How to hedge risks in international trade
Companies do not always appreciate the bigger picture when it comes to the risks involved in international deals – or the trade finance products that can be used to mitigate these risk exposures.
At Nordea, we have seen our customers increasingly formalise their financial policies. As a result, many improve their capability to manage risks, particularly when it comes to international trade.
In a Nordea survey on hedging1, 86% of CFOs and group treasurers at many of the major companies in the Nordic and Baltic region told us they had a formal treasury policy. Surprisingly, however, 28% admitted they did not update the policy annually.
Our survey also showed that Nordic companies are managing FX transaction risk and the interest-rate risks of regular loans using systematic hedging. But some basic payment questions remain, such as whether or not the treasury policy looks at counterparty risk or if it factors in payment, delivery, bank or country risks.
Eighty-six% of companies in the Nordic and Baltic regions have a formal treasury policy, but 28% do not update it annually.
One of the big problems companies face is a disconnect between their CFO’s policy towards risk and how other teams – such as sales and procurement – treat risk.
For instance, sales teams often get their bonus on reaching sales targets. So when negotiating contracts, they focus on price, not other factors such as payment terms. They might not worry about securing payments – that is outside of their remit. Procurement teams, on the other hand, focus on securing supplies at a low unit price – but will they care about maintaining working capital?
Neglecting to consider all aspects of a financial transaction, and all the associated risks, can have real consequences. Some companies have been forced into bankruptcy for failing to understand the nature of the risks from imports and exports – in particular the risk of non-payment by major customers.
We see similar problems elsewhere – even if the consequences are not always as dramatic. In too many cases, we see companies acting as a bank for either their suppliers or their customers because they have not understood their trade finance risks. And the risks are not just limited to non-payment; they also include delay in payment and potential damage to reputation.
Customers can easily be caught out by geopolitical changes. Until the financial crisis in 2007-2008, hardly any company gave bank risk or country risk the level of consideration they do today.
Of course, you knew if you were trading with partners in countries such as North Korea, Iran or Cuba that there might be some red tape, but nobody would have imagined that trading with Greece could cause a problem. Similarly, until very recently, Russia appeared to be a huge opportunity for companies in the Nordic and Baltic regions. Now, in February 2015, many would consider it far too risky.
Another often-overlooked aspect is counterparty risk. At Nordea, we often hear from companies who have offered generous terms to partners they have been trading with for years. But as a seller, you might not know about your counterparties’ financial affairs, what banks they deal with, what customers they have.
Regulations, such as know your customer (KYC), make it increasingly important that you complete due diligence on everyone you trade with – no matter how trusted a partner they are. Besides, undertaking comprehensive risk analysis can provide valuable information on your counterparties that can secure competitive advantage for you.
We have also seen that many of our customers are not aware of the tools they can use to mitigate the risks in trade. You need to know when it is appropriate to use documentary credits (letters of credit) and guarantees to reduce the risk of non-payment – without making it too difficult for counterparties to trade with you.
To achieve the CFO’s vision for risk – whether that is to minimise, optimise or simply maintain current levels – it is important to take an holistic view.
Smoothing the path for trade
We urge all of our customers to adopt a risk strategy at a per-customer level, which includes having a position on bank and country risk. This is something that should be refreshed on a regular basis: as we’ve seen, country risk and bank risk can change dramatically and quickly.
Nordea has developed tools that you can use to assess your exposure and identify appropriate mechanisms to balance your risk profile. For instance, if you’re trading with someone in a highly rated, low risk country, that uses well-rated banks, you may find payments go smoother — as a result, you might be able to offer your customers a better price.
The map below can help you identify levels of risk associated with any country at a given time. Our advisers can work with you to quantify other risks, and establish which trade instruments are most appropriate for you.
Nordea was able to help the company identify suitable trade finance products – in this case documentary credits – that enabled it instead to use open accounts with its Chinese supplier, reducing the risk, and saving an estimated 6-12% on purchase costs.For instance, one company we worked with was hugely proud of the 360-day, security-free credit facility it had with a Chinese supplier. It seemed to give them a positive cash flow for 180 days, once shipping and manufacturing were taken into account. But the supplier was charging an inflated price to account for those generous terms.
Another company we worked with wanted to close an export deal with a customer in the Far East, but the negotiations had struck an impasse. Our client’s financial policy stressed the need to minimise risk, but this was incompatible with the terms their customer wanted.
Nordea was able to identify suitable trade finance products, in line with the company’s risk policy, and secure the deal by offering 180 days deferred payments, which included an attractive financing offer to our customer.
Better informed trade
When it comes to managing risk in international trade, a few simple measures can help smooth the process significantly. Nordea advises all of its customers to ask the following questions:
Is risk at every level examined at the outset, including customer, supplier, bank, country and currency?
What payment terms and trade finance instruments will be used to mitigate risks?
How is staff on the sales and procurement sides informed about risk?
Do you know which partner banks you and your counterparties should be using?
Nordea can help you develop answers to these key questions. If you would like to find out more about our full range of products and services to manage your trade risks, visit our Trade Finance site.
1 Nordea Hedging Survey