Question

Explain what a letter of credit (L/C) is, who the principle parties are, what the principle advantage is, and how the L/C facilitates international trade.

Answer 1

A letter of credit is a guarantee given by the buyer’s bank that the payment will be made in time to the seller for the correct amount. If the buyer does not make the payment, the bank will be required to make the remaining payment on the transaction.

Following are the parties involved:

1: Applicant: this is the buyer in the transaction.

2: beneficiary: this is the person in whose favor, the letter of credit is drawn. He is the seller in the transaction.

3: issuing bank: this is the bank which examines the proposal and opens the letter of credit.

4: negotiating bank: this is the bank which is nominated by the issuing bank for accepting documents and dispersing payment to the beneficiary.

The main advantage of the letter of credit is that it significantly reduces the risk of default in transactions, especially international transactions. In international transactions, it is difficult for the parties to trust each other due to the distance involved and differences in culture. Letters of credit ensure that payment will be received by the seller. It also facilitates financing in the period between the shipment of the goods and receipt of payment. It is beneficial to the buyer since the buyer can demonstrate his solvency by issuing the letter of credit.