Letters of credit

Definition

A letter of credit is a financial document issued by a bank that guarantees a buyer's payment to a seller, provided that the seller meets specific conditions outlined in the letter. This instrument is crucial in international trade as it reduces risks associated with cross-border transactions, ensuring that both parties fulfill their contractual obligations.

5 Must Know Facts For Your Next Test

1. Letters of credit serve as a vital risk management tool in international trade, providing assurance to sellers that they will receive payment as long as they comply with the terms outlined.
2. There are different types of letters of credit, such as irrevocable and revocable, with irrevocable letters being more common because they cannot be altered without agreement from all parties involved.
3. The use of letters of credit helps to build trust between trading partners who may not have established relationships or operating procedures, facilitating smoother transactions.
4. Banks usually charge fees for issuing letters of credit, which can vary based on factors such as transaction size and complexity, but these costs are often considered worthwhile for the security they provide.
5. In case of disputes over the fulfillment of conditions, banks act only on the documents presented and do not involve themselves in the underlying contract between buyer and seller.

Review Questions

• How do letters of credit function as a risk management tool in international trade?
  • Letters of credit function as a risk management tool by providing a guarantee from the bank that payment will be made to the seller upon meeting specified conditions. This assurance minimizes the risk for sellers, especially when dealing with unfamiliar buyers across borders. By requiring specific documentation before releasing funds, banks ensure that both parties adhere to their contractual obligations, fostering a secure trading environment.
• Compare and contrast irrevocable and revocable letters of credit in terms of their implications for international trade transactions.
  • Irrevocable letters of credit cannot be changed or canceled without the consent of all parties involved, providing a higher level of security for sellers. In contrast, revocable letters can be modified or canceled by the buyer without notice, which may leave sellers vulnerable to last-minute changes. In international trade, sellers generally prefer irrevocable letters due to their stability and assurance of payment, making them more reliable in mitigating risks.
• Evaluate the impact of letters of credit on building trust between international trading partners and facilitating global commerce.
  • Letters of credit significantly impact trust-building between international trading partners by providing a structured mechanism for ensuring payment and compliance with contractual terms. They allow traders to engage with new partners without fear of non-payment, creating an environment where businesses can confidently expand into global markets. By enhancing security in transactions and reducing uncertainties, letters of credit facilitate global commerce and foster economic growth through increased cross-border trade.

Related terms

Bill of Lading: A document issued by a carrier to acknowledge receipt of cargo for shipment, serving as a contract between the shipper and carrier.

Trade Finance: The financing of international trade transactions, which includes various financial instruments like letters of credit, aimed at mitigating risks for both buyers and sellers.

Documentary Credit: Another term for letters of credit, emphasizing the requirement for documentation proving that goods have been shipped or services rendered before payment is made.