Chapter 9: Pricing And Financing

Pricing products or services in international marketing is not an easy decision. Price is, in part, a function of
cost, and the foreign exchange rate is an important determinant of a company's cost of production. When
borrowing capital to do business the cost of that capital can be very influential in the price decision. Take, for
example, the export of maize. Firstly the crop has to be bought from the producers. If we assume that the
system is state owned, or administered by a Board, money has to be raised. The money may be raised
locally, say by the issue of bills, or on the international market. The cost of capital has to be included in the
price as well as the possible effect of changes in exchange rates if the capital is raised internationally. When
the maize is bought, part of the surplus may be sold on the international market. If it is not sufficient to cover
the whole of the production, financing and marketing costs, then the system is in trouble. This scenario has
indeed been the case in many African nations in a number of commodity fields.

Chapter Objectives
The objectives of this chapter are:

• To describe the elements of the International Financial System

• To give an understanding of the sources of funds available to finance operations and their impact on prices

• To examine the elements involved in the pricing of products and services

• To look in detail at the options, hedges and futures markets

• To show the interrelatedness of all the above in pricing decisions.

Structure Of The Chapter

The chapter begins with a brief description of the international financial system and then describes the
methods of pricing. In order to mark up prices, not only has the material and labour to be considered,
important as these are, but also the cost of capital. The chapter, therefore, goes into detail on the issues of
funds, both internal and external. An increasing feature of global marketing is the futures market. So the
chapter concludes with a detailed analysis of options, hedges and futures.

The international financial system

When conducting business across international boundaries, and dealing with foreign exchange, the risks rise
enormously, especially the impact on financial resources and decisions, and particularly on pricing strategy.
Foreign exchange is the way business can be conducted across national boundaries. Customers buy value,
reflected in the price and intangible attributes of the product. Price is a function of cost in part, and foreign
exchange affects the cost position. Foreign exchange rates, therefore, directly impact on the production
quality and effectiveness of a company's marketing effort.

Post war Europe

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In 1944, the Allies met at Bretton Woods to create an international monetary framework that would support
post war construction and economic growth. Subsequently two organisations developed, the International
Bank for Reconstruction and Development (IBRD or World Bank) which was chartered to help war-torn
countries' economic reconstruction and the International Monetary Fund (IMF) which was chartered to
oversee the management of the international financial system. The main elements were fiscal exchange
rates for all currencies, tight bands of fluctuation around the pegged rates, a dollar defined in gold equivalent
and controlled adjustment in fixed exchange values. In 1971 the gold system collapsed because of the US
balance of payments deficit. Particularly, the Third World was accumulating dollars and they far exceeded
the US supply of gold.

Today's system

What emerged from the collapse was a managed dirty float (due to supply and demand) with special drawing
rights (SDR). "Dirty" refers to actions by governments participating in exchange rates to influence rates,
"managed" refers to the effort by governments to influence exchange rates with fiscal or monetary policy
instruments. SDRs were created by the IMF to supplement the dollar and gold reserves. Its allocation is
based on a formula which takes into account factors such as share of world trade and can be used to help
balance of payments situations or settle financial obligations like swaps, donations and security for financial
obligations.

Most countries of the world are members of the IMF which, amongst its many functions, exercises
surveillance over exchange rate policies of members, manages the SDR, provides temporary balance of
payment assistance and technical assistance.

Foreign exchange

Foreign exchange is currency bought or sold in the foreign exchange market. The "market" is the total of
persons who buy and sell and involves various financial and other institutions. The "spot" market is for the
immediate delivery, or in the interbank market within two business days, of foreign exchange. The forward
market is for future delivery. The principal players are the banks (interbank market) and others including the
London International Futures Exchange (LIFE). London, New York and Tokyo are the major markets with a
turnover worldwide in excess of US$ 200 billion per day.

The foreign exchange market is very dynamic. The price of one currency in any other currency is the result of
forces of supply and demand in the foreign exchange market. The demand for one currency may be due to
consumers wishing to buy from overseas or a belief that one country's currency is stronger than another's. In
Africa, where exchange controls occur in some countries, this can lead to an official or unofficial black
market. Also currency allocation is a feature which tends to slow down business or hinder its development.

If a country sells more than it buys, its currency value will rise and vice versa. If foreign exchange rates were
set simply by money exchanged for goods and services then forecasting exchange rates would be easy.
However, short and long term capital flows, speculative purchases and sales distort the picture.

Governments intervene to dampen fluctuation in exchange rates. Often they get involved in extensive trading
to stem the rise in currency value so exports are not harmed.

Forecasting exchange rates

Exchange rates are very difficult to forecast due to a multitude of factors. Forecasts are, therefore, a
continuation of economic analysis and judgement.

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In forecasting foreign exchange rates it is important to take account of purchasing power parity (PPP), that is,
one unit of currency should buy the same amount of goods and services as it bought in an equilibrium period,
despite differential rates of inflation. The lower the level of inflation, the greater will be the PPP effect. If
prices in local currency rise faster or more slowly than prices in the rest of the world, an equal adjustment of
the exchange value of the currency in the opposite direction will restore equilibrium to relative price levels.
The formula to calculate the PPP impact and exchange rate is:

where

S = the spot rate of exchange in the number of units of the home currency equal to one unit of the foreign currency
in = the inflation rate in the home country
ir = the inflation rate in the foreign country
t = the base period or the present time
t+1 = the future time period as defined.

For example assume that the exchange rate between Zimbabwe and the UK is Zim$ 10 = UK£ 1. Assume
that the rate of inflation in the UK is 5% per annum, and that the rate of inflation in Zimbabwe is 30% per
annum. Applying the above formula, the exchange rate after one year is (UK home country):

Sti=0.08

or UK£ = Zim$ 1

or UK£ 1 = Zim$ 12.5

Unfortunately as levels of inflation are difficult to predict and foreign exchange transactions are other than
solely for purchasing goods and services, the PPP is not a very reliable forecasting technique. Other factors
affect the foreign rate of exchange other than just PPP. These are:

• economic factors - balance of payments, monetary and fiscal policy, inflation, real and nominal interest
rates, government controls and incentives, etc.

• political factors - philosophy of leaders, elections

• psychological factors - expectations, forward market prices, traders' attitudes.

One of the issues in analysing a country's competitive position is the critical adjustment of the exchange
value of a country's currency. The index is a trade weighted index (based on world trade share). Indices are
issued by various bodies like the IMF.

Pricing products

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Three basic factors determine the boundaries of the pricing decision - the price floor, or minimum price,
bounded by product cost, the price ceiling or maximum price, bounded by competition and the market and
the optimum price, a function of demand and the cost of supplying the product. In addition, in price setting
cognisance must be, taken of government tax policies, resale prices, dumping problems, transportation
costs, middlemen and so on. Whilst many agricultural products are at the mercy of the market (price takers)
others are not. These include high value added products like ostrich, crocodile products and hardwoods,
where demand outstrips supply at present.

In setting prices, it must be made clear what the objectives and policy are. Few organisations can now be
pure profit maximisers - there is hardly a sector of industry where competition, or potential competition is not
prevalent. Three frequently encountered price polices are market penetration, skimming and holding. A low
price (penetration) is a volume policy. A high price (skimming) is used if the product is fairly unique,
development costs are high and demand is relatively inelastic. Market holding is a strategy intended to hold
share. Here products are not based on straight exchange rates at current rates but on what the market can
bear. The three price policies are illustrated in figure 9.1.

Figure 9.1 Pricing policies

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The assumption behind all three pricing policies is that the underlying conditions governing supply and
demand apply. In reality, these do not always do so, if indeed ever.

Export pricing

Actual pricing methods are usually cost, market, or competition oriented. However, in the international arena,
other factors come into play.

Cost plus pricing: There are basically two types under this heading, the historical accounting cost method
and the estimated future cost method. The former includes direct and indirect costs and has the
disadvantage of ignoring demand and competitive position in the target market. Estimated cost approaches
are based on assumptions of production volume (depending on process) which will be a principal factor
determining costs. Again difficulties may lie in trying to estimate production levels. In reality, costs may be a
useful starting point but should never be used as a final arbiter.

Competitive pricing: Whilst costs are important they should be looked at alongside the prices of competitive
products in the target markets. Once these price levels have been established the base price, or price that
the buyer will pay for the product, can be determined. This involves four steps:

i) estimation of demand schedules

ii) estimation of incremental and full manufacturing and marketing costs to achieve projected sales volumes

iii) selection of price which offers the highest contribution

iv) inclusion of other elements of the marketing mix. These steps are by no means easy. Costs are difficult to
assess properly as are demand conditions.

In products of a raw commodity nature or those traded on the international market subject to world prices,
often the producer has no alternative but to take the going price - a price governed by competition, especially
on the supply side. In Malawi, for example, although tobacco prices internationally may be encouraging, if too
many farmers grow it, the price will be suppressed for all.

Market pricing: In certain products one can charge "what the market can bear". If the supplier is one of a
few, despite all the problems associated with price fixing, the market may be able to bear a high price. If, as
in Africa, an export crop fails, then other suppliers can take advantage of this to charge higher prices for a
similar export crop. This was the case, a few years ago, with the Kenyan avocado market. An Israeli crop
failure gave an unprecedented boost to Kenya's price and production.

In other cases the product may be so unique that the company should capitalise on its rarity by charging a
high price. At one time exotic produce like Malaysian starfruit and rambutans could command a high price
due to their scarcity. The problem is, encouraged by the profit margins, more entrants are drawn into the
market.

Price escalation

One major feature of international pricing is the increase on the price due to the application of duties and so
on (see table 9.1).

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Table 9.1 Price escalation

Target price in foreign markets 25.00

Less 40% retail margin on selling price 10.00
Retailer cost 15.00
Less 75% importer/distributor marking up cost 1.96
Distributor cost 13.04
Less 12% value added tax on landed value and duty 1.40
CIF value plus duty 11.64
Less 9% duty on CIF value 0.96
Landed CIF value 10.68
Less ocean freight and insurance 1.40
Required FOB price to achieve target price 9.26

If 9.26 is less than the domestic price, the firm has alternatives:

i) forget about exporting

ii) consider marginal pricing
iii) shorten the distribution channel
iv) modify or simplify product if possible
v) find an alternative source of supply with lower cost.

Dumping

Dumping, as defined by GATT, is the difference between the normal domestic price and the price at which
the product leaves the exporting country. A discussion on dumping has been given fully in chapter four.

Devaluation and revaluation

Devaluation is the reduction and revaluation an increase in the value of one currency vis à vis other
currencies. Under the floating exchange rate system devaluation and revaluation occur when currency
values adjust in the exchange rate system in response to supply and demand. The idea behind devaluation
is to make the domestic price more competitive and so more of the product can be bought for the same
foreign currency. However, it can be negated by the higher price and costs induced by inboard goods and
services which make up the export product. If the product is inelastic in demand, prices can be maintained if
the competitive position is strong.

In revaluation, the revaluing country's prices are more expensive. These price increases may be passed on
to the customers, absorbed or the domestic price may be reduced.

Inflation

Inflation is a world wide phenomenon, and requires periodic price adjustments. Inflation accounting methods
attempt to deal with the phenomenon. It is essential to retain gross and operating profit margins. Actions to
maintain margins are subject to government controls (a typical African situation is where governments use
price or selective price controls rather than rooting out the underlying causes of inflation or foreign exchange

6
shortages), competitive behaviour and the market itself. Price adjustments may affect the demand for
products, and this is the ultimate arbiter of price alterations.

Transfer pricing

Transfer pricing is more appropriate to those organisations with decentralised profit centres. Transfer pricing
is used to motivate profit centre managers, provide divisional flexibility and also further corporate profit goals.
Across national boundaries the system gets complicated by taxes, joint ventures, attitudes of governments
and so on. There are four basic approaches to transfer pricing.

• Transfer at cost: few practise this, which recognises foreign affiliates contribute to profitability by operating
domestic scale economies. Prices may be unrealistic so this method is seldom used.

• Transfer at direct cost plus overheads and margin. Similar to that in transfer at cost.

• Transfer at a price derived from end market prices: very useful strategy in which market based transfer
prices and foreign sourcing are used as devices to enter markets too small for supporting local
manufacturers. This gives a valuable foothold.

• Transfer at an "arm's length": this is the price that would have been reached by unrelated parties in a
similar transaction. The problem is identifying a point "arm's length" price for all products other than
commodities. Pricing at "arm's length" for differentiated products results not in a specific price but prices
which fall in a predeterminable range.

Many governments see transfer pricing as a tax evasion policy and have, in recent years, looked more
closely at company returns. Rates of duty encourage the size of the transfer price: the higher the duty rate
the more desirable a lower transfer price. A low income tax creates a pressure to raise the transfer price to
locate income in the low tax setting. Harmonisation of tax rates worldwide may make the intricacies of
transfer pricing obsolete.

Government controls, like cash deposits on importers, give an incentive to minimise the price of the imported
item. Profit transfer rules may apply which restrict the amount of profit transferred out of the country. Other
controls look at monopoly pricing like the case of the British Government against Hoffman-La Roche, forcing
the price of its tranquilisers downwards.

Joint ventures

These present an incentive to transfer price goods at a higher rate than one that would have been used in
transfer pricing goods to their own wholly owned affiliates because the company's share of the joint venture
earnings is less than 100 percent. It is important, therefore, to work out an agreement in advance. The tax
authorities' criteria of "arm's length" prices is probably the most appropriate for joint ventures.

Global pricing
There are three possible global pricing policies - extension (ethnocentric), adaptation (polycentric) and
invention (geocentric).

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Extension

The same global price. A very simple method but does not respond to market sensitivity.

Adaptation

Different prices in different markets. The only control is setting transfer prices within the corporate system. It
prevents problems of arbitrage when the disparities in local market prices exceed the transportation and duty
costs separating markets.

Innovation

A mix of a) and b). This takes cognisance of any unique market factor (s) like costs, competition, income
levels and local marketing strategy. In addition it recognises the fact that headquarters price coordination is
necessary in dealing with international accounts and arbitrage and it systematically seeks to embrace
national experience.

Financing of exports
Financing exports is a major decision area and one of some considerable complexity. Sources of funds can
be both internal and external to the organisation. Internal sources include subsidiaries and transfer within
groups. External sources include the international money markets, factoring, leasing, hire purchase export
credit guarantee schemes etc. A discussion on sources of funds is appropriate in a chapter on pricing as it is
a "cost" which affects the end price and must be accounted for in selling prices.

Internal sources

The subsidiary: Self-funding obviates the need for currency transfers and avoids exchange rate fluctuations.
It also lessens the burden on the parent company. The major problem may be the lack of sufficient funding
which requires parent contribution.

Transfers within group: May take the form of loans, investment capital, material and/or licences.
Remittances back in interest, dividends, etc. will depend on tax liability operating in the host country (see
previous sections). Whilst transfers are a greater risk than internal subsidiary funding they are more flexible
in dates of payment, direction (one subsidiary to another) and type and scale.

External sources

Host country borrowing: Offers two advantages. Firstly it reduces the loss if expropriation occurs and
secondly, interest payments raised locally can be paid out of revenues, leaving only excesses for exposure
to transfer risk.

Export credit schemes and pre and post-shipment support facility: Zimbabwe does not have guarantee
facility. Malawi is in the process of setting one up, so the schemes available are described in the following
sections.

Export credit guarantee facility: The export credit guarantee (ECG) facility contributes to the growth and
diversification of an export base by providing collateral support through guarantees to the banks extending
pre- or post-shipment financing to enterprises for non-traditional export production and sales. The facility will

8
help such exporters to secure financing and the facility will increase confidence among foreign buyers that
exporters can fulfill their contractual commitments as reliable suppliers.

The facility is expected to be financially self-supporting in the long run, which means that the guarantee fee
income will have to cover administration costs and claim payments. In order to fulfill its export development
function, however, certain risks and guarantee losses will be inevitable and will have to be accepted.
Malawi's facility (below) serves as an example of an ECG scheme.

Malawi - Export Credit Guarantee System

Institutional set-up

The implementing and managing agency of the facility would be the Reserve Bank of Malawi (RBM) which,
will develop required administrative services and establish an Export Credit Guarantee Fund (ECGF) to meet
claims and to be credited with guarantee fee payments by participating banks. The facility will maintain
separate accounts from those of the RBM which would be annually audited. A separate accounting system
will support the reputation of RBM's role as a specific guarantee organisation. Periodic management reports
will be prepared on the operations of the facility.

Participating banks are expected to have an important role in the institutional set-up of the facility. They
would not only extend financing to be guaranteed but also maintain suitable records on export credit and
guarantee transactions for monitoring purposes and promote exporters to use the facility. To strengthen the
collaboration, RBM and participating banks will establish an informal Consultative Group for the support of
the operative staff to:

• discuss on-going export credit and guarantee activities

• provide guidance and recommendations to improve the performance of the facility.

The preliminary plan is that the facility be located in the export section of the Exchange Control Department
of the RBM. Currently the section employs five professional staff dealing with export payments. Their know-
how would support the new activities although it is not directly of the kind required to run the facility. The
immediate professional staffing needs of the facility include two senior officers one for supervision of
activities and administration of the ECGF and the other for operations to process guarantee claim
applications. Their organisational and reporting positions should be designed to attract skilled and motivated
individuals to run the facility.

The policies

Risk covered: The RBM credit guarantees will cover the risk of non-payment of exporters to the participating
banks. The principal repayment source for a bank credit will be the export bill but it is the exporter's
responsibility to repay the credit notwithstanding the foreign buyer's payment.

Pre-shipment credit guarantee: The pre-shipment credit guarantee is designed to provide collateral for
bank credit of up to a maximum of 180 days, that is, granted in an amount of up to the domestic
production/processing costs. The validity of the guarantee will always be in accordance with the production
period, that is, from the purchase of inputs until the date of shipment and equal to the duration of the credit.
Because the domestic costs may include refundable duties at shipment, 'it is possible that pre-shipment
credit guarantee needs to be higher than the export price of the product.

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Post-Shipment credit guarantee: The post-shipment credit guarantee is designed to provide collateral to a
bank credit that is granted to refinance the supplier credit extended by the exporter to his foreign buyer. The
maximum amount of credit to be guaranteed is the same as the supplier credit and the maximum guarantee
period 180 days.

Packing/individual credit guarantee: Under the above categories of pre- and post-shipment credit
guarantees, a guarantee limit is usually granted within which individual export transactions of the exporter
are then financed and guaranteed (packing credit guarantee). A guarantee may also be provided without a
pre-established limit against a specific export order to cover pre- and post-shipment advances to the exporter
who occasionally sells abroad (Individual credit guarantee).

It is expected that a guarantee for pre-shipment finance will be more often used than post-shipment
guarantees because the exporter is usually paid under a Letter of Credit. When this is the case the exporter
will not need either post-shipment finance or guarantee coverage.

Eligibility

The primary objective of the facility is to increase production for export. Therefore, the facility will be available
to all types of Malawi exporters of non-traditional products including not only industrial and agricultural
producers but also export merchants and traders. However, to be eligible for the guarantee of the facility
manufacturers have to show that their export products contain at least 30% local value added. Similarly,
export traders have to prove that their products are locally manufactured with a value added as mentioned
above.

Although the facility is designed to complement rather than substitute normal collateral, exports will not be
classified in this regard in order to widen the risk of spreading of the guarantee portfolio so as to strengthen
the self-sustaining nature of the facility.

Guarantee fee

Depending on the risk assessment, the guarantee fee may vary between 1 - 1.5% per annum for pre-
shipment stage and 0.75 -1.24% for post-shipment. The fee is charged on the highest amount outstanding at
any time during the month. In addition to risk assessment the size of the guarantee fee is also dependent on
the operating cost of the facility.

Resource and assessment

RBM will not require any counter-guarantee or collateral from the exporters. However, foreign receivables will
be usually transferred to the benefit of the bank or RBM. RBM reserves the right of recourse to the exporter
to the extent that claims have been paid to a bank due to the default of the exporter. The aim of a recourse to
the exporter is to discourage a solvent exporter escaping his repayment obligations to the bank just because
the bank has secured a guarantee cover for the credit. It is expected that the bank would be inclined to seek
guarantees to cover clients who, in their judgement, are potentially risky. It is therefore important that
sufficient expertise be developed in RBM for its own risk assessment on exporters and their foreign
transactions to minimise guarantee losses.

Export Credit Guarantee Fund

The facility includes an export credit guarantee fund (ECGF) that is needed as a resource base to meet
claims if and when they arise. The creation of the ECGF will also provide assurance that the RBM/Treasury

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is prepared to pay those claims. In addition to claims, the capital income of ECGF may be used for covering
the operating cost in initial stages of exporter's development.

ECGF is composed of the capital itself, guarantee fee income and interest received on investments of ECGF.
It is not expected that the fund would be immediately required for claims, because guarantee liabilities will
accumulate slowly. As for determining its size, the statistical base is vague because commercial banks do
not separate advances to foreign and domestic production of their clients. However, based on the annual
non-traditional exports volume (roughly K100 million) and assumptions on turnover and utilisation of bank
advances it is estimated that K4 million will be sufficient. It would provide a cover for a guarantee portfolio of
K40 million applying a risk ratio of 10 percent.

Pre- and Post-Shipment Support Facility

a) Pre-shipment credit scheme

Objectives

The objective of this facility is to support, through provision of finance:

• exporters who import certain inputs in order to complete manufacture of their exports

• exporters who require working capital in order not to disrupt the production process while awaiting export
proceeds that are due on credit terms.

Because of the export nature of this finance it must be provided on terms more favourable than borrowings
that are purely for domestic consumption. Therefore, all traders and exporters engaged in export business of
any form should be eligible for assistance, particularly the non-traditional exporters.

b) Post-shipment credit

Objectives

The objective of this scheme is to support, through provision of finance, the needs of the exporter during the
period between shipment of goods and receipt of payment from abroad. The need for post-shipment credit
will vary according to the method of payment and nature of goods.

c) Eligibility

Exporters/traders may be eligible for assistance in respect of the following:

• all types of advances

• packing credits
• pre-shipment loans
• post-shipment loans through discounting bills or letters of credit,

for the purpose of purchasing raw materials, manufacture, processing, packaging etc. of firm export orders.

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Donor agencies and foreign investors: Financial institutions like the World Bank, bilateral and multilateral
aid and direct foreign investment can all be useful sources of funds. Projects executed by the Food and
Agriculture Organization (FAO) and other donor agencies can provide "seed" capital or complete capital for
agricultural projects which may yield goods and services for international marketing. Whilst "capital" in this
situation primarily refers to monetary elements, technology, training and management skills are also
important forms of "capital". Credit from foreign distributors or direct foreign investment, or contributions from
donor agencies in production and/or marketing facilities can all play a role in the "initial" take off of
agricultural commodities.

Similarly, in a non-marketing sense, many agricultural products rely upon imported technologies in the form
of seeds, breeding stocks, planting materials, processing plant and so on. Subsequently these inputs may be
produced locally though licensing or direct foreign supplier investment. In the case of Israeli citrus and
Brazilian frozen concentrated orange juice, bilateral or multilateral development did contribute to the
development of production, marketing and/or transport infrastructure (irrigation, port facilities, etc.). Table 9.2
shows the amount of foreign capital and technology in selected commodity systems as an example.

Table 9.2 The amount of foreign capital and technology in commodity system development.

Commodity Production input Finance of production Finance for Other capital or technology
supplies processing transfer
Kenya vegetables Seeds Minor direct investments Minor Private training
Zimbabwe Root stock seeds Major and minor direct Major in sectors Management training/extension
horticulture investments
Israel fresh fruit Seedlings Some direct investments Donor for irrigation and orchard
rehabilitation
Thailand tuna Processing Fishing by foreign Direct investment Management training
equipment vessels
Argentina beef Breeding stock Direct investment Direct investment

Banks:

Banks provide a number of facilities for potential separators and current exporters.

i) Overdrafts and loans

The security for these is the documents of title to the goods, and evidence that goods have been consigned
to, or to the order of, a bank overseas. Until confidence is established, in the event of a default by an
importer, banks will look at the exporter.

ii) Negotiations of outward collections

Financing by a bank of export documents is normally on the understanding that the transaction is with
recourse to the exporter, in the event of a default. Banks tend to ask for irrevocable authorisation enabling
them to dispose of the goods and retain the sale proceeds. Documentary bills for negotiation by banks which
have a subsidiary or branch in the drawer's country may be claimed "exchange as per endorsement". The
negotiating bank pays the face amount of the bill to the drawer, calculates the equivalent foreign currency
amount due on maturity from the drawee, and endorses these details on, say, the Bank of England. So the
drawee receives and the drawee pays in their respective currencies.

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iii) Documentary letters of credit

In some cases there may be provision for pre-shipment finance. By having a "red clause" inserted in a credit
a beneficiary is able to receive advance payments. When issuance drafts are called for, the normal practice
is for the credit to contain terms to the effect that the drafts are to be negotiated to obtain payment as if the
issuance drafts were at sight.

Acceptance and discount facilities are also available.

Government: As well as credit issuance schemes, such as those described in iii), government may also
operate an export reimbursing fund or retention scheme. For example, if an industry earns foreign currency
through exports, a proportion of the earnings may be available for importation of goods and services.

Factoring: Often done by specialist agencies. These assist in debt collection and may also purchase
accounts receivable. Particularly for open account they provide finance of a short term nature.

Forfeiting: This is normally for items of a capital nature or for commodities whose promissory notes or bills
of exchange are availed of. The forfeiting organisation will purchase the guaranteed debts, assuming
complete responsibility, including country risk. Rates of interest are on a fixed basis, offering the exporter
clearly defined funds.

Confirming houses (and export houses): Confirm to the exporter that payment will be made, and to the
importer that delivery will be effected in accordance with the underlying contract. Therefore, they eliminate
much of the risk element inherent in open account trading.

Leasing and hire purchase: Leasing or purchasing on hire often releases the burden of full payment in
advance. It also gives the option or facility to buy later and/or to make sure the item is maintained at no cost.
This could be important where spare parts may be of concern.

International financial markets: Borrowing money outside national boundaries offers a number of
advantages:

• interest rates in a specific currency may be lower in some financial markets than in others
• in country rates are too high or sums insufficiently large enough
• exchange control barriers may exist in country.

Sources of international money (excluding donor funding)

Foreign currency finance: Professional exporters understand how to use foreign currencies in their
costings and negotiations. Foreign currency may be borrowed, or insurance taken out by covering forward.
Exporters are not in the business of currency speculation per se.

Eurocurrency finance: Eurocurrencies are funds of major world currencies owned outside the relevant
national boundaries. They can be borrowed in sizable amounts. Interest rates are often lower than the
borrowing rate for the same domestic currency.

Currency swaps: Negotiations of outward collections and documentary letters of credit may be open to
some but not all firms as they may not have an international credit rating. Currency swaps are a way to gain

13
access to foreign capital at favourable rates. Swaps involve the exchange of debt from one currency to
another. The process is as follows:

"Swaps comprise contracts to exchange cash flows relating to the debt obligations of the two counterparties
to the agreement. Although swaps are contracts between the two parties they do not alter the direct
responsibilities that each party has for the debt obligation it has personally incurred.

"Let us suppose a well respected Zimbabwe company wants to borrow Botswana pula but it is not well
known in Botswana. If there is a company in Botswana wishing to borrow Zim dollars but is unknown in
Zimbabwe, there is the possibility of a swap. If the Zimbabwe company borrowed in Botswana pula it would
have to pay a relatively high interest rate reflecting its poor credit rating. Similarly the Botswana company
would have to pay a relatively high interest rate on its borrowing in Zimbabwe. From an interest rate point of
view it is better that the Botswana company borrows in Botswana pula and the Zimbabwe company borrows
in Zim dollars. The two companies then swap currencies and the payments related thereto. The Zimbabwe
company pays the interest and eventually repays the Botswana loan and vice versa.

"The simplest method of servicing the loans would be for the Zimbabwe company to pay the interest on the
Botswana pula loan and for the Botswana company to pay the interest on the Zimbabwean dollar loan. In fact
each counter party is paying interest on the other's loan as if it were the borrower. They are both in fact
paying lower interest charges than if they themselves had borrowed the currencies they needed.

"The Botswana company has borrowed pula and the Zimbabwe company Zim dollars. They swap the
currencies, the simplest basis being to do so at the spot price at the time of making the deal. When it comes
to repayment, again the easiest method is for the currency to change hands at the spot rate. The Botswana
company has to repay in Botswana pula; the Zimbabwe company makes the appropriate amount of Bots
pula available to the Botswana company by selling Zimbabwe dollars at the spot rate.

"As can be seen.... a currency swap can be construed as a series of forward exchange contracts... The term
(life) of currency swaps can vary. The swap document should clarify the rates of exchange that will be used.
Normally one currency is recorded as the fixed principle amount, with an agreed rate of exchange for
calculating the amounts in the second currency.

"One of the objectives of the currency swap is to take advantage of lower interest rates, another... is to
restructure the currency base of a company's liabilities. If a UK based multinational found that nearly all its
borrowings were in sterling, it would become worried if (sterling) was getting stronger against the currencies
in which it was generating its earning. It might therefore attempt to swap some of it sterling debts into debts
in other currencies. It would be attempting to reduce its risks due to exchange rate exposure. In restructuring
the debts to balance its exchange rate exposure, the company could also take the opportunity to alter the
structure of its interest rate liabilities. If many of its loans were at fixed interest rates and it was believed that
interest rates would fall in the future, it could at the same time as swapping currencies move from fixed rate
obligations to floating rate commitments."1

The problem is that, although the swap is covered by contract, each party remains responsible for the
original loan (principle) it has incurred in its own currency. It is better, therefore, to get an idea what the
balance on exchange might be at the outset and certainly to understand the counterpart.

Currency transactions

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In every currency transaction there are risks which are the effects of currency exchange rate fluctuations on
the realised value of such transfers. Shifts of rates up or down could lead to a bonus or a loss between
sellers and buyers. The purpose of this section is to explore how the exposure to transaction risks affects
prices and can be accounted for.

Risks can be tackled at two levels - policy and individual level.

Policy level

Risks can be reduced by raising in-country finance, by use of internal sources and by anticipating currency
moves, hence allowing the organisation to devise a pricing policy which will balance out wins and losses. By
holding price for a longer period and by balancing out the value of products marketed in foreign countries
with imports or other cash obligations, net exposure is reduced. However, it is difficult to achieve in practice.

Individual transaction level

In currency movements there are risks to buyer and seller. As a supplier there are advantages in operating in
your own currency, because the customer bears the risk. As a buyer, purchasing in exporter's currency you
can accept the transaction risk by waiting to buy the necessary foreign currency at the time of settlement or
alternatively you can try to reduce the risk by entering a forward exchange deal (known as "money market"
cover). These are explained further below.

Pricing and the use of foreign currencies

An organisation which is prepared to quote prices and invoice in the buyer's currency can obtain many
advantages. In the first place it has a marketing attraction because it simplifies the whole transaction for the
buyer, telling him immediately what the cost is to him, and it demonstrates the exporter's efficiency.
Secondly, because most sales are made on credit terms, there is a possible extra profit available by selling
the expected currency receipts on the forward exchange market.

No operation in foreign currency need present any problems as the banks are fully equipped to provide all
the information and facilities required. The London foreign exchange market is the most efficient and
comprehensive in the world. Any foreign currency received in payment of exports can be readily sold through
the exporter's bank.

Forward market: Where credit terms have been given and goods have been sold at a price expressed in
foreign currency, the risk of changes in the exchange rate can be covered by selling the expected currency
forward. All that is necessary is for the exporter to inform his bank that he expects to receive a certain sum in
a foreign currency on such a date and establish with the bank a "forward" contract. The bank will quote NOW
a rate at which it will buy the currency on that date. The exporter thus knows exactly how much of his own
currency he will receive when the payment is made.

The forward rates are quoted in the press daily for the principal currencies, usually for one, two, three and six
months. For some of the major currencies it is possible to get quotations for up to two or three years and in
the case of the US dollar a period of up to eight years has been arranged. The quotations are shown at a
premium or discount to the spot rate.

Where the exporter cannot be certain as to the exact date when he will receive payment an "option forward"
contract can be arranged. The "option" is not whether to proceed or not but merely as to the date of delivery
of the currency. Say, for example, an exporter has sold on 90 day terms but expects a little slippage, he can

15
sell the currency forward for three months fixed option one further month. He may then deliver the currency
any time from the end of three months up to the end of the fourth month.

Exchange risk: London is by far the biggest money market in the world (480 authorised banks compared
with 200 in the US and 100 in Frankfurt/Zurich).

An exporter may see that a profitable deal at today's exchange rates would become unprofitable if there were
a serious shift in the exchange rate before payment was received. Exporters are not in the business of
exchange gambling, they have enough work making profits on exports anyway without running any additional
risk by speculating in exchange.

So how can the exporter eliminate the exchange risk?

i) Invoice in domestic currency. This is the easy way out. Unfortunately all the exporter is doing is to transfer
the exchange problem onto his customer. There may be occasions when it is better to invoice in sterling,
however, and we need to be professional enough to identify these occasions.

ii) Invoice in foreign currency having fixed the rate in advance with the bank. There is a free market in
forward currency contracts. The exporter's bank will quote a price for the date when the export receipts are
expected, and if the deal is worth £20,000 or more, the cost to the exporter for the quote is likely to be
nothing. The bank makes its profit on the differential between its buying and selling prices.

If a foreign currency is at a premium on the forward market, the forward contract with the bank will guarantee
the exporter more sterling than at today's exchange rate. So if the exporter gets a quote from the bank, he
knows how much extra sterling he is due to get when the foreign currency arrives and he can use this
information to his advantage during the negotiation. So professional exporters are advised to keep their eyes
on the forward market.

iii) Invoice in foreign currency, fixing exchange rate on the invoice. Here, obviously the exporter has to take a
view on what will happen to the exchange rate. At least if he uses the forward rate being quoted by the bank
he may be no worse off than if he had contracted forward with the bank. However the customer may well not
like this method.

iv) Borrow foreign currency from a bank, sell in dollars, and repay the loan with the proceeds of the sale. The
cost of this may be less than it would cost the exporter to sell forward a currency which is going to a discount.

v) Offset imports in one currency with exports in the same currency so avoiding the need to change
currencies and risk exchange loss.

Examples of forward rate calculations can be seen in the following case.

Arbitrage: Investments in forward currency are usually financed by borrowing. This means that the decision
to buy forward or to hold foreign currency on deposit will face the organisation with additional cost in terms of
interest charges. It would seek to reduce the risk and reduce the cost of borrowing. This can be done by
involving three currencies, say:

BC = Buyer's currency
SC = Seller's currency
MC = Mediating currency (it is believed it will strengthen against SC in the period)

16
If buying for settlement in the exporter's currency in three months' time

i) Borrow on BC

ii) Convert at spot rate into MC if you expect MC to strengthen against SC

iii) Invest MC to earn interest

iv) On the appropriate date, cash the MC investment (original sum + interest)

v) Convert this into SC - pay the vendor

vi) Apply the residual to meet borrowing and transaction charges (this may necessitate converting the
residual from SC into BC).

The dangers in this are the move into three currencies and the investment of MC. Currencies and
investments may rise and fall.

Case 9.1 Forward Rate Calculation

A British exporter has sold to Germany, on 26 August, goods on 90 day terms and asks his bank to arrange forward
cover. The rate quoted by the bank will be calculated as follows:

On 26 August the bank's spot rate for deutschmark is 4.0025 - 4.0125. 1 month forward is 1.75 - 1.25 pf. Premium 3
months forward is 4.50 - 4 pf. Premium

The exporter will be selling DM to the bank, therefore the bank will apply its buying rate based on spot 4.0125.

The payment is expected in three months time so the bank will calculate on the basis of the three months forward; rate.
4.50 - 4 pf. Premium. The forward rate is at a premium, i.e. dearer in the future, so the rate will be lower and the: premium
deducted from the spot rate. However, the bank is buying, so it will wish to keep the rate as high as possible and will,
therefore, deduct the smaller premium, i.e. 4 pf. The forward rate; quoted would therefore be 4.0125 less 4 pf = 3.9725.

If, on the other hand, the exporter is expecting payment some time during September/October and wishes to cover
forward he will cover one month fixed, option one further month. The one month fixed takes him to 26 September and he
can receive the benefit of the one month premium but, as payment may be received any time between 26 September and
25 October, he cannot receive the benefit of any extra premium for the I second month and so the rate will be 4.0125 less
0.125 pf. = 4.00.

The exporter has also sold goods to Spain on 90 day terms and wishes to cover forward on 26 August.

The bank rates on this date are 226.30-226.50, 1 month forward 3.18-4.25 c. disc, 3 months forward 11.25-13.65 c. disc.

Again, the bank will base the calculation on the spot buying rate of 226.50 and the 3 months forward rate of 11.25-13.65
c. disc.

In this case, however, the forward rate is a discount, i.e. cheaper forward, and therefore the rate will be high and the
discount added to the spot. The bank, wishing to keep a buying rate as high as possible, will add the larger discount, i.e.
13.65 c. The forward rate would, therefore be 226.50 plus 13.65 = 240.15.1

17
If the exporter is expecting payment during September/October he can still only obtain a fixed forward rate for one month,
i.e. to 26 September with an option for a further two months.

As payment may be received any I time from 26 September to 25 October, i.e. three months, and as the forward rates are
at a discount, the bank will take the maximum discount and apply the three month rate.

Currency baskets

Organisations which have to trade in several currencies may seek to reduce transaction risk by adopting a
portfolio or currency basket approach. There are two ways a) holding a basket of currencies or b) using a
currency basket. For example, the UAPTA and the European ECU is a weighted average of member
currencies and so fluctuates less than, say, between two currencies. Basket currencies sometimes reduce
the accounting complexities faced when doing business in different currencies.

Option
Options, hedging and futures market

Whilst options have, to some extent, been covered in the above sections, appendix I goes into much more
detail. The options and futures market is extremely complicated. The option writer is the one who bears the
main risk in the event of negative exchange. The client is taking out a form of insurance and the commission
charged by the option writer (which can be subtracted) is the premium to cover this. Details of the option and
future markets are given in the appendix. It should be noted that few African countries are involved in
options, hedging and future costs.

Spot marketing trading

Many market exchanges are done "on the spot". In such transactions, goods, services or money are
transferred simultaneously between buyer and seller. Trade takes place on goods which have already been
produced and the going price acts as the source of contracts, incentives and other relevant information. Spot
market transactions can occur across several types of markets, including auctions, private treaty, etc.
Auctions act is a "price discovery" mechanism. They are very useful for standard products - flowers, beef and
so on and can give a flexibility to the price mechanism where they may be updated on a regular basis.
Auctions also have very low transaction costs.

Spot market trading has many advantages:

i) It puts constraints on the individual - budgetary and purchasing.

ii) Prices can be adjusted to market conditions almost on the spot, thus giving great flexibility.

iii) The market price system gives incentives - the price automatically adjusts to productive effort or non-
production. If the spot price is high and attractive, new producers may enter the market and be rewarded. If
there are supply differences then the price adjusts upwards also. Of course, the converse happens with
gluts.

iv) It gives information to economies with market prices "summarising" all, or most, of the information on
transactions required to conduct trade.

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Spot market trading is not just an agricultural commodity phenomenon, but can also be seen in industrials
like oil and metals.

Concluding comments
Pricing in international marketing is an extremely complex affair due to the political and economic risks
involved. Yet astute handling of the elements of price can give the organisation an advantage in terms of
currency gains, but this should not be the reason why organisations should get into foreign transactions.

Many agricultural organisations, especially based in developing countries, are mainly price takers. However,
when the added value process begins to gain momentum, then all the elements of international pricing need
to be considered. In all cases it is often good policy to get help from international bodies like banks and
finance houses.

Chapter Summary
The price of a good or service is the value society places on it to obtain it. Pricing decisions on the marketing
mix are compounded when marketing across international boundaries.

Prices are fixed, usually on the basis of cost, competitive or market considerations and may be pitched high
or low, depending on supply/demand and intangible (image) factors. The process of price fixing is
compounded by exchange rate considerations, currency fluctuations, inflation, devaluation or revaluation,
transfer and price escalation considerations. Pre-financing in export is often essential as sellers have often to
bear the costs involved before obtaining the revenue from the sale. Sources vary, including internal and
external sources. In order to make sure that the export system is supported and encouraged, many countries
have an export credit guarantee system which helps reduce the financial risks involved. Other methods of
obtaining revenue in a risk situation are by operating in the futures and options market. However, these are
not as prevalent in less developed countries as in more developed ones.

Key Terms
Currency swaps Hedging Price floor
Devaluation Inflation Purchasing power parity
Exchange rate Market holding price Revaluation
Export credit guarantee fund Option Skimming price
Foreign exchange Penetration price Spot marketing
Forward rates Price ceiling Transfer pricing
Future Price escalation

Review Questions
1. Explain what is meant by "foreign exchange".

2. What are the main methods of export pricing? What are the dangers in attempting to set prices globally?

3. Describe the principle sources of funds available to an exporter.

4. What is the difference between an "option" and a "future"?

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Review Question Answers
1. Foreign exchange

b) External sources

Foreign exchange is currency bought or sold in the foreign exchange market. It is very dynamic. The price of
one currency in any other currency is the result of forces of supply and demand in the foreign exchange
market. If a country sells more than it buys, its currency value will rise and vice versa.

• Host country borrowing

• Export credit schemes and pre and post shipment support
• Banks - overdrafts and loans
• Government

2. Methods of export pricing.

a) Cost plus - the historical accounting cost method and the estimated future cost method

• Factoring
• Forfeiting
• Confirming house

b) Competitive pricing - Pricing based on manufacturing and marketing costs but cognisant of demand and
supply conditions.

• Leasing and hire purchase

• International finance house

c) Market pricing - pricing at "what the market can bear"

• Students can give details of each source.

• Dangers in price setting - price escalation

4. Option

An option is a bilateral contract giving its holder the right, but not the obligation to buy (sell) a specified asset,
at a specified price at or up to a specific date.

• Devaluation and revaluation

• Inflation
• Dumping

Future

A legally binding contract to deliver/take delivery on a specific date of a given quality and quantity of a
commodity at an agreed price. Difference lies in the degree of commitment to delivery and title.

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3. Sources of funds

a) Internal sources

• Transfers within group

• Subsidiary

Exercise 9.1 Exchange rates

The following table provides spot exchange rates on three currencies. Use this information to answer the
questions set out below:

The US dollar spot 10 July

DM 2.4650 - 2.4660
FF 7.3925 - 7.3975
Yen 237.80 - 237.90

a) What is the rate at which a bank will buy DM for dollars?

b) What is the rate at which a bank will sell yen for dollars?

c) If you wish to sell FF 1,000,000 for US dollars on 10 July, how many dollars would you get from the bank?

d) If you wish to sell US$ 1,000,000 for DM on 10 July how many DM would you get from the bank?

e) What are the spreads on the DM, FF, and yen rates?

f) If you sell DM spot for US dollars on 10 July, when will you get value for your dollars?

Exercise 9.2 Forward trading

a) Let us assume that the date is 6 June. If MPL, whose domestic currency is pounds sterling, has to pay its
Swedish suppliers of paper Swedish Krone 500,000 in two months' time on 6 August, does MPL have a
currency exposure problem?

b) MPL has purchased a German printing machine, and has to pay for it in DM in three months' time. Would
the Finance Director of MPL have to buy or sell DM three months forward in order to eliminate any currency
exposure?

c) Assume you have entered into a forward contract with a bank to sell $1,000,000 forward for sterling at a
rate of $1.6540 for value on 6 August. If by the 6 August, the spot rate for dollars/sterling is $1.7560, will you
have benefitted or not from using the forward contract?

d) If a bank's spot (buying) rate for dollars against sterling is $1.5650, and the three month forward rate on
the US dollar is at a premium of 3.50 cents ($0.0350) against the pound, what is the actual three month
forward rate?

21
e) If a bank's spot (buying) rate for DM against the dollar is DM 2.5240, and the three month forward rate on
DM is at a discount of DM 0.0550 against the dollar, what is the three month forward rate?

References
1. Saunders, J. Quoted in P. Smith, "International Marketing", MBA notes, 1990, Hull University, p50.

Bibliography
2. Chalanda, M.S. "Export Financing". In S. Carter (ed.) "Export Procedures" Network and Centre for
Agricultural Marketing Training in Eastern and Southern Africa, August, 1991, pp 113-117.

3. International Institute for Cotton, Liverpool. "Futures and Hedging Trading in Cotton". In Manual on Cotton
Trading Operations. International Trade Centre UNCTAD/GATT, Geneva, 1989, pp 117-130.

4. Keegan, W. "Global Marketing Management", 4th ed. Prentice Hall, 1989.

5. Osborn, I. "Sources of Export Finance". In Manual on Cotton Trading Operations. International Trade
Centre UNCTAD/GATT, Geneva, 1989, pp 170-180.

6. Smith, P. "International Marketing", MBA notes, Hull University, 1990.

7. Straub, W. A "Short Introduction to Exchange Traded Options". In Manual on Cotton Trading Operations.
International Trade Centre UNCTAD/GATT, Geneva, 1989, pp 131-146.

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