The Role of Trade Finance in Working Capitalsources: commercial insurers and official
export credit agencies. The availability
of cover from both sources varies from
jurisdiction to jurisdiction, especially with
relation to any official export credit agency.
Commercial insurers are able to
offer protection against standard trade
transactions. They are typically used to
protect the trade of consumer and some
commodity goods. Trade in services can
usually be insured as well, often in the form
of a service guarantee. This insurance is
available for domestic transactions as well as
international transactions.
Specialist insurance brokers also offer
protection against the wider credit risks
associated with trade. These cover the
immediate credit risks: the failure of a
counterparty to pay as a result of insolvency
or default. In addition, they cover the political
risks which can prevent a counterparty from
paying. These can include government or
regulatory decisions, such as the imposition
of trade sanctions and exchange controls,
market conditions, such as a lack of available
currency, and other political or environmental
events, such as war or earthquakes. Cover
can usually be arranged for a specific
transaction or on a rolling basis to protect
an ongoing trade relationship. The level of
cover varies but is typically arranged as a
proportion of the value of a specific contract
or the company’s turnover.
Export credit agencies only insure
international transactions, but do offer
protection against both country and
counterparty risk, as long as the requirements
of the programme are met. This insurance
can be particularly appropriate for longer-
term transactions, such as a company’s
participation in a long-term infrastructure
project abroad, or for transactions with parties
located in areas not usually covered by
commercial insurers (where standard policies
do not apply), or where credit check agencies
have little or no coverage.
Credit insurance can also play an
important role in the financial supply chain.
If suppliers are able to arrange credit
insurance against their customers, the
credit insurance acts in a similar way to
a bank guarantee. The suppliers can be
confident that they will be paid, so they may
be prepared to extend credit terms to those
customers. In contrast, if the credit insurer
refuses to offer protection against a specific
customer, then the suppliers may insist on
cash on delivery or cash in advance, as a
condition of trade. Such a change can have
a dramatic impact on the customer’s cash
flow. The withdrawal of credit insurance
for Woolworths’ suppliers in the UK was
a key factor in precipitating the retailer’s
insolvency in 2008.
There is more detail on the use of credit
insurance and export credit agencies on
page 140.Foreign exchange risk
Many companies need to manage foreign
exchange risk as part of the process of
agreeing a trade. In most cases the foreign
exchange risk will be a clear element in
the transaction, as the company will be
required to invoice or be invoiced in a
currency other than its operating currency. In
either circumstance there is a clear foreign
exchange risk to be managed.
For other companies there may well
be an underlying foreign exchange risk in
a transaction. This arises from the pricing
of certain inputs in another currency
affecting the price of the good or the cost
of production. This is most common in the
case of the cost of oil, which indirectly affects
the cost of production through energy and
distribution costs.
There are three different forms of foreign
exchange risk that can affect companies:
transaction risk, translation risk and
economic risk.
Transaction risk.
This is the most apparent risk to those
engaged in international trade. This is the
risk that the exchange rate will change,
adversely affecting either the funds received
or the sum to be paid out. This applies
in a variety of situations. It can be easily
understood in an international transaction,
where a company may find that the value of
a foreign invoice changes so that it ends up
paying more when importing, or receiving
less when exporting, than it had originally