When conducting business internationally it is essential to take every precautionary step to ensure delivery and payment will be made. One way to guarantee that delivery and payment will be made is to have both exporter and importer agree to sign a draft. A draft is an unconditional order in writing, signed by a person, usually the exporter, and addressed to the importer, ordering the importer or the importers agent to pay. Drafts can be one of two types, a sight draft, which states that the payment is due immediately, or a time draft that has a fixed future date when the payment is due. The amount specified on the draft is its face, when a drafted is accepted, the word accepted is written across its face, along with a signature by an authorized agent and the date. Once the document has been accepted and signed, the party accepting the draft incurs the obligation to pay when due.

If the exporter wants the money sooner than the date stated on the draft, they can try to sell it to a bank or any other financial institution. If the bank or other financial institution agrees to purchase the draft, the exporter will receive the face value of the draft less any interest, fees and or commission charged by the bank or financial institution. Discounting is a means of borrowing against a trade or other draft agreement. The bank or other financial institution has the choice of doing a discount with or without recourse. If the agreement is with recourse the bank or other financial institution can go after the exporter if the payment is never received from the importer. If the draft is sold without recourse, the bank accepts all risk if a collection is not made.

Discounting is beneficial for exporters because they are guaranteed a payment on delivered goods by a bank or financial institution that have very strong credit worthiness, rather than an individual or company who may have the credit worthiness but necessarily follow through on payment. Although the exporter is losing money due to the interest, fees and or commission charged by the bank or financial institution purchasing it, sometimes those fees are worth the guaranteed payment by the bank.

Example: An exporter wants to sell its accepted time draft due in 90 days with a face value of $2,000,000.00, if the bank agrees to purchase it, they will charge interest for paying out the draft before its due date and an annual commission rate as follows:

Face Value of Draft $2,000,000.00

Amount paid to the exporter $1,400,000.00

Amount received by the bank $60,000.00

Although it seems like a large amount of revenue lost to commission and discounting fees, the exporter now has received payment and can use that money to increase working capital for his firm. The bank also walks away with a nice payment for paying the draft before the maturity date.

Unfortunately with the credit crunch and recession the world is going through right now, banks and other financial institutions are less likely to do discounting because of the increased risk involved with higher chances of default. When credit is tight firms are held more responsible for the transactions and terms they choose to participate in when operating their firm.

References:

Higson, Chris. "The perfect storm." Financial TImes. 22 Jan. 2009. Web. 2 Nov. 2009. <http://www.ft.com/cms/s/0/0e5f0192-e86e-11dd-a4d0-0000779fd2ac.html>.