Letter of Credit

Definition

A letter of credit is a document issued by a bank that guarantees payment to a seller upon presentation of documents that conform to the letter's terms and conditions. It serves as a means of facilitating international trade by providing security for both the buyer and the seller.

5 Must Know Facts For Your Next Test

1. A letter of credit is a common method of payment in international trade transactions, as it reduces the risk for both the buyer and the seller.
2. The bank that issues the letter of credit is known as the issuing bank, and the bank that confirms the letter of credit is known as the confirming bank.
3. The seller, known as the beneficiary, must present the required documents to the bank in order to receive payment, ensuring that the terms of the transaction have been met.
4. Letters of credit are often used in situations where the buyer and seller do not have a long-standing relationship or where there is a high level of uncertainty about the buyer's ability to pay.
5. The use of a letter of credit can help to mitigate the risk of non-payment, as the bank's guarantee of payment provides a level of security for the seller.

Review Questions

• Explain how a letter of credit facilitates international trade transactions.
  • A letter of credit facilitates international trade transactions by providing security for both the buyer and the seller. The issuing bank guarantees payment to the seller upon presentation of the required documents, reducing the risk of non-payment for the seller. This allows the seller to have confidence in the transaction and be more willing to extend credit to the buyer, who may be located in a different country and have a less established relationship. The letter of credit also protects the buyer by ensuring that the seller fulfills the terms of the transaction before receiving payment.
• Describe the role of the issuing bank and the confirming bank in a letter of credit transaction.
  • In a letter of credit transaction, the issuing bank is the bank that issues the letter of credit on behalf of the buyer. The issuing bank is responsible for evaluating the creditworthiness of the buyer and determining the terms and conditions of the letter of credit. The confirming bank, on the other hand, is the bank that confirms the letter of credit on behalf of the seller. The confirming bank verifies that the documents presented by the seller conform to the terms of the letter of credit and guarantees payment to the seller. The involvement of these two banks helps to mitigate the risk for both parties in the transaction.
• Analyze the advantages and disadvantages of using a letter of credit in international trade transactions compared to other payment methods.
  • The primary advantage of using a letter of credit in international trade transactions is the increased security it provides for both the buyer and the seller. The buyer is protected from the risk of non-delivery of goods, while the seller is protected from the risk of non-payment. This can be particularly beneficial in situations where the parties have a limited relationship or there is a high level of uncertainty about the buyer's ability to pay. However, the use of a letter of credit also comes with some disadvantages, such as the additional fees charged by the banks involved and the complexity of the process, which can be time-consuming and require specialized expertise. Additionally, the seller may be required to provide extensive documentation to receive payment, which can be a burden. Overall, the decision to use a letter of credit should be weighed against the specific needs and risks of the transaction.

Related terms

Trade Credit: Trade credit refers to the credit extended by a seller to a buyer, allowing the buyer to pay for goods or services at a later date, typically 30-90 days after delivery.

Irrevocable Letter of Credit: An irrevocable letter of credit is a type of letter of credit that cannot be modified or canceled without the consent of all parties involved, providing a higher level of security for the seller.

Documentary Letter of Credit: A documentary letter of credit is a type of letter of credit that requires the presentation of specific documents, such as a bill of lading, invoice, and insurance certificate, to trigger payment.