With the international trade estimated to reach a value of 10.600 billions of Us dollars for this year, the valuation of risks for all the entities involved in the process is essential for the economic life and safety of businesses and financial institutions.
More than ever corporations are looking at international trade as the main opportunity to increase revenue and cut costs and at each phase the consideration of the threats and risks that can affect the entire or part of the economic process can undermine, if not properly covered, the profitability and the financial stability of importers and exporters.
In international trade, one of the major source of financing is the trade credit , in both emerging and developed countries, trade credit depends on accurate and timely information and in many country the trade credit has not reached the full potential because for the luck of timely accurate and reliable information.
In the USA this is a form of credit that has been known for centuries but is not yet widely used. It is estimate that only 5% of the company use them against the 40% in Europe, the market is increasing fast pushed by growing internationalization and globalization.
The most common option to transfer the risk is the trade credit insurance . Policies cover the risk of non-payment of trade debt, which are amounts owing to the company as a result of goods or services supplied. Cover is generally for buyer insolvency and late/non-payment , but is possible to add protection against export and political risks and for work-in-progress cover .
Government interference, legal and regulatory risks, terrorism and war, and currency and credit risks are can undermine the financial structure of a company also because often the receivables may comprise over 40% of a company’s current assets.
Positive effects of covering the risk with trade credit insurance are:
-Protection against the impact of bad debt, so that a company can reduce reserves and maintains profitability.
-Using credit insurance enhances credit management improving cash flow.
-It enables to sell on credit terms without taking undue risk company’s balance sheet.
-Export credit insurance opens up new markets for company where previously the credit risk may have been too high to trade.
A company is exposed to credit and trade risk when it extends trade credit or buys or sells derivative instruments because it incurs losses if the counterparty does not fulfill its obligation in time. Credit analysis is concerned with assessing the amount and cost of this credit risk so its effect can be weighted when the original agreement is established.
The credit risk in a particular transaction depends on the probability that the counterparty will become insolvent and the probability that it will default on the obligation in question. The probability a counterparty will default on an obligation depends in part on whether it is solvent or insolvent. A solvent counterparty’s economic incentive to default on a particular transaction is very limited. This company has virtually no incentive to default on small obligations because doing so places the rest of its business in jeopardy. The solvent company’s incentive to default increases with the size of the transaction, however, because a large obligation can cause the business to become insolvent.
Consequently, the focus of credit analysis when examining relatively safe counterparties should be the size of the transaction in comparison to the value of the counterparty’s remaining business.
In the valuation of the case of default a number of variables are considered, financial strength of the buyers, trade sector of the buyers, spread of buyer risk by country, payment history/trading experience with the buyers . To estimate the probability of cash insolvency is widely used a ratio called Lambda ratio .
This ratio has several important features. First, the definition of the initial liquid reserve is flexible; it can include cash and temporary investments, margin accounts, and other forms of collateral. Second, Lambda incorporates cash flows. The net amount of cash a company expects to receive (or pay) is added to (or subtracted from) the initial liquid reserve while the riskiness of these cash flows is accounted for by their standard deviation. Third, a credit analyst can specify the length of the time period of concern which makes the ratio adaptable to different credit situations.
The relatively high implicit interest rates of trade credit result from the existence of insurance and default premiums it is usually more expensive of short term loan. One of the limit of trade credit insurance is that won’t typically cover receivables that go unpaid because of business disputes over defective products or late deliveries.
Watching the Receivables
Companies buy trade-credit insurance for many reasons, and tailor it to their needs.
-38% Insure major accounts*
-33% Insure high-credit-risk sector
-20% Insure for political or geographic risk
-45% Insure both international and domestic receivables
-32% Insure only domestic receivables
-23% Insure only foreign receivables
*Defined as representing 20% of a company’s sales
Source: Trade Credit Foundation