What are the risks and challenges of trade finance?
In comparison, international trade carries substantially more risk than domestic trade. Due to differences in language, culture, politics, legislation and currency, understanding the dynamics and complexities of an international trade are important for buyers, sellers and lenders. Mitigating risk via the type and method of trade finance is crucial in ensuring successful trade. Below we have summarized the different types of risk under product, manufacturing, transport and currency risks.
Product related risks are those which the seller automatically has to accept as an integral part of their commitment, for example, specified performance warranties, agreed maintenance or service obligations. The buyer must consider how external factors such as how negligence during production, or extreme weather during shipping could affect their product.
These matters could well lead to disputes between the parties, even after contracts are signed. It is important for the seller that the contract is worded correctly, such that any changes that could affect the product will by default include compensation or corresponding changes in the seller’s commitments.
Manufacturing risks are particularly common for products which are tailor-made or have unique specifications. Often the seller would be required to cover costs of any readjustments of the product until the buyer sees fit, because the product can’t be resold to other buyers. Such risks can be addressed as early as the product planning phase, which often means the buyer has to enter payment obligations at a much earlier stage of the transaction.
To mitigate the risks for both the buyer and the seller, the terms of payment are often delivered into part-payments and separate guarantees throughout the design, production and delivery of the product.
Aside from risks associated with the product itself, lies the movement of the goods from the seller to the buyer. Cargo and transport risks are reduced through cargo insurance, which is usually defined by standard international policy wordings (issued by the Institute of London Underwriters or the American Institute of Marine Underwriters).
One area of cargo insurance that a seller should be aware of is who should arrange the insurance – this is often determined by the agreed terms of delivery. Another area of cargo insurance is the risk of the buyer arranging insurance according to some terms of delivery. If the buyer fails to insure the cargo shipment in a proper way, the insurance could be invalid if, for example, the port or transport route changes and the items arrive in damaged condition.
In recent years markets have been difficult and foreign exchange levels have remained uncertain; more so than any time in history. All of these factors mean that the currency risk management strategy of a company needs to be strong. There is further pressure to reduce risk due to greater regulatory and governmental scrutiny involved in the financing markets and ever tightening margins.
Currency risk policies have historically taken a back seat and been relatively basic. There are a range of financial instruments available today and all need the correct risk management policies in place. Due to the increasing volatility seen in the market and the need to operate in various currencies, policies need to be flexible and cater accordingly.
Exchange rate volatility can affect all sizes of business, this is important when there are changes to the value of assets, liabilities and cash flows; this is certainly the case when denominated in a foreign currency. Volatility will also affect contracts where you have agreed to sell products at a future point internationally, or where such items are open to exchange rate fluctuations. These moves will have an effect on your profit margin.
Prior to developing a strategy, a company should look at what proportion of a business relates to imports or exports, the currencies that are being used, when payments are to be made, and what currency is used when payments and invoices are made.
Various strategies are used to manage currency risk and these usually involve using spot contracts, options, and forwards.
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