Chapter 4: Multinational Working Capital

Management

MBA 2022

Major: International Business Management,

Course: 508
Department of Management, University of Chittagong
Chapter 4: Short-Term Financing Foreign Trade

Learning Objectives

1. Understand the key elements of import/export business transactions.

2. Explore how the three key documents—Letter of Credit, Draft, and Bill of Lad-
ing—manage risks and finance transactions.

3. Describe various government programs that assist in financing exports.

4. Examine the major trade financing options available.

5. Evaluate the use of forfaiting for medium- to long-term trade financing.

4.1 The Trade Relationship

Trade relationships are divided into three categories: unaffiliated unknown, unaffiliated
known, and affiliated.

Unaffiliated Unknown

This relationship involves no prior business dealings and requires robust contracts and
protections against nonpayment. Trust is minimal, necessitating stringent terms and
documentation.

Unaffiliated Known

An established business relationship exists. While contracts are still necessary, there is
more flexibility due to a history of reliable transactions.

Affiliated

This category includes subsidiaries or related entities. These transactions often occur
without formal contracts but may need safeguards against political or country-specific
risks.

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 The fundamental dilemma in trade is that exporters prefer payment before ship-
ping, while importers want to pay after receiving goods. This issue is typically resolved
by involving a trusted intermediary, such as a bank, to ensure both parties fulfill their
obligations.

Benefit of the system & noncompletion risk

• Protection Against Risk of Noncompletion

• Protection Against Foreign Exchange Risk.

• Financing the Trade.

Figure-1 illustrates the traditional business problem of credit management

Figure 1: The Trade Transaction Time Line and Structure

4.2 Key documents in international trade

The three critical documents in international trade finance are the Letter of Credit (L/C),
Draft, and Bill of Lading (B/L).

Letter of Credit (L/C)

Issued by a bank at the request of the importer, it guarantees payment to the exporter
upon presentation of specific documents, thereby reducing the risk of noncompletion. This

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ensures the exporter will be paid if all conditions are met. Understanding the following
key terms are important in this context:

• Types of letter of credit

• Advantages/disadvantages of an L/C

• The process of an L/C

Draft

An unconditional order in writing to pay a specified amount. Drafts can be:

• Sight Draft: Payable on presentation.

• Time Draft: Payable at a future date. When a draft is accepted by a bank, it

becomes a banker’s acceptance; if accepted by a commercial firm, it becomes a
trade acceptance.

Bill of Lading (B/L)

Issued by the carrier to the exporter, this document serves as a receipt, contract, and
document of title for the goods being shipped. It ensures the exporter retains control
over the goods until payment or a written promise of payment is received.

Steps in a typical international trade transaction

4.3 Trade Financing Alternatives

In order to finance international trade receivables, firms use the same financing instru-
ments that they use for domestic trade receivables, plus a few specialized instruments
that are only available for financing international trade.Several trade financing alter-
natives are available to exporters and importers: Bankers’ acceptance, Trade accep-
tances,Securitization, Bank credit lines, Commercial paper

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 Figure 2: Steps in a Typical Trade Transaction

Bankers’ Acceptances

Time drafts accepted by banks that can be traded in the money market. They provide
secure short-term financing and are similar to marketable bank certificates of deposit in
terms of yield.

Trade Acceptances

Similar to bankers’ acceptances but accepted by commercial firms, these instruments are
sold at a discount to banks and other investors and are used for financing receivables.

Factoring

This involves selling receivables to a factor at a discount. The factor assumes credit,
political, and foreign exchange risks, making it an attractive option for firms seeking to
improve cash flow and reduce risk.

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Securitization

This method involves selling export receivables to a legal entity that issues marketable
securities. It removes receivables from the balance sheet and can be cost-effective for
large transactions with known credit history and default probability.

Bank Credit Lines

These lines are used to finance export receivables and are often covered by export credit
insurance to reduce risk. Although flexible, this option usually comes with higher costs
compared to acceptance financing.

Commercial Paper

These are unsecured promissory notes issued by large, well-known firms to fund short-
term financing needs. They are low-cost financing instruments but are accessible only to
firms with favorable credit ratings.

4.4 Forfaiting

Forfaiting is a specialized trade financing technique that involves selling bank-guaranteed

promissory notes or bills of exchange at a discount. The forfaiter assumes all risks, and
the exporter receives cash immediately.

Steps in Forfaiting

1. Agreement: The importer and exporter agree on terms, typically involving peri-
odic payments over several years.

2. Commitment: The forfaiter commits to financing at a fixed discount rate, which is

based on the cost of funds in the euromarket plus a margin reflecting the perceived
risk.

3. Aval/Guarantee: The importer’s bank guarantees the promissory notes. In Eu-

rope, this unconditional guarantee is known as an aval.

4. Delivery of Notes: Endorsed promissory notes are delivered to the exporter.

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 5. Discounting: The exporter sells the notes to the forfaiter for cash, endorsing them
“without recourse.”

6. Investment: The forfaiter may hold or resell the notes in the money market.

7. Maturity: The investor holding the notes collects payment from the importer’s
bank upon maturity.

Figure 3: Typical Forfaiting Transaction

Forfaiting is particularly useful for medium- to long-term trade financing, pro-

viding exporters with immediate cash while transferring the risk to the forfaiter.

Government Programs to Help Finance Exports

Governments provide various programs to assist exporters in managing risks and obtain-
ing financing.

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Reference

• David K. Eiteman, Arthur I. Stonehill, and Michael H. Moffett; Multinational Busi-

ness Finance, 15th Ed,Ch 16: International Trade Finance