Page 375 - F1 Integrated Workbook STUDENT 2018

Short term finance and investments

1.6 Documentary credits (irrevocable letters of credit)

Trading between other countries, can be complex, particularly when it will take a
considerable time to ship the goods from the exporter’s country to the importer. The
exporter might want payment as soon as possible, but the importer needs to be
satisfied before paying, that the exporter has complied with the terms of the sale
agreement.

The problem of guaranteeing payment can be overcome by using an irrevocable
letter of credit, also called an irrevocable documentary credit. A letter of credit is an
undertaking given by its issuer that payment will be guaranteed for the exporter,
provided that the exporter complies with certain specific requirements within a
specified time limit.

A letter of credit is a document, issued by a bank on behalf of a customer, authorising
a person to draw money to a specified amount from its branches or correspondents,
usually in another country, when the conditions set out in the document have been
met.

1.7 A bill of exchange

A bill of exchange is a negotiable instrument, drawn by one party on another, for
example, by a supplier of goods on a customer, who by accepting (signing) the bill,
acknowledges the debt, which may be payable immediately (a sight draft) or at some
future date (a time draft). The holder of the bill can thereafter use an accepted time
draft to pay a debt to a third party, or can discount it to raise cash.

The drawer and the payee are often the same person. A bill of exchange might be a
sight bill, which is payable immediately, but bills used for export finance are term
bills, which are payable at a specified future date.

A significant characteristic of bills of exchange is that:

 the drawee is given a period of credit before having to pay a term bill, but

 the drawer or payee can obtain payment earlier than the bill’s maturity date, by
means of discounting the bill.

When a bill is discounted, it is sold in the financial markets at a discount to face
value. The size of the discount reflects the rate of interest that the buyer of the bill
requires from holding the bill to maturity.

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