Documentation in foreign trade is supposed to assure that the exporter will receive the payment and the importer will receive the merchandise. More specifically, a number of documents in foreign trade are used to eliminate noncompletion risk, to reduce foreign-exchange risk, and to finance trade transactions.
Noncompletion risk The risk of noncompletion is greater in foreign trade than in domestic trade. This is why exporters want to keep title to the goods until they are paid and importers are reluctant to pay until they receive the goods. Foreign trade and domestic trade use different instruments and documents. Most domestic sales are on open-account credit. Under this credit, a buyer does not need to sign a formal debt instrument, because credit sales are made on the basis of a seller's credit investigation of the buyer. Buyers and sellers are typically farther apart in foreign trade than in domestic trade. Thus, the sellers are seldom able to ascertain the credit standing of their overseas customers. The buyers may also find it difficult to determine the integrity and reputation of the foreign sellers from whom they wish to buy. Much of this non-completion risk is reduced through the use of three key documents: the draft, the bill of lading, and the letter of credit.
Foreign-exchange risk Foreign-exchange risk arises when export sales are denominated in a foreign currency and are paid at a delayed date. In international trade, the basic foreign-exchange risk is a transaction risk. Transaction risk is the potential exchange loss from outstanding obligations as a result of exchange rate fluctuations. Forward contracts, futures contracts, currency options, and currency denomination practices can be used to reduce foreign-exchange risk associated with foreign trade.
Trade financing Because all foreign trade involves a time lag, funds are tied up in the shipment of goods for some period of time. Most trade transactions are free of noncompletion and foreign-exchange risks due to well-drawn trade documents and forward contracts. Banks are thus willing to finance goods in transit or even prior to shipment. Financial institutions at both ends of the cycle offer a variety of financing alternatives that reduce or eliminate either party's (exporter or importer) working capital needs.
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