In some ways, arranging short-term financing for international trade is no different from financing purely domestic operations. In both cases, producers must finance production and inventory and then continue to finance accounts receivable before collecting any cash payments from sales. In other ways, however, the short-term financing of international sales and purchases is fundamentally different from that of strictly domestic trade.
The important difference between international and domestic transactions is that payments are often made or received in a foreign currency. Not only must a U.S. company pay the costs of doing business in the foreign exchange market, but it also is exposed to exchange rate risk. A U.S.-based company that exports goods and has accounts receivable denominated in a foreign currency faces the risk that the U.S. dollar will appreciate in value relative to the foreign currency. The risk to a U.S. importer with foreign-currency-denominated accounts payable is that the dollar will depreciate. Although exchange rate risk can often be hedged by using currency forward, futures, or options markets, doing so is costly and is not possible for all foreign currencies.
Typical international transactions are large in size and have long maturity dates. Therefore, companies that are involved in international trade generally have to finance larger dollar amounts for longer time periods than companies that operate domestically. Furthermore, because foreign companies are rarely well known in the United States, some financial institutions are reluctant to lend to U.S. exporters or importers, particularly smaller firms.
Several specialized techniques have evolved for financing international trade. Perhaps the most important financing vehicle is the letter of credit, a letter written by a company’s bank to the company’s foreign supplier, stating that the bank guarantees payment of an invoiced amount if all the underlying agreements are met. The letter of credit essentially substitutes the bank’s reputation and creditworthiness for that of its commercial customer. A U.S. exporter is more willing to sell goods to a foreign buyer if the transaction is covered by a letter of credit issued by a well-known bank in the buyer’s home country.