Question

Briefly discuss what you understand about letters of credit, bonds, guarantees and
insurance in the context of trade finance.

Answer 1

Letter of Credit: A document sent by importer or buyer's bank to the exporter or seller that the he will receive a payment on the behalf of the buyer on time and full amount. This document act as a guarantee and gives an advantage to the seller if he doesn't trust the credibility of the buyer.It is generally a trade financing technique used in international trade mainly. Bank involves in this process charges some amount of fees for rendering this service to the importer. If the importer is unable to fulfill the payment obligation towards the seller then bank will give the full payment to the exporter or seller. It lowers the risk of the international trade as Letter of Credit is a binding document.

Bonds: It is a debt security issued by a borrower and purchased by an investor. It is usually a long-term financing technique used by many firms. Debtholders or creditors are the owner of the bonds. It is a document having fixed interest payment and it also includes an end date when the principal amount is due. The price of bonds is negatively related to the interest rate which means when the interest rate declines then the price of bonds will rise and vice-versa. Bonds are commonly used by governments and corporations in order to borrow money. Government and corporate bonds usually traded publicly and other bonds are traded through Over-the-counter or privately.

Guarantees: It provides protection to the buyer and seller overall the phase of the transaction. It ensures that both parties fulfill their contractual obligation like payments or delivery of goods or services. It ensures that proper compensation should be paid when the situation arises. It is a kind of promise to make payment to the third party. This also proves the creditworthiness of the companies. It will boost up confidence in the relationship between buyer and seller. Usually, bank guarantees are given in the context of trade finance. There are different types of bank guarantees such as:

Payment guarantee
Custom guarantee
Tender guarantee
Advance payment guarantee
performance guarantee

etc.

Insurance: It protects an exporter against the risk of non-payment by the importer by giving the exporter the assurance that the payment will be made to the exporter if the importer is unable to pay. It covers from the non-payment and also from unforeseen events that could occur in international trade. When the exporter is insured then he can increase export sales, can establish market share in developing countries, and also enhances the competition ability of the exporter.