Trade risk can be managed in several ways. This section will help you make the best coverage choice for your particular circumstances.
International trade is inherently risky. Unfortunately, there is no perfect way to eliminate all risk. The key is to balance the financial risk posed by your buyers with your own risk tolerance. It's important to remember that even by doing nothing, you still are making a choice! The matrix below helps to compare the availability of some common risk mitigation strategies, along with the pros and cons of each:
|Risk Mitigation Strategy||Availability||Pros||Cons|
|Do nothing||Always available||Easy! Costs zero up front.||Risky. One large loss could threaten the existence of your company.|
|Demand upfront pre-payment from customer||Hard to get…||Fully protects against risk; good way to fund your working capital and raw materials purchase||Very hard to negotiate on these terms--especially with any buyers with whom you actually want to do business!|
|Letters of credit (L/C)||Still widely used, but usage is decreasing||So long as vendor complies with L/C, the bank will pay. So, vendor is taking 'bank risk' rather than 'buyer risk'||Difficult to work with! Discrepancies slow things down and make L/Cs time consuming and 'risky'. Buyer's credit lines are occupied, and there are costs for all parties.|
|Documentary collections (CAD, D/P, D/A, or TT copy docs)||Still widely used, but usage is decreasing||Better control of goods during transaction||With CAD (D/P) transactions--buyers can 'play games' or just not pick up goods at port. With D/A, buyer can still go bankrupt--bank does not take the risk, you do!|
|A/R insurance (goverment or private market)||Semi-available||A/R insurance is ideal when trying to protect against unforeseen, low-probability, catastrophic defaults across a large, diversified, low-risk set of customers.||Only available on low- and medium-risk customers; insurer wants to insure all your sales; only small limits typically approved; can be cancelled if buyer credit deteriorates!|
- How are A/R put options priced?
- How much would an A/R put option cost for your specific circumstances?
- How can A/R put options be used to confidently sell to a customer with declining credit?
- How can A/R put options be used to protect your A/R from customer bankruptcy?