Question

Variation in the price of agricultural and non-agricultural commodities is determined over time, by demand-supply dynamics. The last two decades have seen a significant increase in the volume of international trade and business due to globalisation and liberalisation sweeping across the world. This has led to rapid and unpredictable variations in financial assets prices, interest rates and exchange rates, and subsequently, to exposing Multi-National Corporations to financial risk. As a result, financial markets have experienced rapid variations in interest and exchange rates and stock market prices, thus exposing the corporate world to a state of growing financial risk. We can hedge the risk of price variations in stocks, bonds, commodities, currencies, interest rates, market indices etc. Given this context please conduct the necessary research and answer the following questions.

1)      How is a country's economic well-being enhanced through free international trade in goods and services? Provide and discuss two relevant examples specific to your jurisdiction.   (10marks)

2)      Outline and discuss two methods of payments in international trade and two (2 ) methods of financing international trade for a selected Multi National Corporation in your jurisdiction   

3)      Define and discuss two (2) similarities and two (2) differences between a futures contract and a forward contract. When would the use of one be preferred over the other?   

Answer 1

Q1. How is a country’s economic well-being enhanced through free international trade in goods andservices?

A: According to David Ricardo, with free international trade, it is mutually beneficial for two countries toeach specialize in the production of the goods that it can produce relatively most efficiently and thentrade those goods. By doing so, the two countries can increase their combined production, which allowsboth countries to consume more of both goods. This argument remains valid even if a country canproduce both goods more efficiently than the other country. International trade is not a ‘zero-sum’game in which one country benefits at the expense of another country. Rather, international trade couldbe an ‘increasing-sum’ game at which all players become winners.

Q2.Outline and discuss two methods of payments in international trade.

Methods of Payment in International Trade

This chapter is also available via download in PDF format.

To succeed in today’s global marketplace and win sales against foreign competitors, exporters must offer their customers attractive sales terms supported by the appropriate payment methods. Because getting paid in full and on time is the ultimate goal for each export sale, an appropriate payment method must be chosen carefully to minimize the payment risk while also accommodating the needs of the buyer. As shown in figure 1, there are five primary methods of payment for international transactions. During or before contract negotiations, you should consider which method in the figure is mutually desirable for you and your customer.

New Payment Risk Diagram – To Be Created by Designer

	Least Secure	Less Secure		More Secure	Most Secure
Exporter	Consignment	Open Account	Documentary Collections	Letters of Credit	Cash-in-Advance
Importer	Cash-in-Advance	Letters of Credit	Documentary Collections	Open Account	Consignment

Figure 1: Payment Risk Diagram

Key Points

• International trade presents a spectrum of risk, which causes uncertainty over the timing of payments between the exporter (seller) and importer (foreign buyer).
• For exporters, any sale is a gift until payment is received.
• Therefore, exporters want to receive payment as soon as possible, preferably as soon as an order is placed or before the goods are sent to the importer.
• For importers, any payment is a donation until the goods are received.
• Therefore, importers want to receive the goods as soon as possible but to delay payment as long as possible, preferably until after the goods are resold to generate enough income to pay the exporter.

Cash-in-Advance

With cash-in-advance payment terms, an exporter can avoid credit risk because payment is received before the ownership of the goods is transferred. For international sales, wire transfers and credit cards are the most commonly used cash-in-advance options available to exporters. With the advancement of the Internet, escrow services are becoming another cash-in-advance option for small export transactions. However, requiring payment in advance is the least attractive option for the buyer, because it creates unfavorable cash flow. Foreign buyers are also concerned that the goods may not be sent if payment is made in advance. Thus, exporters who insist on this payment method as their sole manner of doing business may lose to competitors who offer more attractive payment terms.

Letters of Credit

Letters of credit (LCs) are one of the most secure instruments available to international traders. An LC is a commitment by a bank on behalf of the buyer that payment will be made to the exporter, provided that the terms and conditions stated in the LC have been met, as verified through the presentation of all required documents. The buyer establishes credit and pays his or her bank to render this service. An LC 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. An LC also protects the buyer since no payment obligation arises until the goods have been shipped as promised.

Documentary Collections

A documentary collection (D/C) is a transaction whereby the exporter entrusts the collection of the payment for a sale to its bank (remitting bank), which sends the documents that its buyer needs to the importer’s bank (collecting bank), with instructions to release the documents to the buyer for payment. Funds are received from the importer and remitted to the exporter through the banks involved in the collection in exchange for those documents. D/Cs involve using 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 collection letter gives instructions that specify the documents required for the transfer of title to the goods. Although banks do act as facilitators for their clients, D/Cs offer no verification process and limited recourse in the event of non-payment. D/Cs are generally less expensive than LCs.

Open Account

An open account transaction is a sale where the goods are shipped and delivered before payment is due, which in international sales is typically in 30, 60 or 90 days. Obviously, this is one of the most advantageous options to the importer in terms of cash flow and cost, but it is consequently one of the highest risk options for an exporter. Because of intense competition in export markets, foreign buyers often press exporters for open account terms since the extension of credit by the seller to the buyer is more common abroad. Therefore, exporters who are reluctant to extend credit may lose a sale to their competitors. Exporters can offer competitive open account terms while substantially mitigating the risk of non-payment by using one or more of the appropriate trade finance techniques covered later in this Guide. When offering open account terms, the exporter can seek extra protection using export credit insurance.

Consignment

Consignment in international trade is a variation of open account in which payment is sent to the exporter only after the goods have been sold by the foreign distributor to the end customer. An international consignment transaction is based on a contractual arrangement in which the foreign distributor receives, manages, and sells the goods for the exporter who retains title to the goods until they are sold. Clearly, exporting on consignment is very risky as the exporter is not guaranteed any payment and its goods are in a foreign country in the hands of an independent distributor or agent. Consignment helps exporters become more competitive on the basis of better availability and faster delivery of goods. Selling on consignment can also help exporters reduce the direct costs of storing and managing inventory. The key to success in exporting on consignment is to partner with a reputable and trustworthy foreign distributor or a third-party logistics provider. Appropriate insurance should be in place to cover consigned goods in transit or in possession of a foreign distributor as well as to mitigate the risk of non-payment.

Q2.two (2 ) methods of financing international trade for a selected Multi National Corporation in your jurisdiction.

The five major processes of transaction in international trade are the following −

Prepayment

Prepayment occurs when the payment of a debt or installment payment is done before the due date. A prepayment can include the entire balance or any upcoming part of the entire payment paid in advance of the due date. In prepayment, the borrower is obligated by a contract to pay for the due amount. Examples of prepayment include rent or loan repayments.

Letter of Credit

A Letter of Credit is a letter from a bank that guarantees that the payment due by the buyer to a seller will be made timely and for the given amount. In case the buyer cannot make payment, the bank will cover the entire or remaining portion of the payment.

Drafts

Sight Draft − It is a kind of bill of exchange, where the exporter owns the title to the transported goods until the importer acknowledges and pays for them. Sight drafts are usually found in case of air shipments and ocean shipments for financing the transactions of goods in case of international trade.

Time Draft − It is a type of foreign check guaranteed by the bank. However, it is not payable in full until the duration of time after it is obtained and accepted. In fact, time drafts are a short-term credit vehicle used for financing goods’ transactions in international trade.

Consignment

It is an arrangement to leave the goods in the possession of another party to sell. Typically, the party that sells receives a good percentage of the sale. Consignments are used to sell a variety of products including artwork, clothing, books, etc. Recently, consignment dealers have become quite trendy, such as those offering specialty items, infant clothing, and luxurious fashion items.

Open Account

Open account is a method of making payments for various trade transactions. In this arrangement, the supplier ships the goods to the buyer. After receiving and checking the concerned shipping documents, the buyer credits the supplier's account in their own books with the required invoice amount.

The account is then usually settled periodically; say monthly, by sending bank drafts by the buyer, or arranging through wire transfers and air mails in favor of the exporter.

Trade Finance Methods

The most popular trade financing methods are the following −

Accounts Receivable Financing

It is a special type of asset-financing arrangement. In such an arrangement, a company utilizes the receivables – the money owed by the customers – as a collateral in getting a finance.

In this type of financing, the company gets an amount that is a reduced value of the total receivables owed by customers. The time-frame of the receivables exert a large influence on the amount of financing. For older receivables, the company will get less financing. It is also, sometimes, referred to as "factoring".

Letters of Credit

As mentioned earlier, Letters of Credit are one of the oldest methods of trade financing.

Banker’s Acceptance

A banker’s acceptance (BA) is a short-term debt instrument that is issued by a firm that guarantees payment by a commercial bank. BAs are used by firms as a part of the commercial transaction. These instruments are like T-Bills and are often used in case of money market funds.

BAs are also traded at a discount from the actual face value on the secondary market. This is an advantage because the BA is not required to be held until maturity. BAs are regular instruments that are used in international trade.

Working Capital Finance

Working capital finance is a process termed as the capital of a business and is used in its daily trading operations. It is calculated as the current assets minus the current liabilities. For many firms, this is fully made up of trade debtors (bills outstanding) and the trade creditors (the bills the firm needs to pay).

Forfaiting

Forfaiting is the purchase of the amount importers owe the exporter at a discounted value by paying cash. The forfaiter that is the buyer of the receivables then becomes the party the importer is obligated to pay the debt.

Countertrade

It is a form of international trade where goods are exchanged for other goods, in place of hard currency. Countertrade is classified into three major categories – barter, counter-purchase, and offset.

• Barter is the oldest countertrade process. It involves the direct receipt and offer of goods and services having an equivalent value.

• In a counter-purchase, the foreign seller contractually accepts to buy the goods or services obtained from the buyer's nation for a defined amount.

• In an offset arrangement, the seller assists in marketing the products manufactured in the buying country. It may also allow a portion of the assembly of the exported products for the manufacturers to carry out in the buying country. This is often practiced in the aerospace and defense industries.

International Trade Payment Methods

The five major processes of transaction in international trade are the following −

Prepayment

Prepayment occurs when the payment of a debt or installment payment is done before the due date. A prepayment can include the entire balance or any upcoming part of the entire payment paid in advance of the due date. In prepayment, the borrower is obligated by a contract to pay for the due amount. Examples of prepayment include rent or loan repayments.

Letter of Credit

A Letter of Credit is a letter from a bank that guarantees that the payment due by the buyer to a seller will be made timely and for the given amount. In case the buyer cannot make payment, the bank will cover the entire or remaining portion of the payment.

Drafts

Sight Draft − It is a kind of bill of exchange, where the exporter owns the title to the transported goods until the importer acknowledges and pays for them. Sight drafts are usually found in case of air shipments and ocean shipments for financing the transactions of goods in case of international trade.

Time Draft − It is a type of foreign check guaranteed by the bank. However, it is not payable in full until the duration of time after it is obtained and accepted. In fact, time drafts are a short-term credit vehicle used for financing goods’ transactions in international trade.

Consignment

It is an arrangement to leave the goods in the possession of another party to sell. Typically, the party that sells receives a good percentage of the sale. Consignments are used to sell a variety of products including artwork, clothing, books, etc. Recently, consignment dealers have become quite trendy, such as those offering specialty items, infant clothing, and luxurious fashion items.

Open Account

Open account is a method of making payments for various trade transactions. In this arrangement, the supplier ships the goods to the buyer. After receiving and checking the concerned shipping documents, the buyer credits the supplier's account in their own books with the required invoice amount.

The account is then usually settled periodically; say monthly, by sending bank drafts by the buyer, or arranging through wire transfers and air mails in favor of the exporter.

Trade Finance Methods

The most popular trade financing methods are the following −

Accounts Receivable Financing

It is a special type of asset-financing arrangement. In such an arrangement, a company utilizes the receivables – the money owed by the customers – as a collateral in getting a finance.

In this type of financing, the company gets an amount that is a reduced value of the total receivables owed by customers. The time-frame of the receivables exert a large influence on the amount of financing. For older receivables, the company will get less financing. It is also, sometimes, referred to as "factoring".

Letters of Credit

As mentioned earlier, Letters of Credit are one of the oldest methods of trade financing.

Banker’s Acceptance

A banker’s acceptance (BA) is a short-term debt instrument that is issued by a firm that guarantees payment by a commercial bank. BAs are used by firms as a part of the commercial transaction. These instruments are like T-Bills and are often used in case of money market funds.

BAs are also traded at a discount from the actual face value on the secondary market. This is an advantage because the BA is not required to be held until maturity. BAs are regular instruments that are used in international trade.

Working Capital Finance

Working capital finance is a process termed as the capital of a business and is used in its daily trading operations. It is calculated as the current assets minus the current liabilities. For many firms, this is fully made up of trade debtors (bills outstanding) and the trade creditors (the bills the firm needs to pay).

Forfaiting

Forfaiting is the purchase of the amount importers owe the exporter at a discounted value by paying cash. The forfaiter that is the buyer of the receivables then becomes the party the importer is obligated to pay the debt.

Countertrade

It is a form of international trade where goods are exchanged for other goods, in place of hard currency. Countertrade is classified into three major categories – barter, counter-purchase, and offset.

• Barter is the oldest countertrade process. It involves the direct receipt and offer of goods and services having an equivalent value.

• In a counter-purchase, the foreign seller contractually accepts to buy the goods or services obtained from the buyer's nation for a defined amount.

• In an offset arrangement, the seller assists in marketing the products manufactured in the buying country. It may also allow a portion of the assembly of the exported products for the manufacturers to carry out in the buying country. This is often practiced in the aerospace and defense industries.

Q3. Differences between a futures contract and a forward contract.

1.

A forward contract is a customized contractual agreement where two private parties agree to trade a particular asset with each other at an agreed specific price and time in the future. Forward contracts are traded privately over-the-counter, not on an exchange.

A futures contract — often referred to as futures — is a standardized version of a forward contract that is publicly traded on a futures exchange. Like a forward contract, a futures contract includes an agreed upon price and time in the future to buy or sell an asset — usually stocks, bonds, or commodities, like gold.

The main differentiating feature between futures and forward contracts — that futures are publicly traded on an exchange while forwards are privately traded — results in several operational differences between them. This comparison examines differences like counterparty risk, daily centralized clearing and mark-to-market, price transparency, and efficiency.

Futures and forwards are financial contracts which are very similar in nature but there exist a few important differences:

• Futures contracts are highly standardized whereas the terms of each forward contract can be privately negotiated.
• Futures are traded on an exchange whereas forwards are traded over-the-counter.

Counterparty risk

In any agreement between two parties, there is always a risk that one side will renege on the terms of the agreement. Participants may be unwilling or unable to follow through the transaction at the time of settlement. This risk is known as counterparty risk.

In a futures contract, the exchange clearing house itself acts as the counterparty to both parties in the contract. To further reduce credit risk, all futures positions are marked-to-market daily, with margins required to be posted and maintained by all participants at all times. All this measures ensures virtually zero counterparty risk in a futures trade.

Forward contracts, on the other hand, do not have such mechanisms in place. Since forwards are only settled at the time of delivery, the profit or loss on a forward contract is only realized at the time of settlement, so the credit exposure can keep increasing. Hence, a loss resulting from a default is much greater for participants in a forward contract.

Secondary Market

The highly standardized nature of futures contracts makes it possible for them to be traded in a secondary market.

The existence of an active secondary market means that if at anytime a participant in a futures contract wishes to transfer his obligation to another party, he can do so by selling it to another willing party in the futures market.

In contrast, there is essentially no secondary market for forward contracts.

2.

The financial contracts, Forwards and Futures are quite similar in nature and follow the same fundamental function; they allow traders to buy or sell the specific type of asset at a given price at a given time. However, there exist some important differences between the two. The major difference between Futures and Forwards is that Futures are traded publicly on exchanges and the Forwards are privately traded.

The Futures Contract
The Futures contracts, also referred to as Futures, are those standardized instruments that are traded through brokerage firms, on the stock exchange which trades that specific contract. The terms for the Futures contract like the volume, delivery dates, credit procedures and technical specifications are standardized for each kind of contract. Similar to the ordinary stock trading, both the parties involved will work through their brokers and transact in the futures trade.

Currency Futures are one of the most traded futures contracts. It is also known as FX Future and is a Futures contract using which the trader can exchange one currency with another on a said date in the future at the price, which is fixed on the day of purchase.

The Forward Contract
The Forward Contract or the Forwards is the agreement which takes place between two parties to either buy or sell the asset at the pre agreed time at a specific price. The Forward contract can entail both the credit risk and the market risk and the profit or loss on such contracts is only known during the time of settlement.
Like in Futures, Currency Forwards is one binding contract in the foreign exchange market which locks the exchange rate for a future date for the sale or buy of a currency. This is normally implemented like hedging and does not involve any initial payment. The Currency Risk too is comparatively low in forwards than the currency futures.

How is Futures Contract different from Forward Contract?

The Structure and Purpose
The Forward contracts can be customized as per the needs of the customer. There is no initial payment required and this is mostly used for the process of hedging. The Futures contracts on the other hand are standardized and traders need to pay a margin payment initially.

The Method of Transaction
The Forward contracts are negotiated directly by the seller and the buyer and are not regulated by the markets. The Futures Contracts are quoted and traded over the stock exchange and are government regulated.

The Risk and Guarantees
The Forward contracts include a high counter party risk and there is also no guarantee of asset settlement till the maturity date. The Futures contract involves a low counterparty risk and the value is based on the market rates and is settled daily with profit and loss.

The Contract Size and Maturity
The Forward contracts mature after the delivery of the commodity and this may not happen in Future contracts. The size of the contract is standardized in Futures and it entirely depends upon the requirements of both the parties in Forwards.

The Risk Factor
When an agreement happens between two different parties, there can be a risk that any one party can renege on the agreement terms. Any of the party can be unwilling or be unable to follow the terms during the time of settlement. This risk is termed as the counterparty risk.
In Futures, the clearing house of the stock exchange acts as counterparty for both parties. This reduces the credit risk and the risk is redued further as all the positions taken in futures are marked to market every day. With such features, there is absolutely no counterparty risk when it comes to a trade in futures.
On the other hand, the Forward contracts do not have any such mechanisms. The Forwards are always settled during the time of delivery and thus the profit or a loss can only be known during settlement. Hence, the loss can be more for the participants in Forwards which can be due to a default.

Q3.Similarities between a futures contract and a forward contract.

1.

They are both 2-party private contracts to purchase something of value at a future time or during a future period, generally a financial asset such as stocks, commodities, or currency.

In most cases the asset underlying a forward or option is not instantiated but is rather a fungible asset — so, for example, an option to purchase shares of AT&T does not identify the share certificate in question, but rather the class of shares and the issuer; a forward contract to purchase 1 million barrels of Brent Crude (a grade of raw petroleum) does not specify the barrels in question, the well, or even the producer of the oil, just the grade and quantity.

Although they are called contracts, and contain contract language, both forwards and options are in most cases considered securities: instruments that have their own value, can be brokered and transferred, and that go through clearance, settlement, and securities registration processes. As such, they would be regulated in the US by the SEC, FINRA, and various other governmental and private regulators. This does not have to be the case, as two parties could hire their own lawyers and custom-draft a 1-to-1 private forward or option. But it is usually the case.

Options and forwards each have buy sides and sell sides: on the opposite side of the holder of each is an issuer. Options have two flavors, though, call options, which are options to buy something, and put options, which are options to sell something.

The main differences is that options are settleable, and, as the name implies, something that gives the holder an optional right. If the price of an underlying asset drops below the call price of an option, or the holder waits past the expiration date to exercise (which never really happens in practice), the option becomes worthless. By contrast, forwards are binding contracts that are settleable only by the actual, physical delivery of the underlying asset. The parties may agree to “book out” a forward for cash, but that would require a negotiated contract modification. So, to use the oil example, if you buy a 90-day futures contract for Brent Crude and the price goes up beyond the strike price at any time before 90 days, you tell your broker and cash appears in your bank account. By contrast, if you buy a 90-day forward contract for Brent Crude, you’d better have a tank handy, because 90 days from now you’re going to see a truck or a pipeline with a lot of oil for you.

2.

Futures contracts and forward contracts are agreements to buy or sell an asset at a specific price at a specified date in the future. These agreements allow buyers and sellers to lock in prices for physical transactions occurring at a specific future date to mitigate the risk of price movement for the given asset through the date of delivery.

Historically, a forward contract set the terms of delivery and payment for seasonal agricultural commodities, such as wheat and corn, between a single buyer and seller. Today, forward contracts can be for any commodity, in any amount, and delivered at any time. Due to the customization of these products they are traded over-the-counter (OTC) or off-exchange. These types of contracts are not centrally cleared and therefore have a higher rate of default risk.

The futures market emerged in the mid-19th century as increasingly sophisticated agricultural production, business practices, technology, and market participants necessitated a reliable and efficient risk management mechanism. Eventually, the exchange model established for agricultural commodities expanded to other asset classes such as equities, foreign exchange, energy, interest rates, and precious metals.

The modern futures exchange has evolved over time and continues to serve the needs of traders and other users. Futures contracts are used by traders today in many ways. Traders will often use futures contracts to directly participate in a move up or down in a particular market, without having any need for the physical commodity. Traders will hold their positions for various lengths of time, ranging from day trading to longer term holdings of weeks to months or longer.

Forward Contract Example

Suppose that Ben’s coffee shop currently purchases coffee beans at a price of $4/lb. from his supplier, CoffeeCo. At this price, Ben’s is able to maintain healthy margins on the sale of coffee beverages. However, Ben reads in the newspaper that cyclone season is coming up and this may threaten to destroy CoffeCo’s plantations. He is worried that this will lead to an increase in the price of coffee beans, and thus compress his margins. CoffeeCo does not believe that the cyclone season will destroy its operations. Due to planned investments in farming equipment, CoffeeCo actually expects to produce more coffee than it has in previous years.

Ben’s and CoffeeCo negotiate a forward contract that sets the price of coffee to $4/lb. The contract matures in 6 months and is for 10,000 lbs. of coffee. Regardless of whether cyclones destroy CoffeeCo’s plantations or not, Ben is now legally obligated to buy 10,000 lbs of coffee at $4/lb (total of $40,000), and CoffeeCo is obligated to sell Ben the coffee under the same terms. The following scenarios could ensue:

Scenario 1 – Cyclones destroy plantations

In this scenario, the price of coffee jumps to $6/lb due to a reduction in supply, making the transaction worth $60,000. Ben benefits by only paying $4/lb and realizing $20,000 in cost savings. CoffeeCo loses out as they are forced to sell the coffee for $2 under the current market price, thus incurring a $20,000 loss.

Scenario 2 – Cyclones do not destroy plantations

In this scenario, CoffeeCo’s new farm equipment enables them to flood the market with coffee beans. The increase in the supply of coffee reduces the price to $2/lb. Ben loses out by paying $4/lb and pays $20,000 over the market price. CoffeeCo benefits as they sell the coffee for $2 over the market value, thus realizing an additional $20,000 profit.

Futures Contract Example

Suppose that Ben’s coffee shop currently purchases coffee beans at a price of $4/lb. At this price, Ben’s is able to maintain healthy margins on the sale of coffee beverages. However, Ben reads in the newspaper that cyclone season is coming up and this may threaten to destroy coffee plantations. He is worried that this will lead to an increase in the price of coffee beans, and thus compress his margins. Coffee futures that expire in 6 months from now (in December 2018) can be bought for $40 per contract. Ben buys 1000 of these coffee bean futures contracts (where one contract = 10 lbs of coffee), for a total cost of $40,000 for 10,000 lbs ($4/lb). Coffee industry analysts predict that if there are no cyclones, advancements in technology will enable coffee producers to supply the industry with more coffee.

Scenario 1 – Cyclones destroy plantations

The following week, a massive cyclone devastates plantations and causes the price of December 2018 coffee futures to spike to $60 per contract. Since coffee futures are derivatives that derive their values from the values of coffee, we can infer that the price of coffee has also gone up. In this scenario, Ben has made a $20,000 capital gain since his futures contracts are now worth $60,000. Ben decides to sell his futures and invest the proceeds in coffee beans (which now cost $6/lb from his local supplier), and purchases 10,000 lbs of coffee.

Scenario 2 – Cyclones do not destroy plantations

Coffee industry analyst predictions were correct, and the coffee industry is flooded with more beans than usual. Thus, the price of coffee futures drops to $20 per contract. In this scenario, Ben has incurred a $20,000 capital loss since his futures contracts are now worth only $20,000 (down from $40,000). Ben decides to sell his futures and invest the proceeds in coffee beans (which now cost $2/lb from his local supplier), and purchases 10,000 lbs of coffee.