Hold the buyer's terms fixed, then price each route as financing, fees and expected loss. On fees alone open account always wins, and that is the wrong test.
Open account, unless the buyer is risky. On an illustrative 4,200,000 export order with 90 days of buyer credit held on every route, open account costs 182,974 all in and a confirmed letter of credit discounted at presentation 201,406. The confirmed credit only wins once the buyer's one-year default probability exceeds 6.35 per cent; at the case's 4.10 per cent, insured open account is the cheapest route at 178,040.
Worked in full in Trade Finance by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The comparison is usually made on fees, and on fees open account always wins because it has none. But each route also finances a different number of days and leaves a different loss behind. The fair test holds the buyer's terms fixed at 90 days, so that only the instrument moves, and prices three things on every row: financing of the exporter's cost until cash arrives, bank and insurance charges, and the expected loss.
| Input | Value |
|---|---|
| Contract value / cost of goods sold financed | 4,200,000 / 3,423,000 |
| Operating margin before finance | 306,600 |
| Production / transit / shipment to presentation, days | 70 / 26 / 9 |
| Buyer credit, held on every route | 90 days |
| Exporter's cost of funds, actual/360 | 8.4% |
| Buyer one-year default probability / loss given default | 4.1% / 62% |
| Issuing bank / country event, one year | 1.35% / 1.8% |
| Confirmation a year / discount a year, on the face | 1.85% / 6.9% |
| Credit insurance premium / cover | 0.62% / 90% |
| First presentations refused / refusals waived | 62% / 94% |
Financing = 3,423,000 × 8.4% × days to cash ÷ 360
Expected loss = 4,200,000 × [1 − (1 − annual PD)exposure days ÷ 365] × 62%
Total cost = financing + fees + expected loss; margin after finance = 306,600 − total
In Excel, per route: =Cost*CoF*Days/360+Fees+V*(1-(1-PD)^(Exp/365))*LGD
| Route | Days to cash | Financing | Fees | Expected loss | Total cost | Margin after |
|---|---|---|---|---|---|---|
| Open account, insured | 186 | 148,558 | 26,040 | 3,442 | 178,040 | 128,560 |
| Open account | 186 | 148,558 | 0 | 34,416 | 182,974 | 123,626 |
| Confirmed LC, discounted | 116.82 | 93,304 | 106,449 | 1,652 | 201,406 | 105,194 |
| Unconfirmed LC, held | 206.82 | 165,187 | 7,020 | 32,976 | 205,183 | 101,417 |
The confirmed credit removes 32,764 of expected loss against plain open account and saves 55,254 of financing by paying 69.18 days earlier. It still ends 18,431 dearer, because the discount and the confirmation together cost more than both savings. The unconfirmed credit is the worst of the four: it adds 20.82 days to cash and swaps the buyer's risk for a bank-and-country risk of almost the same size.
| Buyer PD | Open account | Insured | Unconfirmed LC | Confirmed LC |
|---|---|---|---|---|
| 1.0% | 156,862 | 175,429 | 203,544 | 200,153 |
| 2.0% | 165,224 | 176,265 | 204,070 | 200,554 |
| 4.1% | 182,974 | 178,040 | 205,183 | 201,406 |
| 6.0% | 199,264 | 179,669 | 206,199 | 202,185 |
| 8.0% | 216,656 | 181,408 | 207,280 | 203,016 |
| 10.0% | 234,308 | 183,173 | 208,371 | 203,858 |
Plain open account becomes dearer than the confirmed credit at a buyer default probability of 6.35 per cent, and dearer than the unconfirmed credit at 6.85 per cent. Below a 3.45 per cent default probability plain open account is the cheapest route of all; above it, insured open account is, but only because the premium is held at 0.62 per cent: an insurer would reprice a buyer at 8 per cent, or decline it, long before the exporter could rely on that row. Where cover is refused, the confirmed credit is the instrument for a weak buyer.
The insurance side of the comparison is worked in whether trade credit insurance is worth the premium, and the confirmation decision in whether a confirmation fee is worth paying.
Price each route as financing plus fees plus expected loss, at the same buyer terms. On this order: insured open account 178,040, open account 182,974, confirmed credit 201,406. The credit is worth its cost only above a 6.35 per cent buyer default probability, or where insurance is unavailable. All six routes, at held and at natural terms, are live formulas in the free workbooks for this order.
A confirmed credit is: on the illustrative 4,200,000 order it cuts expected loss from 34,416 to 1,652. An unconfirmed credit swaps the buyer's risk for the issuing bank's and the country's, 30,813 of expected loss plus 2,162 from refused documents, and it takes 20.82 days longer to pay.
When the buyer's risk is high enough that the loss avoided exceeds the cost of the credit, or when credit insurance is unavailable. On the illustrative order a confirmed, discounted credit costs 18,431 more than open account at a 4.1 per cent buyer default probability and breaks even at 6.35 per cent.
Because the bank's discount is charged on the whole invoice while the exporter's own financing is charged only on its cost. Paying 69.18 days earlier saves 55,254 of financing, but the 72,450 discount and 26,979 confirmation outweigh that and the 32,764 of loss removed.
This article is one calculation from Trade Finance. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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