Definition
A Letter of Credit (L/C) is a financial instrument issued by a bank on behalf of a buyer, guaranteeing that the seller will receive the agreed payment amount under specific conditions. This instrument is widely used in international trade to mitigate risks for the seller, as the bank commits to covering the payment if the buyer is unable to fulfill the contractual obligation.
Examples
- Export/Import Transactions: A US-based company enters into a contract with a manufacturer in China. The US company requests their bank to issue a Letter of Credit in favor of the Chinese manufacturer to assure payment upon shipment of goods.
- Construction Projects: A contractor is required by their client to obtain a Letter of Credit from their bank. This ensures the client that funds are available for the contractor to complete the project.
- Performance Bonds: In the event that a service provider needs to guarantee their performance about certain service levels, a Letter of Credit serves as a financial assurance to the client.
Frequently Asked Questions
What are the different types of Letters of Credit?
- Revocable and Irrevocable L/C: Whether the terms of the L/C can be modified or cancelled without the beneficiary’s consent.
- Confirmed and Unconfirmed L/C: Whether an additional bank, typically in the beneficiary’s country, adds its guarantee to the issuing bank’s L/C.
- Sight and Time L/C: Specifies whether payment is to be made immediately upon presentation of documents (sight) or after a specified period (time).
How does a Letter of Credit mitigate risk for the seller?
The issuing bank’s guarantee replaces the credit risk of the buyer with that of the bank, ensuring that the seller will receive payment as long as they comply with the terms set in the L/C.
What documents are typically required to be presented under a Letter of Credit?
Common documents include a commercial invoice, bill of lading, packing list, certificate of origin, and sometimes insurance certificates.
Who are the parties involved in a Letter of Credit transaction?
- Applicant: The buyer who requests the issuance of the L/C.
- Beneficiary: The seller or exporter entitled to payment under the L/C.
- Issuing Bank: The bank that issues the L/C at the request of the applicant.
- Advising/Confirming Bank: The bank that may add its own guarantee to the L/C and facilitate its communication.
How is a Letter of Credit different from other payment methods like wire transfer or open account?
A Letter of Credit provides a higher level of security compared to wire transfers or open accounts because it involves a bank’s undertaking to ensure payment, reducing the risk for both parties in the transaction.
Related Terms
- Bill of Lading: A document issued by a carrier acknowledging that goods have been received for shipment.
- Standby Letter of Credit (SBLC): A guarantee that a bank will cover payment if the applicant fails to fulfill their contractual obligations.
- Documentary Collection: A method where the seller instructs their bank to forward documents to the buyer’s bank with a request to release the documents to the buyer against payment or acceptance.
- Trade Finance: Financial products and services that support the financing of international trade transactions.
Online References
- Investopedia - Letter of Credit
- Wikipedia - Letter of Credit
- International Chamber of Commerce (ICC) - FAQs on Documentary Credits
Suggested Books for Further Studies
- “Letters of Credit: Theory and Practice” by Matt Penarcic
- “Uniform Customs and Practice for Documentary Credits (UCP 600)” by the International Chamber of Commerce
- “The Law of Letters of Credit and Bank Guarantees” by Agasha Mugasha
Fundamentals of Letter of Credit: International Business Basics Quiz
### What primary purpose does a Letter of Credit serve in international trade?
- [x] To mitigate the risk to the seller by substituting the bank's credit for the buyer’s
- [ ] To ensure the seller can retain ownership of goods
- [ ] To encourage lower pricing in international contracts
- [ ] To bypass the payment of taxes and tariffs
> **Explanation:** A Letter of Credit serves to mitigate the risk to the seller by substituting the buyer's obligation with the bank's undertaking to guarantee payment.
### Who requests the issuance of a Letter of Credit?
- [ ] The seller (beneficiary)
- [ ] The advising bank
- [x] The buyer (applicant)
- [ ] The confirming bank
> **Explanation:** The buyer, known as the applicant, requests their bank to issue a Letter of Credit in favor of the seller.
### Which type of Letter of Credit cannot be modified or canceled without the consent of the beneficiary?
- [x] Irrevocable L/C
- [ ] Revocable L/C
- [ ] Confirmed L/C
- [ ] Unconfirmed L/C
> **Explanation:** An Irrevocable Letter of Credit cannot be modified or canceled without the consent of the beneficiary.
### What document issued by a carrier acknowledges that goods have been received for shipment?
- [ ] Commercial Invoice
- [x] Bill of Lading
- [ ] Certificate of Origin
- [ ] Packing List
> **Explanation:** A Bill of Lading is issued by a carrier to acknowledge that the goods have been received for shipment and is often required in L/C transactions.
### Who is responsible for adding an additional guarantee to the Letter of Credit, typically in the country of the beneficiary?
- [ ] The issuing bank
- [x] The confirming bank
- [ ] The applicant
- [ ] The advising bank
> **Explanation:** The confirming bank adds an additional guarantee to the Letter of Credit, providing extra assurance to the beneficiary.
### What is a Standby Letter of Credit (SBLC) used for?
- [ ] To finance short-term trade
- [x] To cover payment in case the applicant fails to fulfill contractual obligations
- [ ] To facilitate immediate payment upon document presentation
- [ ] To reduce the cost of export goods
> **Explanation:** A Standby Letter of Credit (SBLC) is used to guarantee payment in case the applicant fails to meet their contractual obligations.
### Which party holds the financial risk in an open account payment method?
- [ ] The issuing bank
- [ ] The confirming bank
- [x] The seller
- [ ] The advising bank
> **Explanation:** In an open account payment method, the seller holds the financial risk, as payment is made after goods are shipped and received by the buyer.
### How does a Documentary Collection differ from a Letter of Credit?
- [ ] It eliminates all risks for the buyer.
- [ ] It always involves a third-party insurance company.
- [x] It uses the seller's bank to collect payment only upon document acceptance.
- [ ] It ensures immediate payment upon documentation presentation.
> **Explanation:** A Documentary Collection involves using the seller's bank to collect payment upon the buyer's acceptance of the documents, as opposed to guaranteeing payment like a Letter of Credit.
### What major global organization provides the standardized practices for Letters of Credit?
- [ ] World Bank
- [ ] International Monetary Fund (IMF)
- [x] International Chamber of Commerce (ICC)
- [ ] United Nations
> **Explanation:** The International Chamber of Commerce (ICC) provides standardized practices, including the Uniform Customs and Practice for Documentary Credits (UCP 600), governing Letters of Credit.
### Which option constitutes a sight payment under a Letter of Credit?
- [ ] Payment after a 90-day period
- [ ] Payment upon project completion
- [x] Payment immediately upon presentation of required documents
- [ ] Payment upon product inspection
> **Explanation:** A sight payment under a Letter of Credit is made immediately upon presentation and verification of the required documents.
Thank you for exploring Letter of Credit concepts and engaging with our Quiz! Keep honing your skills in international trade and finance.
