Explain how the use of a letter of credit in an international transaction reduces the risk...

Explain how the use of a letter of credit in an international transaction reduces the risk for a seller. In your answer, describe two factors which may increase the cost of a letter of credit for the buyer.

Expert Solution

In case of international trade, the seller undertakes more risk as the buyer is from different country. He may not know the buyer personally, there are different laws in other countries. Due to all these risks the seller needs protection against the risks. A letter of credit works as a protection against the risk of non payment for the seller.

It is a letter from bank of the buyer's country that provides guarantee of buyer's payment to the seller on time. In case if the buyer fails to pay the seller the bank will pay. It serves as the guarantee of payment to the seller, hence it reduces the risk for the seller.

Two factors which may increase the cost of a letter of credit for the buyer are as follows-

--> One of the major factor which will impact the cost of letter of credit is the credit rating of the buyer. Credit rating is impacted by the default rate of the buyer. If the credit rating of the buyer is low, the cost will be high as it will increase the risk of the bank providing the guarantee.

--> The other factor which will impact the cost of letter of credit is the amount of purchase. If the amount of purchase is high/ the bank has to guarantee huge amount of money, it will increase the risk for the bank which will increase the cost of letter of credit.

Hope it clarifies!

jeff jeffy answered 1 year ago

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