READING MATERIALS
READING
2.2.4
Managing and financing international trade
1 INTRODUCTION
Trade finance is directed towards commercial cashflows and enables banks to assist in managing the risks that arise between strangers trading, commonly across borders.
International trade finance is about two things:
• finance (who pays for what and when)
• risk (who takes it).
There is also the issue of cost, i.e. the cost of finance and the cost of risk, but this follows from these two major aspects.
The provision of funding via a trade finance route is linked with working capital considerations and its amount and availability will be dependent on the volumes of suitable sales and purchases to support it. It does not depend on credit ratios and so is a very useful add-on to traditional cashflow based lending products.
Trade finance may provide new sources of finance, a sales tool, risk management products, and cost reduction and facilities based on trade dynamics rather than traditional credit measures.
2 RISK IN INTERNATIONAL TRADE
Trade across borders carries additional risks and financing requirements compared to domestic trade and these can be addressed in a number of ways. The main aims of trade finance are to ensure that:
• the seller provides goods of the expected quality and quantity to the buyer
• the buyer pays the seller
Figure 1: international trade transaction
We explore the risks that the seller and buyer will face in sections 2.1 and 2.2.
2.1 Risks of the supplier
Figure 2: risks of the supplier
Risk
Description
Low liquidity
This is perhaps a generic issue but essentially any organisation must have capital to be able to trade, to pay wages, rent, etc. When money is limited or unavailable then choices and risks arise.
Money tied up in receivables
This is probably the biggest financing issue.
Money tied up in inventory or work in progress (WIP)
This refers to inventory that will not move or inventory that is simply required to trade. In some businesses (classically manufacturing and construction, but also some consultancy) WIP can be a significant number.
Dependence on customer
Customer loyalty is very important to many organisations.
Credit risk on customer
This is probably the biggest risk, for invoices and orders outstanding. It is also a longer-term risk where continuity of business is important.
Credit and political risk of a country
If the country of a customer fails or imposes payment or import restrictions, that can make selling to even a profitable customer challenging.
Credit risk on banks in the value chain
There will be banks in the financial supply chain, even if only for payments and cash movement. To the extent that banks become involved in risk transfer or finance, then there is risk on those banks.
Timing of payment
Some of the strongest customers may be some of the latest payers and this risk is generally of customers paying later than expected, so slightly different from the risk of having money in receivables.
Bonding risk
To the extent that bid bonds, advance payment bonds and performance bonds have been issued, there is always the risk of a fraudulent or malicious call on the bonds, which are usually payable on demand to the issuing bank.
Risk
Low liquidity
This is perhaps a generic issue but essentially any organisation must have capital to be able to trade, to pay wages, rent, etc. When money is limited or unavailable then choices and risks arise.
Money tied up in receivables
This is probably the biggest financing issue.
Money tied up in inventory or work in progress (WIP)
This refers to inventory that will not move or inventory that is simply required to trade. In some businesses (classically manufacturing and construction, but also some consultancy) WIP can be a significant number.
Dependence on customer
Customer loyalty is very important to many organisations.
Credit risk on customer
This is probably the biggest risk, for invoices and orders outstanding. It is also a longer-term risk where continuity of business is important.
Credit and political risk of a country
If the country of a customer fails or imposes payment or import restrictions, that can make selling to even a profitable customer challenging.
Credit risk on banks in the value chain
There will be banks in the financial supply chain, even if only for payments and cash movement. To the extent that banks become involved in risk transfer or finance, then there is risk on those banks.
Timing of payment
Some of the strongest customers may be some of the latest payers and this risk is generally of customers paying later than expected, so slightly different from the risk of having money in receivables.
Bonding risk
To the extent that bid bonds, advance payment bonds and performance bonds have been issued, there is always the risk of a fraudulent or malicious call on the bonds, which are usually payable on demand to the issuing bank.
2.2 Risks of the buyer
Mirroring the issues with customers, the dependence on a supplier and the credit risk of the supplier go hand in hand, but they are different. A long relationship with a supplier could be described as a good relationship but if the supplier fails then no amount of goodwill will replace that supplier.
Figure 3: risks of the buyer
Risk
Description
Dependence on supplier
Supplier loyalty is very important to many organisations looking for sustainable quality and service.
Credit risk on supplier
The credit risk on the supplier should be low, unless the buyer is paying cash in advance. But a supplier failure can be difficult, especially if spares, service contracts, software support or proprietary knowledge is involved in the relationship. This also occurs if the delivery of a contract is made over an extended period of time.
Delivery risk, time and specification (broadly, quality issues)
This is fairly obvious, as a buyer will demand on-spec, on-time delivery for goods and services, especially where ‘just-in-time’ deliveries are used.
Credit and political risk of country
Although exporting is usually so valuable to a country that it is always supported, unless the transaction comes within any sanctions imposed by the authorities.
Credit risk on banks in the value chain
As for supplier as mentioned in figure 2 above.
Risk
Dependence on supplier
Supplier loyalty is very important to many organisations looking for sustainable quality and service.
Credit risk on supplier
The credit risk on the supplier should be low, unless the buyer is paying cash in advance. But a supplier failure can be difficult, especially if spares, service contracts, software support or proprietary knowledge is involved in the relationship. This also occurs if the delivery of a contract is made over an extended period of time.
Delivery risk, time and specification (broadly, quality issues)
This is fairly obvious, as a buyer will demand on-spec, on-time delivery for goods and services, especially where ‘just-in-time’ deliveries are used.
Credit and political risk of country
Although exporting is usually so valuable to a country that it is always supported, unless the transaction comes within any sanctions imposed by the authorities.
Credit risk on banks in the value chain
As for supplier as mentioned in figure 2 above.
READING
3.2.3
The cost of equity and debt capital
1 INTRODUCTION
Investing in bonds issued by reputable governments is generally considered the safest form of investment. The rate of return offered on government bonds and treasury bills is regarded as the rate used to benchmark other rates of return. This is the theoretically ‘risk free’ rate of return.
Debt that is not underwritten by a reputable government carries risk. Although the borrower is contractually obliged to pay interest and eventually repay the amount borrowed, if its business fails, it may find it difficult or impossible to do so. In order to compensate for this increased risk, investors require an increased return, or margin over the risk-free rate. This is the ‘risk premium’.
Equity shareholders demand a still higher return because of the higher variability of the return on the investment. Shares in different organisations have different levels of risk.
2 KEY CONCEPTS AND RELATIONSHIPS IN MODELLING THE COST OF CAPITAL FOR CORPORATES
2.1 Cost of capital
The cost of capital to the company is exactly the same as the required return for investors for each source of financing. The company must provide the return that investors demand otherwise they will not invest or continue to supply funding.
The weighted average cost of capital (WACC) reflects the weighted average cost of each source of capital for the company as a whole. This is discussed in reading 3.2.4.
2.2 Diversifiable and systematic risk
Share prices respond to many different variables leading to fluctuations in returns.
Some of these are unique to the particular share (such as a marketing triumph, a deterioration in corporate culture, competitor liquidation, etc). The impact of these variables is known as diversifiable risk (also referred to as unsystematic, company, unique or specific risk).
Other variables will affect all shares, to a greater or lesser extent (e.g. tax and interest rate changes, inflationary expectations, economic growth, etc.). The impact of these variables is known as systematic risk (also referred to as market or non-diversifiable risk).
Under the capital asset pricing model (CAPM) only the non-diversifiable/systematic risk of securities is rewarded with additional returns, because the model assumes that rational market participants have all fully diversified away all diversifiable/specific risk within their investment portfolios.
2.3 Beta
Beta, β, is the systematic risk, i.e. the relative market risk of the share, compared with the average market risk of the market as a whole.
A share with a risk exactly equal to the average risk of the market will have a beta of 1.0.
A share which, on average, rises exactly half as much as the market when the market rises and which, on average, falls exactly half as much as the market when the market falls would have a beta of 0.5. This is often called a defensive share as it has lower volatility than the market average.
Similarly, greater increases and greater falls than the market would give a beta of higher than one.
Example 1: implications of high and low betas
If the market rose by 10% and a company had a beta of 1.20, it would be expected that the share price would rise by 12% (10% x 1.20).
If the market fell by 10% and a company had a beta of 1.20, it would be expected that the share price would fall by 12% (-10% x 1.20).
If the market rose by 10% and a company had a beta of 0.80, it would be expected that the share price would rise by 8% (10% x 0.80).
If the market fell by 10% and a company had a beta of 0.80, it would be expected that the share price would fall by 8% (-10% x 0.80).
There are a few other concepts that need to be considered in respect of betas:
– betas in practice are driven by two key factors:
- business risk: The higher the business risk the higher the beta. A Utility for example is a stable business so will have a lower business risk than an oil exploration company
- financial risk as measured by gearing. The higher the level of gearing the higher the risk. If there were two similar supermarkets operating in the same market and having the same business risk, the one with the higher level of gearing will typically have the higher beta
– published betas are normally geared betas, i.e. the beta that is applied to a business that has debt
– an equity beta is used for a company that has no debt or the financial risks (associated with having debt) have been stripped out (the process of undertaking this, is outside the scope of this qualification).
Importantly, the geared equity beta is measured empirically from actual share and market returns. So the reported geared equity beta is not what someone has judged it should be, it is deduced from actual observation.
Please review the webinar to support your understanding on this topic
First published 2016. Updated and republished 2022.
Published by: ACT (Administration) Limited www.treasurers.org
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