Credit Risk

Credit Risk
Prof Mahesh Kumar

Amity Business School
profmaheshkumar@rediffmail.com
International Finance is about Risk
Mitigation or Risk Engineering
Financial
Risks
Operational Risk
Reputational Risk
Business and
strategic risks
Market Risk
Credit Risk

Introduction
Risk is multidimensional
Introduction
One can slice and dice these multiple dimensions of risk
Portfolio
Concentration
Risk
Transaction Risk
Counterparty
Risk
Issuer Risk
Trading Risk
Gap Risk
Equity Risk
Interest Rate Risk
Currency Risk
Commodity Risk
Financial
Risks
Operational
Risk
Reputational
Risk
Business and
strategic risks
Market Risk
Credit Risk
Specific
Risk
General
Market
Risk
Issue Risk
The Trade Relationship
Trade financing shares a number of common characteristics with the
traditional value chain activities conducted by all firms.
All companies must search out suppliers for the many goods and
services required as inputs to their own goods production or service
provision processes.
Issues to consider in this process include the capability of suppliers
to produce the product to adequate specifications, deliver said
products in a timely fashion, and to work in conjunction on product
enhancements and continuous process improvement.
All of the above must also be at an acceptable price and payment
terms.
The Trade Relationship
The nature of the relationship between the
exporter and the importer is critical to
understanding the methods for import-export
financing utilized in industry.
There are three categories of relationships (see
next exhibit):
Unaffiliated unknown
Unaffiliated known
Affiliated (sometimes referred to as intra-firm trade)
The composition of global trade has changed
dramatically over the past few decades, moving
from transactions between unaffiliated parties to
affiliated transactions.
7
Alternative International Trade Relationships
Unaffiliated
Known Party
A long-term customer
with which there is an
established relationship of
trust and performance
Unaffiliated
Unknown Party
A new customer
which with exporter has
no historical business
relationship
Affiliated
Party
A foreign subsidiary
or affiliate
of exporter
Requires:
1. A contract
2. Protection against
non-payment
Requires:
1. No contract
2. No protection against
non-payment
Requires:
1. A contract
2. Possibly some protection
against non-payment
Exporter
Importer is .
The Trade Dilemma
International trade (i.e. between and importer and
exporter) must work around a fundamental dilemma:
They live far apart
They speak different languages
They operate in different political environments
They have different religions
They have different standards for honoring obligations
In essence, there could be distrust, and clearly the importer
and exporter would prefer two different arrangements for
payment/goods transfer (next exhibit)
9
The Mechanics of Import and Export
Importer
Importer
Exporter
Exporter
Importer Preference
Exporter Preference
1
st
: Exporter ships the goods
2
nd
: Importer pays after goods received
1
st
: Importer pays for goods
2
nd
: Exporter ships the goods after being paid
The Trade Dilemma
The fundamental dilemma of being unwilling to trust a
stranger in a foreign land is solved by using a highly
respected bank as an intermediary.
The following exhibit is a simplified view involving a letter
of credit (a banks promise to pay) on behalf of the
importer.
Two other significant documents are an order bill of
lading and a sight draft.
11
The Bank as the Import/Export Intermediary
Importer
Exporter
Bank
1
st
: Importer obtains banks promise
to pay on importers behalf.
2
nd
: Bank promises exporter
to pay on behalf of importer.
3
rd
: Exporter ships to the bank
trusting banks promise.
4
th
: Bank pays the
exporter.
6
th
: Importer pays
the bank.
5
th
: Bank gives merchandise
to the importer.
Benefits of the System
The system (including the three documents discussed)
has been developed and modified over centuries to
protect both importer and exporter from:
The risk of noncompletion
Foreign exchange risk
To provide a means of financing

Elements of an Import/Export Transaction
Each individual trade transaction must cover three
basic elements: description of goods, prices, and
documents regarding shipping and delivery
instructions.
Contracts:
An import or export transaction is by definition a contractual
exchange between parties in two countries that may have
different legal systems, currencies, languages, religions or units
of measure
All contracts should include definitions and specifications for the
quality, grade, quantity, and price of the goods in question
Prices:
Price quotations can be a major source of confusion
Price terms in the contract should conform to
published catalogs, specify whether quantity
discounts or early payment discounts are in effect,
and state whether finance charges are relevant in the
case of deferred payment, and should address other
relevant fees or charges
Documents:
Bill of lading issued to the exporter by a common
carrier transporting the merchandise
Commercial invoice issued by the exporter and
contains a precise description of the merchandise (also
indicates unit prices, financial terms of the sale etc.)
Insurance documents specified in the contract of sale
and issued by insurance companies (or their agents)
Consular invoices issued in the exporting country by
the consulate of the importing country
Packing lists
International Trade Risks
The following exhibit illustrates the sequence of events in
a single export transaction.
From a financial management perspective, the two
primary risks associated with an international trade
transaction are currency risk (currency denomination of
payment) and risk of non-completion (timely and
complete payment).
The risk of default on the part of the importer is present
as soon as the financing period begins.
The Trade Transaction Time-Line and Structure
Time and Events
Price
quote
request
Export
contract
signed
Goods
are
shipped
Documents
are
accepted
Goods
are
received
Negotiations
Backlog
Documents Are
Presented
Cash
settlement
of the
transaction
Financing Period
What is credit risk ?
In international trade there are various modes of
payments like cash, cheque, bills of exchange etc.
Thus before any export order is executed, both
importer and exporter agree on the terms of the
transaction. But still there is a default in payment
and the repossession of goods is difficult if not
impossible.
Credit risk is the risk that one may not be paid for
goods and services supplied.
Payment Methods for International
Trade
In any international trade transaction, credit is
provided by either
the supplier (exporter),
the buyer (importer),
one or more financial institutions, or
any combination of the above.
The form of credit whereby the supplier funds the
entire trade cycle is known as supplier credit.
PAYMENT TERMS
Four Principal Means:
1. Prepayments
2. Letter of Credit
3. Drafts
4. Open Account
5. Consignment

Method O : Prepayments
The goods will not be shipped until the buyer has
paid the seller.
Time of payment : Before shipment
Goods available to buyers : After payment
Risk to exporter : None
Risk to importer : Relies completely on exporter
to ship goods as ordered
Trade
Trade
Cash Payment with order:
This is an ideal mode of payment to exporter as he
possesses both the goods as well as the payment
for the limited period till the execution of the order.
Trade
Cash on Delivery:
This a variant of CWO and is used for small value
goods which can be sent by post.
These goods are released only after receiving
payment of the invoice plus COD charges.
Payment Methods for International Trade
PREPAYMENT
1. Minimal risk to exporter
2. Used where there is
a) Political unrest
b) Goods made to order
c) New and unfamiliar customer
d) Exporter is competitively very strong
e) Importers credit worthiness is doubtful

Method O : Letters of credit (L/C)
These are issued by a bank on behalf of the
importer promising to pay the exporter upon
presentation of the shipping documents.
Time of payment : When shipment is made
Risk to exporter : Very little or none
Risk to importer : Relies on exporter to ship
goods as described in documents
Trade
26
Parties to a Letter of Credit (L/C)
Issuing Bank
Beneficiary
(exporter)
Applicant
(importer)
The relationship between the importer and the
exporter is governed by the sales contract.
The relationship between the
importer and the issuing bank is
governed by the terms of the
application and agreement
for the letter of credit (L/C).
The relationship between the
issuing bank and the exporter
is governed by the terms of the
letter of credit, as issued by
that bank.
Letter of Credit (L/C)
The essence of the L/C is the promise of the issuing
bank to pay against specified documents, which must
accompany any draft drawn against the credit.
To constitute a true L/C transaction, all of the following
five elements must be present with respect to the
issuing bank:
1. Must receive a fee or other valid business
consideration for issuing the L/C
2. The L/C must contain a specified expiration date or
definite maturity
3. The banks commitment must have a stated
maximum amount of money
4. The banks obligation to pay must arise only on the
presentation of specific documents
5. The banks customer must have an unqualified
obligation to reimburse the bank on the same
condition as the bank has paid
Commercial letters of credit are also classified:
Irrevocable versus revocable
Confirmed versus unconfirmed
The primary advantage of an L/C is that it
reduces risk the exporter can sell against a
banks promise to pay rather than against the
promise of a commercial firm.
The major advantage of an L/C to an importer is
that the importer need not pay out funds until
the documents have arrived at the bank that
issued the L/C and after all conditions stated in
the credit have been fulfilled.
PAYMENT TERMS
1. A letter addressed to seller
a. written and signed by buyers (importer) bank
b. promising to honor sellers (exporter) drafts.
c. Bank substitutes its own commitment
*d. Seller must conform to terms
e. Protects in case of discrepancies

* Not an advantage to the exporter
PAYMENT TERMS
Advantages of an L/C to Exporter
a. eliminates credit risk and
b. pre-shipment risk of order cancellation

PAYMENT TERMS
Advantages of L/C to Importer
a. shipment by exporter assured
b. documents inspected ensure the correct order
c. may allow better sales terms

PAYMENT TERMS
Safest type of L/Cs
a. documentary
includes bill of lading and commercial invoice

b. irrevocable
99% of the time
c. confirmed

Method O : Drafts (Bills of Exchange)
These are unconditional promises drawn by the
exporter instructing the buyer to pay the face
amount of the drafts.
Banks on both ends usually act as intermediaries
in the processing of shipping documents and the
collection of payment. In banking terminology,
the transactions are known as documentary
collections.
Trade
Draft
A draft, sometimes called a bill of exchange
(B/E), is the instrument normally used in
international commerce to effect payment.
A draft is simply an order written by an exporter
(seller) instructing and importer (buyer) or its
agent to pay a specified amount of money at a
specified time.
The person or business initiating the draft is
known as the maker, drawer, or originator.
Normally this is the exporter who sells and ships
the merchandise.
The party to whom the draft is addressed is the
drawee.
Draft
If properly drawn, drafts can become negotiable
instruments.
As such, they provide a convenient instrument for financing
the international movement of merchandise (freely bought
and sold).
To become a negotiable instrument, a draft must conform
to the following four requirements:
1. It must be in writing and signed by the maker or drawer
2. It must contain an unconditional promise or order to
pay a definite sum of money
3. It must be payable on demand or at a fixed or
determinable future date
4. It must be payable to order or to bearer
There are time drafts and sight drafts.
Management of Credit Risk
Bill of Exchange: This is the most prevalent mode
of credit payment. A bill of exchange is defined as
an unconditional order in writing addressed by one
person to another, signed by the person giving it,
requiring the person to whom it is addressed to
pay on demand or at a fixed or determinable
future date, a sum certain in money to or to the
order of a specified person or to the bearer. Bill of
exchange can also be discounted by negotiation.
PAYMENT TERMS
DRAFTS
1. Definition:
- unconditional order in writing
- exporters order for importer to pay
- at once (sight draft) or
- in future (time draft)

PAYMENT TERMS
Three Functions of Drafts
a. clear evidence of financial obligation
b. reduced financing costs
c. Can be a financial product for investors
(i.e. A time draft may be converted to a bankers acceptance)
PAYMENT TERMS
Types of Drafts
a. sight
b. time

Sight drafts (documents against payment): When
the shipment has been made, the draft is presented
to the buyer for payment.
Time of payment : On presentation of draft
Risk to exporter : Disposal of unpaid goods
Risk to importer : Relies on exporter to ship goods
as described in documents
Trade
Time drafts (documents against acceptance): When
the shipment has been made, the buyer accepts
(signs) the presented draft.
Time of payment : On maturity of draft
Goods available to buyers : Before payment
Risk to exporter : Relies on buyer to pay
Risk to importer : Relies on exporter to ship goods
as described in documents
Trade
Management of Credit Risk
Method O : Open Accounts
Open Account is a procedure in which the financing burden
lies with the exporter unlike CWO.
In this mode, exporter and importer agree that the account
will be settled at a predetermined date.
After the agreement, the exporter starts sending the goods
to the importer along with the shipping documents and the
importer can use the goods as he wishes to use and on the
payment date, the accounts are settled as per the
agreement.
OA trading is used when there is a trusted relationship
between the trading partners
PAYMENT TERMS
OPEN ACCOUNT
1. Creates a credit sale
2. To importers advantage
3. More popular lately because
a. major surge in global trade
b. credit information improved
c. more global familiarity with exporting.
PAYMENT TERMS
4. Benefits of Open Accounts:
a. greater flexibility in making a trade
b. lower transactions costs
5. Major disadvantage:
-Slow payment
-highly vulnerable to government currency controls.
The exporter ships the merchandise and expects
the buyer to remit payment according to the
agreed-upon terms.
Time of payment : As agreed upon
Risk to exporter : Relies completely on buyer to
pay account as agreed upon
Risk to importer : None
Trade
Method O : Consignments
This is a variant of open account payment where an
exporter supplies an overseas buyers to build stocks
of his product sufficient to cover its continued
demand.
In this case, the exporter remains the owner of the
goods until these goods are sold for an agreed price.
The account are settled at interval agreed between
importer and exporter.
Trade
Consignments
The exporter retains actual title to the goods that
are shipped to the importer.
Time of payment : At time of sale by buyer to
third party
Risk to exporter : Allows importer to sell inventory
before paying exporter
Risk to importer : None
Trade
Comparison of Payment Methods
Financing Techniques
Four Types:
1. Accounts receivable financing
2. Bankers Acceptances
3. Discounting the draft
4. Factoring
5. Forfaiting

Trade Finance Methods
OAccounts Receivable Financing
An exporter that needs funds immediately may
obtain a bank loan that is secured by an
assignment of the account receivable.
O Factoring
Factoring is of recent origin in Indian Context.
Kalyana Sundaram Committee recommended
introduction of factoring in 1989.
Banking Regulation Act, 1949, was amended in
1991 for Banks setting up factoring services.
SBI/Canara Bank have set up their Factoring
Subsidiaries:-
+SBI Factors Ltd., (April, 1991)
+CanBank Factors Ltd., (August, 1991).
RBI has permitted Banks to undertake factoring
services through subsidiaries.
WHAT IS FACTORING ?
Factoring is the Sale of Book Debts by a firm (Client) to a
financial institution (Factor) on the understanding that the
Factor will pay for the Book Debts as and when they are
collected or on a guaranteed payment date. Normally, the
Factor makes a part payment (usually upto 80%)
immediately after the debts are purchased thereby providing
immediate liquidity to the Client.
PROCESS OF FACTORING

CLIENT
CUSTOMER
FACTOR
So, a Factor is,
a)A Financial Intermediary
b)That buys invoices of a manufacturer or a
trader, at a discount, and
c) Takes responsibility for collection of payments.

The parties involved in the factoring transaction
are:-
a)Supplier or Seller (Client)
b)Buyer or Debtor (Customer)
c) Financial Intermediary (Factor)
Services offered by Factor

1. Follow-up and collection of Receivables from
Clients.
2. Purchase of Receivables with or without recourse.
3. Help in getting information and credit line on
customers (credit protection)
4. Sorting out disputes, if any, due to his relationship with
Buyer & Seller.
Process involved in Factoring

Client concludes a credit sale with a customer.
Client sells the customers account to the Factor and notifies
the customer.
Factor makes part payment (advance) against account
purchased, after adjusting for commission and interest on
the advance.
Factor maintains the customers account and follows up for
payment.
Customer remits the amount due to the Factor.
Factor makes the final payment to the Client when the
account is collected or on the guaranteed payment date.
TYPES OF FACTORING
Recourse Factoring

Non-recourse Factoring

Maturity Factoring

Cross-border Factoring

RECOURSE FACTORING

Upto 75% to 85% of the Invoice Receivable is factored.

Interest is charged from the date of advance to the date of
collection.

Factor purchases Receivables on the condition that loss arising on
account of non-recovery will be borne by the Client.

Credit Risk is with the Client.

Factor does not participate in the credit sanction process.

In India, factoring is done with recourse.
NON-RECOURSE FACTORING
Factor purchases Receivables on the condition that the Factor has
no recourse to the Client, if the debt turns out to be non-
recoverable.

Credit risk is with the Factor.

Higher commission is charged.

Factor participates in credit sanction process and approves credit
limit given by the Client to the Customer.

In USA/UK, factoring is commonly done without recourse.
MATURITY FACTORING
Factor does not make any advance payment to the Client.

Pays on guaranteed payment date or on collection of
Receivables.

Guaranteed payment date is usually fixed taking into
account previous collection experience of the Client.

Nominal Commission is charged.

No risk to Factor.

CROSS - BORDER FACTORING
It is similar to domestic factoring except that there are four parties,
viz.,
a) Exporter,
b) Export Factor,
c) Import Factor, and
d) Importer.

It is also called two-factor system of factoring.
Exporter (Client) enters into factoring arrangement with Export
Factor in his country and assigns to him export receivables.
Export Factor enters into arrangement with Import Factor and has
arrangement for credit evaluation & collection of payment for an
agreed fee.
Notation is made on the invoice that importer has to make payment
to the Import Factor.
Import Factor collects payment and remits to Export Factor who
passes on the proceeds to the Exporter after adjusting his advance,
if any.
Where foreign currency is involved, Factor covers exchange risk
also.
FACTORING
Factoring: Firms sell accounts receivable to another firm
known as the factor.
a. Discount charged by factor
b. Non-recourse basis: Factor assumes all payment risk.
c. When used:
1. Occasional exporting
2.Clients geographically dispersed.
STATUTES APPLICABLE TO FACTORING
Factoring transactions in India are governed by the following
Acts:-

a) Indian Contract Act

b) Sale of Goods Act

c) Transfer of Property Act

d) Banking Regulation Act.

e) Foreign Exchange Regulation Act.
WHY FACTORING IS NOT POPULAR IN
INDIA
Banks reluctance to provide factoring services

Banks resistance to issue Letter of Disclaimer (Letter of
Disclaimer is mandatory as per RBI Guidelines).

Problems in recovery.

Factoring requires assignment of debt which attracts Stamp
Duty.

Cost of transaction becomes high.
OLetters of Credit (L/C)
These are issued by a bank on behalf of the
importer promising to pay the exporter upon
presentation of the shipping documents.
The importer pays the issuing bank the
amount of the L/C plus associated fees.
Commercial or import/export L/Cs are usually
irrevocable.
OLetters of Credit (L/C)
The required documents typically include a draft
(sight or time), a commercial invoice, and a bill of
lading (receipt for shipment).
Sometimes, the exporter may request that a local
bank confirm (guarantee) the L/C.
DISCOUNTING
Discounting
a. Converts exporters time drafts to cash minus interest to maturity
and commissions.
b. Low cost financing with few fees
c. May be:
with recourse (exporter still liable)
or
without recourse (bank takes liability for nonpayment)
Example of an Irrevocable Letter of
Credit
Documentary Credit Procedure
Buyer
(Importer)
O Sale Contract
Seller
(Exporter)
O Deliver Goods
O
Request
for Credit
Importers Bank
(Issuing Bank)
O
Documents
& Claim for
Payment
O
Present
Documents
O
Deliver
Letter of
Credit
O Present
Documents
O Send Credit
Exporters Bank
(Advising Bank)
O Payment
O Letters of Credit (L/C)
Variations include
standby L/Cs : funded only if the buyer does not pay the
seller as agreed upon
transferable L/Cs : the first beneficiary can transfer all or
part of the original L/C to a third party
assignments of proceeds under an L/C : the original
beneficiary assigns the proceeds to the end supplier
FACTORING
vs
BILLS DISCOUNTING
BILL DISCOUNTING
1. Bill is separately examined and
discounted.

2. Financial Institution does not
have responsibility of Sales
Ledger Administration and
collection of Debts.

3. No notice of assignment
provided to customers of the
Client.
FACTORING
1. Pre-payment made against all
unpaid and not due invoices
purchased by Factor.

2. Factor has responsibility of
Sales Ledger Administration
and collection of Debts.

3. Notice of assignment is
provided to customers of the
Client.
FACTORING
vs.
BILLS DISCOUNTING (contd)
BILLS DISCOUNTING
4. Bills discounting is usually
done with recourse.

5. Financial Institution can
get the bills re-
discounted before they
mature for payment.
FACTORING
4. Factoring can be done with
or without recourse to
client. In India, it is done
with recourse.

5. Factor cannot re-discount
the receivable purchased
under advanced factoring
arrangement.

OBankers Acceptance (BA)
This is a time draft that is drawn on and
accepted by a bank (the importers bank). The
accepting bank is obliged to pay the holder of
the draft at maturity.
If the exporter does not want to wait for
payment, it can request that the BA be sold in
the money market. Trade financing is provided
by the holder of the BA.
Bankers Acceptance
OBankers Acceptance (BA)
The bank accepting the drafts charges an all-in-
rate (interest rate) that consists of the discount
rate plus the acceptance commission.
In general, all-in-rates are lower than bank loan
rates. They usually fall between the rates of short-
term Treasury bills and commercial papers.
BANKERS ACCEPTANCES
1. Bank created acceptances
a. Creation: Time drafts accepted by bank
b. Terms: Payable at maturity to holder
c. Sale in the money market: Bankers acceptance
d. Highly liquid market

Life Cycle of a Typical Bankers Acceptance
8. Pay Discounted Value of BA
1 - 7 : Prior to BA
1. Purchase
Order
Importer Exporter
5. Ship
Goods
Importers
Bank
2. Apply
for L/C
11.
Shipping
Documents
14. Pay
Face Value
of BA
10. Sign
Promissory
Note to Pay
6.
Shipping
Documents
& Time
Draft
4. L/C
Notification
9. Pay
Discounted
Value of
BA
7. Shipping Documents
&
Time Draft
Exporters
Bank
3. L/C
12. BA
Money Market
Investor
13. Pay Discounted Value of BA
16. Pay Face Value of BA
15. Present BA at Maturity
14 - 16 : When BA
matures
8 - 13 : When BA
is created
O Working Capital Financing
Banks may provide short-term loans that finance the
working capital cycle, from the purchase of inventory
until the eventual conversion to cash.
FORFAITING

Forfait is derived from French word A Forfait
which means surrender of fights.

Forefaiting is a mechanism by which the right for
export receivables of an exporter (Client) is
purchased by a Financial Intermediary
(Forfaiter) without recourse to him.

It is different from International Factoring in as
much as it deals with receivables relating to
deferred payment exports, while Factoring deals
with short term receivables.

O Medium-Term Capital Goods Financing (Forfaiting)
The importer issues a promissory note to the exporter to pay for
its imported capital goods over a period that generally ranges
from three to seven years.
The exporter then sells the note, without recourse, to a bank
(the forfaiting bank).
Forfaiting involves the purchasing of receivables from
exporters.
The forfaiter takes on all risks involved with the receivables.
It is different from the factoring operation in the sense that
forfaiting is a transaction-based operation while factoring is a
firm-based operation: In factoring, a firm sells all its receivables
while in forfaiting, the firm sells one of its transactions.
FORFAITING (contd)
Exporter under Forfaiting surrenders his right for claiming
payment for services rendered or goods supplied to
Importer in favor of Forefaiter.

Bank (Forefaiter) assumes default risk possessed by the
Importer.

Credit Sale gets converted as Cash Sale.

Forfaiting is arrangement without recourse to the Exporter
(seller)

Operated on fixed rate basis (discount)

Finance available upto 100% of value (unlike in Factoring)

Introduced in the country in 1992.
FORFAIT
Forfaiting
a. Definition: discounting at a fixed rate without recourse
for medium- term accounts receivable
b. Use: Large capital purchases
c. Most popular in W. Europe
MECHANICS OF FORFAITING

EXPORTER
IMPORTER
FORFAITER
AVALLING BANK
HELD TILL MATURITY
SELL TO GROUPS OF INVESTORS
TRADE IN SECONDARY MARKET
ESSENTIAL REQUISITES OF
FORFAITING TRANSACTIONS
Exporter to extend credit to Customers for periods above 6
months.

Exporter to raise Bill of Exchange covering deferred
receivables from 6 months to 5 years.

Repayment of debts will have to be avalled or guaranteed
by another Bank, unless the Exporter is a Government
Agency or a Multi National Company.

Co-acceptance acts as the yard stick for the Forefaiter to
credit quality and marketability of instruments accepted.
IN FORFAITING:-

gPromissory notes are sent for avalling (guarantee) to
the Importers Bank.

gAvalled notes are returned to the Importer.

gAvalled notes sent to Exporter.

gAvalled notes sold at a discount to a Forefaiter on a
NON-RECOURSE basis.

gExporter obtains finance.

gForfaiter holds the notes till maturity or securitises
these notes and sells the Short Term Paper either to a
group of investors or to investors at large in the
secondary market.
CHARACTERISTICS OF FORFAITING
Converts Deferred Payment Exports into cash transactions,
providing liquidity and cash flow to Exporter.

Absolves Exporter from Cross-border political or conversion risk
associated with Export Receivables.

Finance available upto 100% (as against 75-80% under
conventional credit) without recourse.

Acts as additional source of funding and hence does not have impact
on Exporters borrowing limits. It does not reflect as debt in
Exporters Balance Sheet.

Provides Fixed Rate Finance and hence risk of interest rate
fluctuation does not arise.
CHARACTERISTICS OF FORFAITING
(contd.)
Exporter is freed from credit administration.

Provides long term credit unlike other forms of bank credit.

Saves on cost as ECGC Cover is eliminated.

Simple Documentation as finance is available against bills.

Forfait financer is responsible for each of the Exporters trade
transactions. Hence, no need to commit all of his business or
significant part of business.

Forfait transactions are confidential.

COSTS INVOLVED IN FORFAITING
Commitment Fee:- Payable to Forfaiter by Exporter in
consideration of forefaiting services.

Commission:- Ranges from 0.5% to 1.5% per annum.

Discount Fee:- Discount rate based on LIBOR for the period
concerned.

Documentation Fee:- where elaborate legal formalities are
involved.

Service Charges:- payable to Exim Bank.

FACTORING vs. FORFAITING
POINTS OF
DIFFERENCE
FACTORING FORFAITING
Extent of Finance Usually 75 80% of the
value of the invoice
100% of Invoice value
Credit
Worthiness
Factor does the credit
rating in case of non-
recourse factoring
transaction
The Forfaiting Bank
relies on the
creditability of the
Availing Bank.
Services provided Day-to-day administration
of sales and other allied
services
No services are
provided
Recourse With or without recourse Always without
recourse
Sales By Turnover By Bills
COMPARATIVE ANALYSIS
BILLS
DISCOUNTED
FACTORING FORFAITING
1. Scrutiny Individual Sale
Transaction
Service of Sale
Transaction
Individual Sale
Transaction
2. Extent of
Finance
Upto 75 80% Upto 80% Upto 100%
3. Recourse With Recourse With or
Without
Recourse
Without
Recourse
4. Sales
Administration
Not Done Done Not Done
5. Term Short Term Short Term Medium Term
6. Charge
Creation
Hypothecation Assignment Assignment
WHY FORFAITING HAS NOT DEVELOPED
1. Relatively new concept in India.
2. Depreciating Rupee
3. No ECGC Cover
4. High cost of funds
5. High minimum cost of transactions (USD 250,000/-)
6. RBI Guidelines are vague.
7. Very few institutions offer the services in India. Exim
Bank alone does.
8. Long term advances are not favored by Banks as hedging
becomes difficult.
9. Lack of awareness.

STAGES INVOLVED IN FORFAITING
= Exporter approaches the Facilitator (Bank) for obtaining Indicative
Forfaiting Quote.

= Facilitator obtains quote from Forfaiting Agencies abroad and
communicates to Exporter.

= Exporter approaches importer for finalizing contract duly loading the
discount and other charges in the price.

= If terms are acceptable, Exporter approaches the Bank (Facilitator) for
obtaining quote from Forfaiting Agencies.

= Exporter has to confirm the Firm Quote.

= Exporter has to enter into commercial contract.

= Execution of Forfaiting Agreement with Forefaiting Agency.

= Export Contract to provide for Importer to furnish availed BoE/DPN.

STAGES INVOLVED IN FORFAITING (contd..)
= Forfaiter commits to forefait the BoE/DPN, only against Importer Banks
Co-acceptance. Otherwise, LC would be required to be established.

= Export Documents are submitted to Bank duly assigned in favor of
Forfaiter.

= Bank sends document to Importer's Bank and confirms assignment and
copies of documents to Forefaiter.

= Importers Bank confirms their acceptance of BoE/DPN to Forfaiter.

= Forfaiter remits the amount after deducting charges.

= On maturity of BoE/DPN, Forfaiter presents the instrument to the Bank
and receives payment.

= Forfaiter commits to forefait the BoE/DPN only against Importer Banks
Co-acceptance. Otherwise, LC would be required to be established.
STAGES INVOLVED IN FORFAITING (contd)
= Export Documents are submitted to Bank duly assigned
in favor of Forfaiter

= Importers Bank confirms their acceptance of BoE/DPN
to Forfaiter.

= Forfaiter remits the amount after deducting charges.

= On maturity of BoE/DPN, Forfaiting Agency presents the
instruments to the Bank and receives payment
STAGES INVOLVED IN EXPORT FACTORING
Exporter (Client) gives his name, address and credit limit required
to the Export Factor.

Export Factor submits the details of Buyer to the Import Factor.

Import Factor decides on the credit cover and communicates
decision to Export Factor.

Export Factor enters into Factoring Agreement with Exporter.

Overseas Buyer is notified of this arrangement.

Exporter is then free to ship the goods to Buyers directly.

Exporter submits original documents, viz., invoice and shipping
documents duly assigned and receives advance there-against (upto
80%).
STAGES INVOLVED IN EXPORT FACTORING
(contd..)
Export Factor dispatches all the original documents to
Importer/Buyer after duly affixing Assignment Clause in
favor of the Import Factor.

Export Factor sends copy of invoice to Import Factor in the
Debtors country.

Import Factor follows up and receives payment on due
date and remits to Export Factor.

Export Factor, on receipt of payment, releases the balance
of proceeds to Exporter.

O Counter trade
These are foreign trade transactions in which the
sale of goods to one country is linked to the
purchase or exchange of goods from that same
country.
Common counter trade types include barter,
compensation (product buy-back), and counter
purchase.
The primary participants are governments and
MNCs.
COUNTERTRADE
Three Specific Forms:
1. Barter: Direct exchange in kind. Barter requires
double coincidence of wants.
2. Buyback: repayment of original purchase through
sale of a related product. A buy-back transaction
involves a technology transfer via the sale of a
manufacturing plant.
The seller of the plant agrees to buy back some of the
output of the plant once it is constructed.
3. Counter purchase: Sale/purchase of unrelated
goods but with currencies. Thus a counter purchase
trade agreement is similar to a buy-back
transaction, but differs in that
The output that the seller of the plant agrees to buy is
unrelated to the plant.
Disadvantages of Countertrade
1. It is inefficient.
2. Some claim that such transactions tamper with
the fundamental operation of free markets, and
therefore resources will be used inefficiently.
3. Transactions that do not make use of money
represent a huge step backwards in economic
development.
Advantages of Countertrade
1. Countertrade conserves cash and hard currency.
2. Advantages also include
i. the improvement of trade imbalances
ii. the maintenance of export prices
iii. enhanced economic development
iv. increased employment
v. technology transfer
vi. market expansion
vii. increased profitability,
viii. less costly sourcing of supply, reduction of surplus
goods from inventory
ix. the development of marketing expertise.
Generalizations about Countertrade
There are advantages and disadvantages
associated with countertrade.
It can benefit both parties and in some
circumstances is the only trade possible.
Whether countertrade transactions are good or
bad for the global economy, it appears certain
that they will increase in the near future as world
trade increases.
COUNTERTRADE
When to Use Counter trade
1. with soft-currency developing countries
2. when tariffs or quotas prevent trade.
Due to the inherent risks of international trade, government
institutions and the private sector offer various forms of
export credit, export finance, and guarantee programs to
reduce risk and stimulate foreign trade.
Governments of most export-oriented industrialized
countries have special financial institutions that provide
some form of subsidized credit to their own national
exporters.
These export finance institutions offer terms that are better
than those generally available from the competitive private
sector.
Thus domestic taxpayers are subsidizing lower financial
costs for foreign buyers in order to create employment and
maintain a technological edge.
The most important institutions usually offer export credit
insurance and a government-supported bank for export
financing.

Agencies that Motivate International
Trade

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