Question

q1. Bonds or standby letters of credit are an important feature of international business. Identify and explain each type of bond and describe the advantages and disadvantages of each for both parties in an international trade transaction. Identify one major risk for an exporter who might issue a bond. Is there a way to mitigate against this

q2. Define the characteristics of a Documentary Collections compared to a Letter of Credit. Explain the risk implications for a Documentary Collections compared to a Letter of Credit for each commercial party in an international trade transaction.

Answer 1

Standby letter of credit: It’s a financial instrument being used for many years by international traders to safeguard their financial interests. It’s a document issued by a bank to a third party beneficiary which serves as a guarantee in which bank is responsible to pay the beneficiary if business stops its operations or is unable to pay its vendors & investors. It is a type of guarantee than a payment instrument in case of a default. It is similar to a letter of credit but with different objectives & required documents. In stand by letter of credit issuing bank will pay in case of a default by the buyer.

Bond: A guarantor (normally a bank or insurance company) issues a bond on behalf of an exporter. It is a guarantee to the buyer that exporter will fulfill his contractual obligations & if he fails to fulfill obligations bank or insurance company will pay a sum of money to the buyer. Since in international trade it is difficult to gage the professional & financial stability of seller, so buyers require a guarantee that seller is able to fulfill his commitment. Bonds provide a purchaser the security of a guarantee in case of failure by seller when he fails to meet contractual obligations.

There are several types of bonds used in international trade.

1) Bid or tender bond: The purpose of this type of bond is to guarantee that contract will be fulfilled if it’s awarded. It protects the importer from any loss if the exporter fails to sign the contract after it is awarded. If a tender is accepted the bid or tender bond is normally replaced by a performance bond. Here buyer becomes confident that seller is financially able to enter into an agreement. It’s normally 2% to 5% of contract value.

2) Performance bond: This is one of the most commonly used guarantee by international traders. Performance bond guarantees that a product will be of certain quality & standard & if it is not as per standard a penalty will be applicable. It is normally issued by a bank or insurance company to guarantee satisfactory completion of a contract. It comes in place after cancellation of bid or tender bond. The validity term is for full amount until the complete execution of contract.

3) Advance payment bonds: Advance payment bonds are used to protect buyers in case of any advance payments to seller if goods or services are unsatisfactory.

4) Warranty or maintenance bonds: This a type of guarantee that seller will maintain the equipment performance satisfactorily for a specific maintenance or warranty period.