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Letter of Credit

Assess the place of Letters of Credit in the International commercial arena

What is International Finance Management?

The international financial management of a trust/company is concerned with management of its funds which reflects how efficiently the company is managing its funds. The overall objective of all business is to secure funds at low cost and their effective utilisation in the business for a profit. The funds so utilised must generate an income higher than the cost of procuring them. Here it is to be noted that all companies need both long-term and short-term capital. The finance manager must therefore keep in view the needs of both long-term debt and working capital and ensure that the business enjoys an optimum level of working capital and that it does not keep too many funds blocked in inventories, book-debts, cash, etc. The capital structuring and average cost of capital for the company should also be examined.[1]

Financial analysis is analysis of financial statements of a company to assess is financial health and soundness of its management. "Financial Statement analysis" involves a study of the financial statements of a company to ascertain its prevailing state of affairs and the reasons therefore. Such a Study would enable the public and investors to ascertain whether one company is more profitable than the other, and also to state the causes and factors probably responsible for this[2].

Letters of Credit

In a document, the bank agrees to honor a draft drawn on the importer, provided the bill of lading and other details are in order. Obviously, the local bank will "not issue a letter of credit unless it feels the importer is creditworthy and will pay the draft. The letter of credit arrangement pretty much eliminates the exporter's risk in selling goods to an unknown importer in another country.

Illustration of a Confirmed Letter

The arrangement is strengthened further if a bank in the exporter's country confirms the letter of credit. A New York exporter wishes to ship goods to a Brazilian importer located in Rio de Janeiro. The im­porter's bank in Rio regards the importer as a sound credit risk and is willing to is­sue a letter of credit guaranteeing payment for the goods when they are received. Thus, the Rio bank substitutes its credit for that of the importer. In fact, the deal is mutually between the Rio bank and the New York exporter- the beneficiary of the letter of credit,. The exporter may wish to work through her bank, because she has little knowledge of the Rio bank. She asks her New York bank to confirm the Rio bank's letter of credit. If the New York bank is satisfied with the creditworthiness of the Rio bank, it will agree to do so. When it does, it obligates itself to honor drafts drawn in keeping with the letter of credit arrangement.[3]

Thus, when the exporter ships the goods, she draws a draft in accordance with the terms of the letter of credit arrangement. She presents the draft to her New York bank and the bank pays her the amount designated, assuming all the conditions of shipment is met. As a result of this arrangement, the exporter has her money, with no worries about payment. The New York bank then forwards the draft and other documents to the Rio bank. Upon affirming that the goods have been shipped in a proper manner, the Rio bank honors the draft and pays the New York bank. In turn, it goes to the Brazilian importer and collects from him once the goods have arrived in Rio and are delivered.

Trade Facilitation

Rather than extending credit directly to an im­porter, the exporter relies on one or more banks, and their creditworthiness is sub­stituted for that of the importer. The letter itself can be either irrevocable or revoca­ble, but drafts drawn under an irrevocable letter must be honored by the issuing bank. A revocable letter makes sure for an arrangement for pay­ment of cash. However we cannot guarantee that the draft will be paid. Most letters of credit are irre­vocable, and the process described assumes an irrevocable letter.

The three documents described—the draft, the bill of lading, and the letter of credit—are required in most international transactions. Established procedures ex­ist for doing business on this basis[4].

Process of the Letter of Credit transaction and the problems associated with enforcement of parties’ rights in a conflict situation.

 

Expansion and Contraction

 

Countertrading

In addition to the documents used to facilitate a standard transaction, more customized means for financing trade. One method is the countertrade. Countertrade agreement is where the selling party accepts payment in the form of goods as opposed to currency. When exchange restrictions and other preclude payment in hard currencies, such as dollars and yen, it may be to accept goods instead. These goods may be produced in the country .But this need not be the case. Countertrading is nothing more than anything.-l needs to be mindful that there are risks in accepting goods in lieu of a hard facts. Quality and standardization on receipt may differ from what was there. There may be volatility in prices, if indeed a viable market exists at all. All the method involves risk, countertrade associations and consultants, together other infrastructure, have developed to facilitate this means of trade.

Factoring

. The factor assumes the credit risk, so the exporter is assured of being true. The typical fee is around 2 percent of the value of the overseas shipment. But receivable is collected, a cash advance is possible for upward to 90 percent a shipment's value. For such an advance, the exporter pays interest, and this is  and above the factor's fee. Most factors will not do business with an exporter . less the volume is reasonably large, say at least $2 million in annual transactions,  Also, the factor can reject certain accounts that it deems too risky For accounted are accepted, the main advantage to the exporter is the peace of mind that credit  entrusting collections to a factor with international contacts and experience.

Forfeiting

Forfeiting is a means of financing trade which resembles factoring. An expo who is owed money evidenced by a longer-term note, as opposed to sell the note to a financial institution at a discount. The discount reflects I length of time the note has to maturity as well as the credit risk of its drawer usually the note is for 6 months or longer and involves larger transactions. An institution would not engage in forfeiting a $9,600 note but might if it were $180,000. [5]

 

Expansion abroad is undertaken to go, into new markets, acquire less costly pro­duction facilities, and secure raw materials. Foreign investment different from domestic investment, as there are a number of reasons left behind that. Taxation is different, and there are risks present in po­litical conditions.

A company faces three types of risk in its foreign operations: translation exposure, trans­actions exposure, and economic exposure. Changes in exchange rates cause translation exposure and its change in accounting income and balance sheet statements. Transactions exposure relates to settling a particular transaction, like open account credit, at one exchange rate when the obligation was booked at another. Economic exposure has to do with the impact of changing exchange rates on the existing balance sheet of a foreign subsidiary and on the expected future repatriated cash flows. Two frameworks were presented for measuring the degree of eco­nomic exposure. The first aggregated the indi­vidual exposure coefficients for all balance sheet items.[6]

The second measured the degree of net exposure for expected future cash flows. This was net of any natural hedge, where local cur­rency margins adjust naturally to offset a change in exchange rates. A natural hedge de­pends on the degree to which prices and costs are globally determined or domestically deter­mined. A relationship can be plotted between the value of repatriated cash flows and the ex­change rate. The direction of the line and its steepness tells us whether or not we are hurt if the foreign currency appreciates (depreciates) in value and the degree of exposure. Net expo­sure is that which remains after any natural hedge.[7]

Using several protective devices, a company can protect against any net exposure. If the expo­sure is short-term in nature, it can adjust intercompany accounts in what is known as an operating hedge. For longer-term exposure, it can undertake a hedge by financing in differ­ent currencies. The major sources of interna­tional financing are commercial banks, discounted trade drafts, Eurodollar loans, and in­ternational bonds. The last includes Eu­robonds, foreign bonds, floating-rate notes linked to LIBOR, currency-option bonds, and multiple-currency bonds.

Eventually, we can see that there are currency hedges, may include, futures contracts, forward contracts, currency swaps, cur­rency options etc. For the first, one buys a forward contract for the exchange of one procedure for another at a specific future date and at an exchange ratio set in advance. For this protection, there is a cost that is determined by the difference in the forward and spot exchange rates. Currency futures contracts are like forward contracts in function, but there are differences in settlement and other features. Currency options afford protection against "one-sided" risk. Fi­nally, currency swaps are an important longer-term risk-shifting device.

 

There are several theories provide a better understanding of the relationship be­tween interest rates, inflation, and rate of exchange. Purchasing power parity is the idea that a basket of goods should sell at the same price internationally, after factoring into account ex­change rates. Relative inflation has an impor­tant influence on exchange rates and on rela­tive interest rates. Interest-rate parity suggests that the difference between forward and spot currency exchange rates can be explained by differences in nominal interest rates between two countries.

Three principal documents are involved in international trade. The draft is an order by the exporter to the importer to pay a specified amount of money either upon presentation of the draft or a certain number of days after pre­sentation.

Translation Exposure

Translation exposure relates to the accounting treatment of changes in exchange rates. State­ment of the Financial Accounting Stan­dards Board deals with the translation of for­eign currency changes on the balance sheet and income statement. An American company must determine a func­tional currency for each of its foreign sub­sidiaries under those mentioned rules, If the subsidiary is a stand-alone op­eration that is integrated within a particular country, the functional currency may be the lo­cal currency; otherwise, it is the dollar where high inflation occurs the functional currency must be the dol­lar regardless of the conditions given.

 

The functional currency used is important because it determines the translation process. Moreover, translation gains or losses are not reflected in the income statement, but rather are recognized in owners' equity as a translation adjustment. The fact that such ad­justments do not affect accounting income is appealing to many companies. If the functional currency is the dollar, however, this is not the case. Gains or losses are reflected in the income statement of the parent company using what is known as the temporal method. In general, the use of the dollar as the functional currency re­sults in greater fluctuations in accounting in­come, but in smaller fluctuations in balance sheet items than does the use of the local cur­rency. Let us examine the differences.

Differences in Methods

With the dollar as the functional currency, bal­ance sheet and income statement items are cat­egorized as to historical exchange rates or as to current exchange rates. Cash, receivables, lia­bilities, sales, expenses, and taxes are trans­lated using current exchange rates[8], whereas in­ventories, plant and equipment, equity, cost of goods sold, and depreciation are translated at the historical exchange rates existing at the time of the transactions. This differs from the situation where the local currency is used as the functional currency; here all items are translated at current exchange rates.

To illustrate, a company we shall call Richmond Precision Instruments has a sub­sidiary in the Kingdom. At the first of the year, the exchange rate is 8 to the dollar, and that rate has prevailed for many years. During the year however, it declines steadily in value to 10 to the dollar at year end. But the rate of exchange comes to 9. It shows the balance sheet and the income statement for the foreign subsidiary at the beginning and at the end of the year and the effect of the method of transla­tion.

 

The oppo­site would occur in our example if the liso in­creased in value relative to the dollar. We see that there is substantially more change in total assets when a local functional currency is used than when a dollar functional currency is employed. In our example, sales are adjusted by the average exchange rate that prevailed during the year for both accounting methods. For column 4, local functional currency, all cost and expense items are adjusted by this exchange rate[9]. For the last column, dollar functional cur­rency, cost of goods sold, and depreciation are translated at historical exchange rates whereas the other items are translated at the current average rate. We see that operat­ing income and net income are larger when the local functional currency is used than when the functional currency is the dollar. For the latter method, the translation gain is factored in, so that net income agrees with the change in re­tained earnings from 12/31/xl to 12/31/x2. We see that this change is $845 - $750 = $95. In contrast, when the functional currency is local, the translation adjustment occurs after the in­come figure of $111. The adjustment is that amount, —$176, that, together with net income, brings the liability and net worth part of the balance sheet into balance. This amount then is added to the sum of past translation adjust­ments to obtain the new accumulated transla­tion adjustment figure that appears on the bal­ance sheet. As we assume past adjustments total zero, this item becomes —$176. Thus, the translation adjustments far in two methods are in opposite directions. Shot the liso increase in value relative to the data the effect would be the reverse of that illus­trated: Operating income would be higher.

Implications

Because translation gains or losses are not re­flected directly on the income statement; it supported operating income tends to fluctuate when the functional currency is local when it is the dollar. However, the balance sheet items is increased, o the translation of all items by the current change rate. Because many corporate fives are concerned with accounting FASB No. 52 is popular, as long as qualifies for a local functional currency ever, this accounting method also has its backs. For one thing, it distorts the sheet and the historical cost numbers over, it may cause return on asset and other measures of return to be less.

 

RISK MANAGEMENT AND WEALTH MAXIMISATION

 

Here the techniques for managing financial risks, in particular those that arise more prominently in the context of international finance are being discussed. The above discussion of the impact of risk on the value of the firm gives rise to a very important and interesting question: what should be the attitude of the firm's management regarding firm-specific risks? It appears that since these risks are diversifiable, they are not "priced" by the investors, that is, they do not affect the expected rate of return demanded by the investors—the discount rate. Why then should the firm spend resources to insure against these risks? Even if certain risks are systematic in the sense that they affect almost all firms adversely, it is not clear hedging such risks necessarily adds to shareholder value.[10] Risks can be hedged only at a cost since the party to whom the risk is transferred will demand compensation for bearing the risk. Thus, while it is true that increase in energy costs will have an adverse impact on almost all firms, in an efficient market, the compensation that has to be paid for bearing this risk would just equal the increase in the value of the firm resulting from eliminating this risk; on balance the firms’ shareholders will neither rain nor los[11]e.                                                                                   

Risks arising out of fluctuations in exchange rates, interest rates and commodity prices are pervasive, It is, they affect most firms; however they affect different firms in different ways and are therefore idiosyncratic.[12]

Finally, even if the irrelevance argument is not found to be convincing, the well-known Modigliani-Miller analysis of a firm's optimal capital structure offers another argument against hedging. In a world of no taxes, no transactions costs and no information asymmetries, they demonstrated that a firm's financing policy does not matter as long as it does not affect its investment policy. If some shareholders are unhappy with the particular debt-equity structure adopted by the firm, they can achieve whatever leverage they de­sire by trading on their own account. The same argument can be extended to hedging risks such as ex­change rate risks. A firm which exports to the United States and has dollar receivables can hedge these with forward sales of dollars against rupees; but if its shareholders can achieve the same result on their own (by taking similar but smaller positions in the dollar-rupee forward market), hedging by the firm will add no shareholder value. If capital markets are perfect, individual investors, in particular a firm's share­holders can replicate any financial strategy adopted by the firm. In such a world active risk management policy cannot add value.

In practice, we find that firms do expend considerable amount of resources—managerial time and money—in an attempt to hedge firm-specific risks. For instance, they avoid highly risky investment projects, purchase insurance against product liability suits, enter into forward contracts in foreign ex­change, and specific commodities and so forth. Is there a rationale for these actions?

In addition to the "irrelevance of unsystematic risks" or "shareholders can do it themselves" arguments against hedging, it has also been argued that since financial markets are efficient, it makes little difference in the long run whether and what kind of risk management posture a firm adopts. This means that with efficient markets it would not matter in the long run whether a firm follows an active hedging policy, a purely passive strategy of hedging all risks at all times, or a policy of no hedging at all. Note however that the hypothesis of efficiency of financial markets is far from firmly established.

If active risk management by a firm adds shareholder value it must be (i) because it alters the firm's cash flow in a way which is beneficial to the shareholders even after meeting the cost of hedging and (ii) the firm can achieve this at a lower cost than what the shareholders would have to incur if they did it on their own. This is possible in the presence of some capital market imperfections which are assumed away by the Modigliani-Miller theorem.

With reference to the valuation equation, hedging can increase shareholder wealth both by influencing future cash flows and by reducing the discount rate at which these cash flows are discounted. In general it is true that the former effects stronger though there can be circumstances under which hedging can reduce the expected return investors demand from a particular firm[13].

One of the most cogent arguments for hedging by the firm has been presented by Froot et al (1994). They not only provide a rationale for hedging as such but also put forward an explanation as to why selec­tive or discretionary hedging rather than 100 per cent hedging might be an optimal policy under certain conditions. The main thrust of their argument can be summarized as follows:

Firms enhance shareholder wealth—create "corporate value"—by making good investments. "Invest­ments" here means not only physical plant and equipment but also R&D, product development, mar­ket investments such as advertising and promotion and so forth.[14]

THE GLOBAL FINANCIAL MARKET

The last two decades have witnessed the emergence of a vast financial market straddling national boundaries enabling massive cross-border capital flows from those who have surplus funds and are in search d high returns to those seeking low-cost funding. The phenomenon of borrowers, including governments, one country accessing the financial markets of another is not new; what is new is the degree of mobility d capital, the global dispersal of the finance industry, and the enormous diversity of markets and inst which a firm seeking funding can tap.

 

THE LETTER OF CREDIT MECHANISM

 In such a case, the opening bank "accepts" the draft and it becomes A Banker's Acceptance: The exporter can get immediate payment by discounting the accepted draft either with the opening bank, o with his own bank or by selling the acceptance in the market'. Financing is thus provide* by the bank which discounts the draft or by a money market investor who buys the acceptance. (With sigh drafts, the importer's bank may provide credit to the importer as a part of their ongoing business relationship).

To cater to the wide variety of transactions and customers, different types of letters of credit have evolved. A Revocable L/C is issued by the issuing bank and contains a provision that the bank may amend or cancel the credit without the approval of the beneficiary. An Irrevocable L/C cannot be so amended or cancelled without the exporter's prior approval. A Confirmed, Irrevocable L/C contains an extra protection; in addition to the issuing bank's commitment, a Confirming Bank adds its own undertaking to pay provided a] conditions are met. The confirming bank (which may be but need not be the same as the advising bank will pay even if the issuing bank cannot or will not honor the exporter's draft. A Revolving L/C is use when the exporter is going to make shipments on a continuing basis and a single L/C will cover several shipments. A Transferable L/C permits the beneficiary to transfer a part or whole of the credit in favor of one or more secondary beneficiaries. This type of L/C is used by trader exporters who act as middlemen on recourse basis. The ultimate holder of the notes than presents them to the bank at which they are pay­able, as they fall due.[15]

Traditionally, Forfeiting used to be a form of fixed rate, medium-term funding, but over time Forfeiters have become very flexible and are willing to offer terms to suit the needs of their customers. Some Forfeiting houses will accept paper with maturities up to ten years while in other cases it may be as short as 180 days. The secondary market for the paper generally ranges between one and ten years, depending upon the reputation of the importer, the country to which the importer belongs and the reputation of the bank providing the guarantee.

Normally Forfeiters will ensure that the importer, not the exporter bears the cost of financing. That is, the face value of the notes is such that after applying the discount, the exporter gets paid what he would normally charge for cash payment. However for competitive reasons some exporters may choose to ab­sorb some of the financing cost to make the transaction more attractive to the importer.

Charges depend on the market interest rates for the currency of the underlying contract and on the per­ceived credit risks related to the importer, his country and the credit rating of the availing (or guaranteeing) bank.

The interest cost is made up of the following components:

(1)  The Forfeiter’s refinancing costs benchmarked to the cost of funds in the relevant Euromarkets seg­ment applicable to the average life of the transaction. For a five year deal, for example, repayable by ten semi-annual equal installments, LIBOR rate applicable for 2.75 years would be used.

(2)  A margin or spread for covering the political, commercial, and transfer risks attached to the availed/ guarantor. It varies from country to country, and guarantor to guarantor[16].

(3)  Some additional charges such as interest for "grace period" granted to the importer and a commit­ment fee when necessary.

The whole transaction can be processed quite fast. Many Forfeiters claim that they take no more than two days after the exporter presents all the proper documents.

Buyers' Credits are a form of Eurocurrency loans designed to finance a specific transaction involving import of goods and services. The importer works out a deferred payment arrangement with the lending bank which the bank treats as a loan. [17]

Traditionally, Forfeiting used to be a form of fixed rate, medium-term (one to five years) funding, but over time Forfeiters have become very flexible and are willing to offer terms to suit the needs of their customers. Some Forfeiting houses will accept paper with maturities up to ten years while in other cases it may be as short as 180 days. The secondary market for the paper generally ranges between one and ten years, depending upon the reputation of the importer, the country to which the importer belongs and the reputation of the bank providing the guarantee.

Normally Forfeiters will ensure that the importer, not the exporter bears the cost of financing. That is, the face value of the notes is such that after applying the discount, the exporter gets paid what he would normally charge for cash payment. However for competitive reasons some exporters may choose to ab­sorb some of the financing cost to make the transaction more attractive to the importer.[18]

Charges depend on the market interest rates for the currency of the underlying contract and on the per­ceived credit risks related to the importer, his country and the credit rating of the analyzing (or guaranteeing) bank.

The interest cost is made up of the following components:

(1)  The Forfeiter’s refinancing costs benchmarked to the cost of funds in the relevant Euromarkets seg­ment applicable to the average life of the transaction.

(2)  A margin or spread for covering the political, commercial, and transfer risks attached to the availed/ guarantor. It varies from country to country, and guarantor to guarantor.

(3)  Some additional charges such as interest for "grace period" granted to the importer and a commit­ment fee when necessary.

 

Bibliography

A.    Articles/Books/Reports

Kraus, M.W.; Keltner, D. (2008), "Signs of Socioeconomic Status

Barro, Robert (1979) "On the Determination of the Public Debt", Journal of Political Economy, Vol 87, pages 940-71.

Barro, Robert (1999) "Notes on Optimal Fund Management", Harvard University, May2006

Dornbusch, Rudi (2001) 'A Primer on Emerging Market Crises', MIT, January.

Leong, Donna (1999) " Fund Management: Theory and Practice", HM Treasury Occasional Paper.

Boushey, Heather and Weller, Christian. (2005) “What the Numbers Tell Us.” Pp 27-40. Demos.

B.     Cases

Lucas, Robert and Nancy Stokey (1983) "Optimal Fiscal and Monetary Policy in an Economy without Capital", Journal of Monetary Economics 12, pp. 55-93.

C.     Legislation

Missale, Alessandro (1997) "Managing the Public Fund: The Optimal Taxation Approach", Journal of Economic Surveys Vol 121 No.3.

 

 

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