By: John Michael Pierobon
International trade is the exchange of capital, goods, and services across international borders.
International trade has many risks including political risk, economic risk, foreign exchange risk (currency devaluation), and transaction exposure. An importer (buyer) or exporter (seller) can hedge foreign currency exchanges, but the one risk they can truly mitigate is transaction exposure.
As with any transaction, buyers want to make sure they receive their purchase on time and in good condition. Sellers need to know they will get paid in a timely manner. Naturally, an exporter wants to receive payment as soon as possible, preferably as soon as an order is placed or before the goods are sent to the importer. An importers wants to receive the goods as soon as possible, but delay payment as long as possible, preferably until after the goods are resold to generate enough income to pay the exporter.
This article sets out to explain different methods to minimize the risk of transaction exposure in the minds of both importers and exporters.
Cash-in-Advance
This is the fastest and least costly payment method, but it requires the most trust. An exporter can avoid credit risk with cash-in-advance payment terms because payment is received before the ownership of the goods is transferred. Wire transfer and credit card payments are the most commonly used methods of cash-in-advance payments.
Requiring payment in advance is the least attractive option for the buyer because it creates cash flow problems. Foreign buyers are also concerned that the goods may not be sent even if payment is made in advance. Exporters who insist on this payment method may lose business to competitors who offer more attractive payment terms.
Letters of Credit
A letter of credit is a commitment written by the importer's bank on behalf of the importer stating that payment will be made when the terms and conditions stated in the letter of credit have been met, as verified through the presentation of all required documents.
Most letters of credit are "irrevocable", which means that once sent, it cannot be changed unless both the buyer and the seller agree.
Letters of credit deal in documents, not goods. The process works in favor of both the buyer and the seller. The buyer pays their bank to render this service. A letter of credit is useful when reliable credit information about a foreign buyer is difficult to obtain, but the exporter is satisfied with the creditworthiness of the buyer’s foreign bank. A letter of credit also protects the buyer because no payment obligation arises until the goods have been shipped or delivered as promised.
Documentary Collection
A documentary collection is a transaction whereby the exporter, in addition to shipping the goods, gives the documents necessary to claim the goods at the foreign port, to the remitting bank (exporter’s bank), which in turn sends the documents to the collecting bank (importer’s bank) along with payment instructions. Funds are received from the importer and remitted to the exporter through the banks involved in the collection in exchange for the documents. A documentary collection is a draft that requires the importer to pay the face amount either at sight (document against payment) or on a specified date (document against acceptance). The draft gives instructions specifying the documents required for the transfer of title to the goods. Although banks do act as facilitators for their clients, documentary collections offer no verification process and limited recourse in the event of non-payment. They are used because they are usually less expensive than letters of credit.
Open Account
An open account transaction is a sale where the goods are shipped and delivered before payment is due. This option is the most advantageous option to the importer in terms of cash flow and cost, but it is the highest risk option for an exporter. The exporter receives payment only after the buyer has received and inspected the goods.
Because of intense competition in export markets, foreign buyers often press exporters for open account terms. Exporters who are reluctant to extend credit may lose a sale to their competitors. However, an exporter can offer competitive open account terms while substantially mitigating the risk of non-payment by using of one or more of the appropriate trade finance techniques, such as export credit insurance.
This article was paid for under an open account agreement.