10.9.1-RISK AND THE RELATION TO TRADE CREDIT-DOCUMENTARY CREDIT
Letters of credit can serve a dual purpose:
A guarantee of payment once shipment has been made, to reduce the exporter's credit risk.
A means of advancing credit to an exporter, enabling goods to be bought and shipped.
In the first instance the exporter is paid against submission of the complete and correct set of shipping documents as stipulated in the letter of credit (L/C):
the documentary credit
. This is a guarantee of payment once shipment has been made. It is not a specifically designed instrument to enable one to raise credit although occasionally banks may accept documentary credits as a form of collateral.
Documentary credits include:
Sight letter of credit
: payable on first sight (presentation) of the documents to the bank.
Usance or time letter of credit
: payable after a certain period has elapsed.
In addition there is the
performance or bid letter of credit
, whose value is forfeited if the party concerned fails to perform (i.e. does not deliver, or does not establish the requisite documentary letter of credit). These are sometimes used for large, long-term supply contracts or in conjunction with tenders (a form of bid bond). For more on using documentary letters of credit see also Section 04, Contracts.
: Here the letter of credit becomes a means of raising credit. The buyer or (more likely) a bank agrees to release funds whenever an agreed set of circumstances arises and certain pre-conditions are met. In this category there are three main types of letters of credit. See 10.09.02, 10.09.03 and 10.09.04.
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