for
collection.
(iii) Advances against duty drawback
receivable from Government

39. Liquidation of Post-shipment Credit:
Post-shipment credit is to be liquidated by the
proceeds of export bills received from abroad in
respect of goods exported / services rendered.
Further, subject to mutual agreement between the
exporter and the banker it can also be repaid /
prepaid out of balances in Exchange Earners
Foreign Currency Account (EEFC A/C) as also from
proceeds of any other unfinanced (collection) bills.
Such adjusted export bills should however continue
to be followed up for realization of the export
proceeds and will continue to be reported in the
XOS statement.

40. Rupee Post-shipment Export Credit
• the case of demand bills, the period of advance shall be the
Normal Transit Period (NTP) as specified by FEDAI.
• In case of usance bills, credit can be granted for a maximum
duration of 365 days from date of shipment inclusive of Normal
Transit Period (NTP) and grace period, if any. However, banks
should closely monitor the need for extending post shipment credit
up to the permissible period of 365 days and they should influence
the exporters to realize the export proceeds within a shorter
period.
• Normal transit period' means the average period normally
involved from the date of negotiation / purchase / discount till the
receipt of bill proceeds in the Nostro account of the bank
concerned, as prescribed by FEDAI from time to time. It is not to be
confused with the time taken for the arrival of goods at overseas
destination.

41. Post-shipment Advances against Duty Drawback
Entitlements
• Banks may grant post-shipment advances to exporters
against their duty drawback entitlements as provisionally
certified by Customs Authorities pending final sanction
and payment.
• The advance against duty drawback receivables can also
be made available to exporters against export promotion
copy of the shipping bill containing the EGM Number
issued by the Customs Department. Where necessary,
the financing bank may have its lien noted with the
designated bank and arrangements may be made with
the designated bank to transfer funds to the financing
bank as and when duty drawback is credited by the
Customs

42. ECGC Whole Turnover Post-shipment Guarantee
Scheme
The Whole Turnover Post-shipment
Guarantee Scheme of the Export Credit
Guarantee Corporation of India Ltd. (ECGC)
provides protection to banks against non-
payment of post-shipment credit by
exporters. Banks may, in the interest of
export promotion, consider opting for the
Whole Turnover Post-shipment Policy. The
salient features of the scheme may be
obtained from ECGC.

43. DEEMED EXPORTS - CONCESSIVE RUPEE EXPORT CREDIT
Banks are permitted to extend rupee pre-
shipment and post-supply rupee export credit at
concessional rate of interest to parties against
orders for supplies in respect of projects
aided/financed by bilateral or multilateral
agencies/funds (including World Bank, IBRD,
IDA), as notified from time to time by
Department of Economic Affairs, Ministry of
Finance under the Chapter "Deemed Exports" in
Foreign Trade Policy, which are eligible for grant
of normal export benefits by Government of
India.

44. INTEREST ON EXPORT CREDIT
• A ceiling rate has been prescribed for rupee export credit
linked to Benchmark Prime Lending Rates (BPLRs) of
individual banks available to their domestic borrowers.
Banks have, therefore, freedom to decide the actual
rates to be charged within the specified ceilings. Further,
the ceiling interest rates for different time buckets under
any category of export credit should be on the basis of
the BPLR relevant for the entire tenor of export credit.
• ECNOS: ECNOS means Export Credit Not Otherwise
Specified in the Interest Rate structure for which banks
are free to decide the rate of interest keeping in view the
BPLR and spread guidelines. Banks should not charge
penal interest in respect of ECNOS.

45. Interest Rate Structure
• Pre-shipment Credit (from the date of advance) : (a) Up to 180
days / (b)Against incentives receivable from Government covered
by ECGC Guarantee up to 90 days.
• Post-shipment Credit (from the date of advance) : a) On demand
bills for transit period (as specified by FEDAI) (b) Usance bills (for
total period comprising usance period of export bills, transit
period as specified by FEDAI, and grace period, wherever
applicable)
Up to 90 days
Up to 365 days for exporters under the Gold Card Scheme.
(c) Against incentives receivable from Govt. (covered by ECGC
Guarantee) up to 90 days
(d) Against undrawn balances (up to 90 days)
(e) Against retention money (for supplies portion only) payable
within one year from the date of shipment (up to 90 days)

46. EXPORT CREDIT IN FOREIGN CURRENCY
• Pre-shipment Credit in Foreign Currency (PCFC): The
scheme is an additional window for
providing pre-shipment credit to Indian
exporters at internationally competitive
rates of interest. It will be applicable to
only cash exports. The instructions with
regard to Rupee Export Credit apply to
export credit in foreign currency also
mutatis mutandis, unless otherwise
specified.

47. Source of Funds for Banks
• The foreign currency balances available with the bank in
Exchange Earners Foreign Currency (EEFC) Accounts,
Resident Foreign Currency Accounts RFC(D) and Foreign
Currency (Non-Resident) Accounts (Banks) Scheme
could be utilized for financing the pre-shipment credit in
foreign currency.
• Banks are also permitted to utilise the foreign currency
balances available under Escrow Accounts and Exporters
Foreign Currency Accounts for the purpose, subject to
ensuring that the requirements of funds by the account
holders for permissible transactions are met and the
limit prescribed for maintaining maximum balance in
the account under broad based facility is not exceeded.

48. Post-shipment Export Credit in Foreign Currency
• Banks may utilise the foreign exchange
resources available with them in Exchange
Earners Foreign Currency Accounts (EEFC),
Resident Foreign Currency Accounts (RFC),
Foreign Currency (Non-Resident) Accounts
(Banks) Scheme, to discount usance bills and
retain them in their portfolio without resorting
to rediscounting. Banks are also allowed to
rediscount export bills abroad at rates linked to
international interest rates at post-shipment
stage.

49. International Trade finance/ glance
Private sources : commercial
banks, export finance
companies, factoring houses,
forfeit houses, international
leasing companies, in-house
finance companies and private
insurance companies.

50. A BANK GUARENTEE : is a financial instrument that
guarantees specified sum payment to either the
exporter or importer. Apart from regular bank
guarantees, there are three other types of
guarantees:-
1. The loan guarantee, in which a loan is granted
conditional on security provided by the borrower.
2. A distraint guarantee, which helps s debtor to
recover his seized assets; and
3. A bill of lading Guarantee, which ensures that
the carrier will hand over the goods to the
consignee when individual bills of lading lost.

51. A Bank line of credit >
>Is a sum of money allocated to an
exporter by a bank to finance its
export business. This could also be
meant to finance a specific export
transaction from the foreign
customer’s side, and allows the
exporter to extend competitive
credit terms to foreign customers.

52. Buyer Credit >>
>> refers to credit extended by one or more
financial institutions in the exporter’s
country. This form of finance is mostly used
to finance capital equipment purchases, but
other goods with payment terms of up to
one year can also be financed by buyer
credits. Buyer credits are normally arranged
under an export credit insurance
programme.

53. Export factoring
EF is particularly suited for small and medium sized
exporters as it enables them to be more
competitive by selling on open account rather
than using more costly methods such as L/C s. It
involves the sale of export accounts receivables to
a third party that assumes the credit risk. This
technique proceeds through factoring houses that
not only provide financing but also perform credit
investigations, guarantees commercial and
political risks ,,,, and …/// how about
commission ?? // widely used in USA …

54. Forfaiting///
Transaction In which exporter transfers
responsibility of commercial and political risks for
the collection of a trade –related debt to a
forfaiter ( often financial institutions), and in turn
receives immediate cash after the deduction of its
interest charge( the discount) //// Two segments :
1. primary Mkt: consists of Banks and forfait
houses that buy properly executed and
documented debt obligations directly from
exporters. 2. The secondary Mkt : consists of
trading these forfait debt obligations among
themselves. //// widely used in EUROPE//

55. BANKER’S ACCEPTANCE
• Is a time draft drawn on and accepted by one
bank to another // interbank financing
methods// 30 /60/ 90 to 180 days after sight or
date ///
• CORPORATE GUARENTEE : is a method of
finance where on company undertake to pay the
principal debts of another corporate house. The
method is used when creditors ask the corporate
or parent company to guarantee an obligation of
one or more its overseas subsidiaries////

56. Government sources
Export import Bank financing: Many countries have
put in place EXIM financing programmes to
provide finance for exports, imports and overseas
investments. The loans are low cost for a medium
–to- long term period arranged in collaboration
with larger commercial banks throughout the
world. Eg . South korea’s EXIM bank offers such
services as direct lending to both suppliers and
sellers, re-lending facilities to foreign financial
institutions, and the issuance of guarentee and
export insurance .///

57. FOREIGN credit INSURANCE
• USA: Insurance programmes are offered by both
EXIM bank and FCI Association.
• CANADA: Export Credit Insurance Corporation
• Japans’s International Trade Bureau
• HONG KON: Export Insurance Credit corporation
• INDIA: Export Credit Guarantee Corporation Ltd
• Taiwans ‘ Central Trust of China programmes.
• Latin America: Compania Argentina de seguros
de Credito a la exportation in argentina.
• Brazil: Instituto de Resserguros do Brazil///

58. FOREX risk and Exposure
• FOREX RISK: Concerns the variance or
change in domestic currency value of an
asset, liability or operating income that
takes place due to unanticipated changes in
exchange rates.
• FOREX EXPOSURE: Refers to the sensitivity
of changes in the real domestic-currency
value of assets, liabilities, or operating
incomes to unanticipated changes in
exchange rates.

59. Three Kinds of Exposures>>
>>may lead to risk
1.Transaction Exposure
2.Economic( or operating)
exposure
3.Translation exposure

60. Types of Foreign Exchange Exposure
 Changes in exchange rates can effect firm value through:

61. 61
Translation exposure, also called accounting exposure,
arises because financial statements of foreign
subsidiaries – which are stated in foreign currency –
must be restated in the parent’s reporting currency for
the firm to prepare consolidated financial statements.
Translation exposure is the potential for an increase or
decrease in the parent’s net worth and reported net
income caused by a change in exchange rates since the
last translation.
The accounting process of translation, involves
converting these foreign subsidiaries financial
statements into home currency-denominated
statements.
Translation Exposure

62. 62
Two basic methods for the translation of foreign
subsidiary financial statements are employed
worldwide:
– The current rate method
– The temporal method
Regardless of which method is employed, a translation
method must not only designate at what exchange rate
individual balance sheet and income statement items
are remeasured, but also designate where any
imbalance is to be recorded (current income or an
equity reserve account).
Translation Methods

63. 63
The current rate method is the most prevalent in the
world today.
– Assets and liabilities are translated at the current rate of
exchange.
– Income statement items are translated at the exchange rate
on the dates they were recorded or an appropriately weighted
average rate for the period.
– The biggest advantage of the current rate method is that the
gain or loss on translation does not pass through the income
statement but goes directly to a reserve account (reducing
variability of reported earnings).
Current Rate Method

64. 64
Under the temporal method, specific assets are
translated at exchange rates consistent with the
timing of the item’s creation.
This method assumes that a number of
individual line item assets such as inventory and
net plant and equipment are restated regularly
to reflect market value.
Gains or losses resulting from remeasurement
are carried directly to current consolidated
income, and not to equity reserves (increased
variability of consolidated earnings).
Temporal Method

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 If these items were not restated but were instead carried at
historical cost, the temporal method becomes the
monetary/non-monetary method of translation.
– Monetary assets and liabilities are translated at current exchange
rates.
– Non-monetary assets and liabilities are translated at historical
rates.
– Income statement items are translated at the average exchange
rate for the period.
– Dividends (distributions) are translated at the exchange rate on
the date of payment.
– Equity items are translated at historical rates.
Monetary / Non-monetary Method

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The main technique to minimize translation exposure is
called a balance sheet hedge.
A balance sheet hedge requires an equal amount of
exposed foreign currency assets and liabilities on a firm’s
consolidated balance sheet.
If this can be achieved for each foreign currency, net
translation exposure will be zero.
These hedges are a compromise in which the
denomination of balance sheet accounts is altered,
perhaps at a cost in terms of interest expense or
operating efficiency, to achieve some degree of foreign
exchange protection.
Managing Translation Exposure

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Transaction Exposure
 Transaction exposure measures changes in the
value of outstanding financial obligations
incurred prior to a change in exchange rates
but not due to be settled until after the
exchange rates change.
 Thus, this type of exposure deals with changes
in cash flows that result from existing
contractual obligations.

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Sources of Transaction Exposure
 Transaction exposure arises from:
 Purchasing or selling on credit goods or services whose
prices are stated in foreign currencies.
 Borrowing or lending funds when repayment is to be
made in a foreign currency.
 Being a party to an unperformed foreign exchange
forward contract.
 Otherwise acquiring assets or incurring liabilities
denominated in foreign currencies.

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Real Life Example
In 1971, Great Britain’s Beecham
Group borrowed SF100 million
(equivalent to £10.13 million).
When the loan came due five years
later, the cost of repayment of
principal was £22.73 million – more
than double the amount borrowed!

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To Hedge or not?
 Hedging is the taking of a position, either
acquiring a cash flow or an asset or a contract
(including a forward contract) that will rise (fall)
in value to offset a fall (rise) in value of an
existing position.
 Hedging, therefore, protects the owner of the
existing asset from loss (but it also eliminates
any gain resulting from changes in exchange
rates on the value of the exposure).

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Operating exposure, also called economic
exposure, competitive exposure, and even
strategic exposure on occasion, measures any
change in the present value of a firm resulting
from changes in future operating cash flows
caused by an unexpected change in exchange
rates.
Measuring the operating exposure of a firm
requires forecasting and analyzing all the firm’s
future individual transaction exposures together
with the future exposures of all the firm’s
competitors and potential competitors
worldwide.
Operating Exposure

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Operating exposure is far more important for the
long-run health of a business than changes
caused by transaction or accounting exposure.
Operating exposure is inevitably subjective,
because it depends on estimates of future cash
flow changes over an arbitrary time horizon.
Planning for operating exposure is a total
management responsibility because it depends
on the interaction of strategies in finance,
marketing, purchasing, and production.
Operating Exposure

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An expected change in foreign exchange rates is not
included in the definition of operating exposure,
because both management and investors should have
factored this information into their evaluation of
anticipated operating results and market value.
From an investor’s perspective, if the foreign exchange
market is efficient, information about expected changes
in exchange rates should be reflected in a firm’s market
value.
Only unexpected changes in exchange rates, or an
inefficient foreign exchange market, should cause
market value to change.
Operating Exposure

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Recognising Operating Exposure
 Where is the company selling? [domestic
v. foreign]
 Who are the key competitors? [domestic
v. foreign]
 How sensitive is demand to price?
 Where is the company producing?
[domestic v. foreign]
 Where are the company’s inputs coming
from? [domestic v. foreign]

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Recognising Operating Exposure
 Volvo produces most of its cars in Sweden, but buys most of its
inputs from Germany.
 The U.S. is an important export market for Volvo.
 Volvo management believed that a depreciating Swedish krona
versus the $ and an appreciating Swedish krona versus the DM
would be beneficial to Volvo.
 But researchers found that statistically:
 A depreciating krona relative to the Deutschemark
improved Volvo’s cash flow!
 These results reflect the fact that Volvo’s major competitors are
the German firms BMW, Mercedes and Audi.

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Recognising Operating Exposure
 Aspen Skiing Company owns and operates ski resorts in
Colorado
• Uses only American labor and materials
• Nonetheless, hurt by a strong dollar that made
American skiers opt for the French Alps or the
Canadian Rockies, and foreign skiers stay at
home.
 So, even a domestic firm with zero transaction
exposure to exchange rates can be vulnerable to
exchange rate risk.

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Managing Operating Exposure
 Pass Through – can the company pass the price
increase on to the customer?
 This depends on the product and the level of
competition in the market.
 For low-quality goods, price competition is usually
intense, so no one company can change prices.
 For high-quality goods, there may be room to increase
prices and not effect demand.

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Managing Operating Exposure
 Use of Marketing Strategies
 Market Selection
 Pricing Strategy/Product Strategy
 Promotional Strategy
 Use of Production Management
 Input mix
 Plant Location & Shifting production among plants
 Raising Productivity (i.e. lowering costs)
 Financial Hedging techniques may also be used

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Example
 Matsushita exports TVs to the US. Suppose the yen is expected
to move from ¥130/$ to ¥110/$ over the next few years. What
can Matsushita do about its currency risk?
 As yen appreciates, Matsushita becomes less competitive. Can it
increase prices in the US? Probably not as TV market is
competitive.
 It can keep US$ prices constant to retain market share but this
will hurt profits. Can it cut costs and become more efficient?
 Matsushita could move production to US or low-cost US$ zone.
 Move to high-end TVs or other products with less price
competition.
 Hedge using currency derivatives.
 Stop selling in US markets.

80. •Good bye
for the day